Small Caps are Down or Are they?

In today’s edition of Business Line, Aarati Krishnan tries to explore the gap between Large Cap and Small Cap and comes up with a few suggestions. While suggestions are valid, I think the reasons themselves lie elsewhere.

Let’s start with the chart plotting the relative movement of Nifty 50 (Large Cap), Nifty Mid Cap 100 and Nifty Small Cap 100 from 2018 for this dichotomy started then.

While Nifty 50 has generated an absolute positive return of 16%, in the same duration the Mid Cap lost 19% and the Small Cap 35%. Lets go a bit backward in time – 2013 August when this bull rally actually got started.

Suddenly the chart doesn’t appear so dichotomous. Nifty Midcap is the clear winner followed by Nifty 50 and Nifty Small Cap with more or less similar returns. Isn’t it amazing how the narrative can be changed by just changing the time frame we view.

Institutions are skeptical of buying small cap stocks for two reasons. 

1. Liquidity: Mutual Funds, Hedge Funds and even Insurance funds are investing funds that one day needs to be returned back. For Mutual Funds, they need to be able to arrange for the liquidity on the same day as the request from the client flows in. This means that while they can risk being locked into low liquid stocks for a small part of the portfolio, for a large part, they are more comfortable with high liquid stocks that can be sold without having to crater the price.

1. Corporate Governance: Indian companies, even the large cap ones are the best examples of good corporate governance. The risk multiplies manifold when we look at small cap stocks. There are barely any adequate checks and balances which mean that the promoters more often than not are able to get away with decisions that could have a positive impact on their own pockets while having a negative impact on the company.

Indian Markets for all our chest thumping is fairly small. In the United States, any company with a market Capitalization of less than 1 Billion USD is considered a small cap and those below 300 Million USD, Microcap.

From Screener.in, I was able to get market capitalization data for 3800 Companies. Of these, just around 275 companies have a market cap greater than 1 Billion USD. Another 200+ would qualify as Small Cap and the rest, 3300+ companies are microcap.

It’s not so much of a surprise that most mutual funds are concentrated only in the top 300 stocks. Lower you go in market cap, Lower your ability to exit easily. Of the 3300+ companies with market cap of 2000 Crores or below, 2700+ companies have free foat (non-promoter) holding market cap of 100 Crores or below. Basically, much of the small cap universe is nano cap and one where you cannot enter and exit with even a basic capital of a few lakhs per day.

Another 270+ companies have free float market cap between 100 Crore and 250 Crore, 186 between 250 and 500 and 120 between 500 and 1000 Crores. Remember, we are talking just about the non promoter holding and often there are corporate houses that seem to hold a substantial quantity and ones that never seem to be liquidated. The real liquid shares which can be categorized as those held by Individuals with share capital upto Rs. 2 Lacs is very small.  

Another big risk when it comes to small cap universe is the risk of delisting. Every year, a large number of small cap stocks are delisted to never make it back again. A company that gets delisted becomes a dead investment for the investor for he has no way to liquidate his investment even though the company in many cases are that continue to exist. 

Investors are attracted to small cap stocks due to the supposed cheapness of the stock though most stocks are cheap for a reason. Very few small caps are able to break through and become midcaps and an even smaller number become large cap. Identifying them at a microcap stage is literally impossible for 99% of investors.

Today when small caps are down  big time from their all time high, it appears to be cheaper but that is missing the forest for the trees. Most trees are down because there is very low probability they can survive let alone thrive. If you are a small investor, your best bet in small cap would be via a small cap mutual fund rather than actively investing unless you have the deep knowledge and experience that is required for such investing.