Three basic rules for amateur retail investors looking to play small- and microcaps

In Mehta’s words, an investor should not sell a stock just because it has delivered 100 percent returns.

Shares of small- and microcap companies are on fire, and that is drawing a lot of first-time investors to the market hoping to make a quick buck. Rajiv Mehta, algo trader and investor in small-cap and microcap stocks, has seen this cycle many times since he made his first investment in 1992 while still in college.

“Social media is full of finfluencers (financial influencers) spouting wisdom on how to identify the right stocks—read investment books, company balance sheets, analyse cash flows,” he told Moneycontrol in a free-wheeling chat. “Investors may have a rough idea of the company’s business. But the point is: how many of these first-time investors actually understand financial statements or have the time to do detailed research if they are only investing Rs 20,000 or some such small amount?”

Mehta says most of these investors will eventually lose money, either due to greed or overconfidence. He lists three basic rules which if followed can improve the probability of making decent returns or, if nothing else, minimise loss of capital.

Price is king

Mehta’s first and foremost rule is that price rules over all and one can make good returns only after buying a stock at a good price. Price is the only indicator one needs to follow, he suggests retail investors, adding that it contains all the market wisdom there is about a certain stock.

Though this advice is not unique and has been reiterated by several legendary investors, determining what price is right is a tall ask for most retail investors.

“There is always this temptation to buy a stock that is being widely talked about. Before jumping in, one should look at the price trend of the last 10 years,” says Mehta. “You also need to take a look at what kind of investors have invested in the stock during this period.”

For instance, if a stock has delivered multibagger returns—say, 10 times or 20 times—and well-known investors have already invested in the stock early on, you may have already missed the bus, he explains. Once the price has appreciated significantly, the margin of safety is much lower, meaning that if the company fails to deliver on market expectations, the fall could be sharp. For those who have invested early, this may not matter much. But for those who have entered late, the losses can be huge.

“Lots of newbie investor’s flock to small-caps or micro-caps or even SME (small and medium enterprises) companies giving reasons like ‘small-cap companies are under-researched and, hence under-priced’. But in the end, it is the price at which you have bought will decide your returns. So all these micro-caps are to be picked when no one is looking and then average up,” he says. By averaging up, Mehta suggests buying more of the stock when the price rises.

Mehta adds that new investors should not invest in a stock just because everyone else is investing in that and the stock has become a multibagger. “The blind quest for a multibagger can end up making you a beggar,” he warns.

On the other hand, if a stock is available at a low price (in comparison to the market leader in that industry/sector) and is yet to gain the attention of smart money, one can invest in that, he adds. A low price is no surety that the stock will do well in future, as Mehta has himself has often found to his cost. After all, there are reasons for the price being low. But the advantage is that buying a stock at a low price provides a good margin of safety.

Mehta recalls a small-cap investment that he thought was attractively valued but later realised that the promoters were an unscrupulous lot. That explained why the market was ignoring the scrip. The price subsequently more than doubled, but Mehta chose to hang on to it. Over the last few years, the stock has risen and fallen sharply and is not much above his average acquisition price. “I can afford to be patient because that stock is only a small part of my portfolio and I am convinced that the market will at some point recognise its true worth,” he says.

Strict stop-loss

Mehta’s second rule is that those looking to invest in small- and microcap stocks should have strict stop-losses. The idea is to find your own risk tolerance and sell a stock as soon as the tolerance level is hit. “Namak swaad anusar (salt according to taste) is how I would put it, as risk tolerance level varies from investor to investor,” he says.

“Find your risk tolerance level—10 percent, 20 percent, 30 percent—and fix that as a stop-loss for your trade. Once the stop-loss is hit, exit, no matter what. You can again enter the stock when the price recovers to previous level,” he says.

Moreover, one needs to calculate stop-losses from the highs and not from the entry price, or in other words, the stop-loss should be dynamic. For example, if you bought a stock at Rs 100 and it has now made a top of Rs 200, and if your risk tolerance is 20 percent, you will need to sell the stock when it hits Rs 160 and not Rs 80.

“Many first-time investors are casual in their approach to profits because they think it comes easily. But a loss of profit is also a loss. And without that discipline, you can never make money consistently. In this way (by trailing the stop-loss), your profits will be protected to a large extent,” he said.

Don’t sell early

“People underestimate the power of luck in stock selection,” Mehta says, adding that many investors have stumbled on multibaggers through sheer luck and not detailed research. The corollary to that is many investors have lost heavily despite having researched a stock thoroughly.

So if you have been lucky enough to pick a winner, hang on to it as long as your stop-loss is not breached. Mehta cites the example of two his bets—Praj Industries and Eicher Motors—that he managed to buy dirt cheap in the early Noughties. “I bought Praj when it was going for Rs 7 and Eicher when it was available for Rs 88. My reasoning for both investments were pretty simple. In the case of Praj, ethanol blending was a little-known concept at that time. As for Eicher, most of the trucks plying on the Delhi roads at that time (before they were banned from entering the city during daytime) were from Eicher. I made handsome returns on both stocks, but cashed out too early.”

In Mehta’s words, an investor should not sell a stock just because it has delivered 100 percent returns. “When booking profits, take out only as much as you need to spend on that something you were looking forward to. If you want to create wealth, then you need to hold on to your winners for as long as possible,” he says, adding, “…a process has to be in place, and you should just follow that process. No biases. No intervention.”