Investors have to accept governance risk in small-caps, says Shankar Sharma

One of Shankar Sharma's investments - Brightcom - has also been in the eye of the storm due to accounting lapses

Investors can’t avoid governance issues in small-caps and they should accept losses as part of an occupational hazard, said ace smallcap investor Shankar Sharma. In an exclusive interview with Moneycontrol, Sharma also shared his checklist to minimize the risk.

“Companies have to go through a cycle of misgovernance to improve governance. We as minority investors don’t know what the company does behind the scenes even auditors get fooled,” said Sharma.

Giving the example of the Worldcom and Enron scandals, Sharma explained that not just small-caps but even large-cap companies are not risk-free.

US-based, WorldCom Inc. collapsed in 2002, following revelations of an $11 billion accounting fraud that was then the largest in US history. The fraud included pressure by top executives on subordinates to inflate numbers to make the company seem more profitable.

Also Read: Shankar Sharma's 4 AM strategy, Brightcom blueprint and lessons learnt from bad bets

“Enron and WorldCom were not tiny companies, they were held by marquee investors. They had audits, like Arthur Andersen. So we accept that as part of an occupational hazard,” said Sharma.

One of Shankar Sharma's investments - Brightcom - has also been in the eye of the storm due to accounting lapses.

The investment in smaller cap companies is considered riskier compared to mid and large caps as according to Sharma, they're untested and lack data governance. “Many management have to go through a cycle of misgovernance to improve back into governance.”

“We might have bad eggs, maybe 5 percent of the portfolio and even if we lose 50 percent on that we are still okay because the ones we will make money on will more than make up for the bad eggs. That is the only way you can live with the bad eggs in your portfolio,” Sharma added.

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On how investors can mitigate risk, Sharma said that apart from the quality of the company’s board, he closely looks at the tax and dividend payments.

“These two hygiene checks are not 100 percent foolproof, but back-of-the-envelope - tax and dividend payments would ensure that the company is generating cash and not just accounting profits. And that is a good enough reason to buy a small position in a company from a retail investor standpoint,” said Sharma.