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Thursday, September 17, 2009

Why small investors should avoid small cap stocks

There are several reasons why small cap stocks should not be considered for investment by any investor - new or old, small or large. Before I start to argue my case, let me define what is a small cap stock.

The market capitalisation (or market 'cap') of a stock is the product of a stock's current market price and the total number of equity shares outstanding. In other words, a stock having total outstanding equity shares of 10 Million (1 Crore) and a price of Rs 100 has a market cap of Rs 1 Billion (100 Crore).

The question is: What market cap makes a company a small cap, or a mid cap or a large cap? The short answer is: It depends on whom you ask. There are no precise definitions. The industry norm for a small cap company seems to be a market cap of upto Rs 2500 Crore!

A mid cap company has market cap ranging from Rs 1000 Crore to Rs 13000 Crore. Large caps are those forming part of the Sensex 30 and Nifty 50 stocks. As you can see, the whole thing is pretty confusing.

Small investors get attracted to small caps because of two main reasons - 'affordability' and greed. Most small companies are also small cap companies that trade typically at few tens of Rupees. This price is attractive to small investors with small capital. (Many don't realise that a Rs 30 stock may have a Re 1 face value and may be trading at a P/E of 30.)

Many of today's large caps were small caps 10 or 12 years back. The general assumption is that all small caps have the potential to become large caps and give multibagger returns. But only a small minority out of the thousands traded in the stock market actually make the transition. Most will remain small caps, or disappear into the sunset.

Why are small cap stocks so risky that they are best avoided by small investors?

  • lack of transparency of management
  • lack of adequate research by fund houses and brokers
  • lack of financial muscle
  • low liquidity
  • high volatility

Management is too busy trying to survive (or siphon off money) to look after investor relations and proper communication of plans. Fund houses shun such stocks, so analysts don't cover them or visit their factories to ask tough questions.

One or two bad quarters can wipe out a small company, who may not have access to big money. Low volume of trading leads to difficulty in getting in or out, and wild price swings if small quantities are traded.

Only those investors with adequate experience and knowledge of fundamental and technical analysis should attempt investing in small cap stocks. That too, with the awareness that the entire investment can go down the drain. Preferably, the investment in small cap stocks should be limited to 10% of total portfolio value, to mitigate the risks involved.

The vast majority of investors should look for more expensive but less risky large cap stocks, or stick to index funds or index ETFs. Always remember Warren Buffet's investment rule: Don't lose money.

Related Post

The futile quest for the mythical 'multibagger'

5 comments:

Ramchandra said...

Dear Sir,
Today I understood why I could not avoid buying share called ‘Teledata Informatics Limited’. Averaging the price is easier in small cap. This is also might be the main reason why retail investors run behind the stock..I did the same thing keep on averaging and at last get trapped in well executed net.
Sir, I am following your blog and learning lot about the technicals. I have also found one website called www dot chartnexus dot com to get free charts. I believe the entire friends here can get benefit from this. In case if anybody face problem please contact me at ramvhegde at gmail dot com.
Once again, thank you very much sir.
Kind Regards,
Hegde.

SG Money Mind said...

You only have to do a very few things right in your life so long as you don't do too many things wrong. - Warren Buffett

Vast majority of the investors would be better off if they don't even look at the small caps.

Subhankar said...

@Ramchandra: Appreciate your feedback.

Averaging down - particularly in a bear market - is a money-losing strategy. It makes more sense in a bull market correction. That is where knowledge of technicals help.

@SGMM: Agreed.

Small investors seem to gravitate towards the wrong stocks at market highs. The job market has a lot of entry barriers. The stock market is a perrenially open door!

swati said...

Dear all, I m also learnig about how mkt work but ,As invester invest his fund then one thing we can say that he isn't update with mkt wht happening in mkt which factor he has 2 notice and relating to sectors he/she just do his investment accordingly read the tv news comment, ask to brokers about he pickup the frunt line stock for selected peried 2- 5 yr as i'll suggest to do ur investment with need base it will manage ur portfolio with particular return %

Subhankar said...

You have raised an important issue, Swati.

Investing in a stock isn't like buying a lottery ticket. It is part ownership in a business. So you have to nurture the investment. That requires time and effort - to read the Annual Reports, keep regular track of events relating to the industry or sector, judicious buying and booking profits from time to time.

This is far easier to do with large-caps, where management regularly communicates with analysts and investors. Small-cap companies are too busy making ends meet to keep investors properly informed.