Great returns but greater risk: 7 mistakes to avoid while investing in smallcaps

The exuberant returns raked in by small-caps in 2023 have left several investors looking at the space as their shot to success in investing. But truth be told, investing in small caps will not double your money in 21 days like Hera Pheri's famous Laxmi Chit Fund. Brewing such dreams will sink you deep into losses.

Money managers swear by three mantras as the stepping stones when it comes to small-cap investments - time the entry, give it ample time to grow, and build a risk appetite to sail through seasonal pitfalls.

Sandeep Raina, EVP - Research at Nuvama Professional Clients Group, said that with the higher returns, small caps also demand a higher risk, which requires investors to be more judicious with their investment analysis.

Sham Chandak, Head of Institutional Broking at Elios Financial Services, also agrees as he believes that the performance of small-cap stocks is cyclical, not perennial. Accordingly, he suggests investors identify the sectors and themes which are in favour due to macro, regulatory, geo-political or other factors which will help them target better entry points.

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In addition, Raina also believes that one should enter the small cap space when they have developed a risk appetite big enough to deal with the shocks of volatility which is a common occurrence in most small-cap stocks. Hence, he believes going long term with a focus of at least a year becomes an anchor for investors to safeguard their wealth.

Going full throttle from day one

Exuberance can often be blinding and hence the lure of solid returns, a trend seen across most small-caps in 2023 often motivates new investors to go big in the hunger for reaping stellar gains. For money managers though, going full throttle on small-caps from day one is a big red flag.

With such a steep rally in the background which cautions profit booking ahead, low float, and high volatility often attached with small caps, taking the risk of investing your entire capital on the segment is a big mistake. Amit Kumar Gupta, Founder of Fintrekk Capital suggests investors test the water by investing around a third of their total allocations. If the growth prospects and cyclical tailwinds remain intact, investments can be ramped up gradually over time.

Equating PE with valuations

Most investors consider a company's price-to-equity (PE) ratio as the ultimate testament of its valuation with regards to its peers. However, the case might be slightly different for small-caps as the segment houses stocks across a multitude of sectors, categories and niche businesses. With a lack of or very few peers to compare with, relying solely on PE to determine valuations can often be misleading.

Raina suggests looking into the company's long-term growth trajectory along with other factors like opportunity size, growth prospects, margin performance and ROCE (Return on Capital Employed) as major parameters to assert reasonable valuations for a particular business.

Gupta also believes that one should not pay so much attention to PE in small-caps but rather look at their growth prospects and cyclical tailwinds. "Since small caps are generally a very cyclical segment, a good strategy would be to invest in businesses when they are at the low end of the cycle," he added.

Sluggish research

Investing in small caps requires one to scratch beneath the surface with extensive research and due diligence. Since many small-cap participants operate in small and niche segments, thorough due diligence becomes imperative in understanding the company's financials, goals and growth trajectory.

According to Chandak, one must read the annual reports and investor calls of at least two years to understand the business, revenue mix, factors impacting top line and margins, competitive landscape, regulatory environment, management commentary and their actions.

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While this is indeed time consuming, one has to do this drill to get hold of the company. The way the company presents information, its financial disclosures, and management discussion should also give a feel of how open the management is and how sound its growth strategy is. The management talk, of course, also needs to be mapped to the performance. Does the management commentary corroborate the performance quarter-after-quarter? "Filter out the risky and uncertain ones. One should also filter out small-cap companies that have uncomfortably high debt, do not generate any free cash flows, have contracting growth rates and margins, and operate in a hyper-competitive sector," he added.

Ignoring the big money guys

Since doing such extensive research on a small-cap company is a tedious task, a good way to spot quality stocks is to look for pockets where institutional investors are buying. These big guys are financially more informed and have access to interact with the managements of most of these small-cap companies. "If there is no institutional investor in the shareholding pattern of a small-cap company, there is most likely a reason behind it," Chandak said. The prospect of identifying a multi-bagger yourself that institutions will latch on to later may sound great, but you need to have the rigour and wherewithal to do a high degree of research.

One size fits all

Businesses in the small-cap segment are spread across a wider expanse of categories than large-caps. This means that one has to approach valuations, investment rationales and growth analysis on a company-to-company basis.

Avoid using the same set of strategies to analyse businesses belonging to different categories. Raina also suggests avoiding stocks that belong to complex and niche categories as understanding the business model, revenue mix and growth prospects in such cases becomes tricky due to the lack of options available for comparison.

Going for low free float counters

Investing in small-cap stocks with low free float is a trap. Veteran Fund Manager, Pankaj Tibrewal, explains that when the free float is low, shares are in the hands of very few investors and that may give a false sense of the stock going up but it may not be the correct way of looking at it. That is because, at some point in time, the company needs to dilute or offer equity shares to comply with regulatory norms, he added. Also, fewer investors involved in a counter limits the chances of exiting the stock even if prices fall beyond one's risk threshold.

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