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Choose your cap

By Narayan Krishnamurthy and Sameer Bhardwaj     July 10, 2007

One of the longest running investing debates is about the pros and cons of investing in small stocks versus large stocks. Should you pay a premium for a stock with a large market capitalisation or should you go for cheap small-cap stocks? Logic can be marshalled on both sides of the fence.

The argument in favour of investing in small caps is simple. A small business can grow quicker because of the smaller base and therefore, returns are higher. As businesses grow larger, their growth rate could slow down. A classic example is Infosys. The software biggie doubled its turnover and profits every year for the first eight years after listing in 1993. In 2006-7, it achieved Rs 13,149 crore turnover and although its revenues rose by Rs 4,121 crore, the growth rate was 45%—impressive but slower than in the past.

So growth prospects are in favour of small stocks. But the arguments in favour of a big-stock focus also deserve to be heard. A big business is less vulnerable to crisis like the loss of a big client. It has a proven track record (otherwise it would not have become big) and due to institutional interest, corporate governance is likely to be better. Institutional holding also lends support to the price of large-cap stocks — institutions don’t sell stocks in a hurry.

In an attempt to resolve the argument, MONEY TODAY undertook an indepth comparison of the BSE Sensex to the BSE Midcap and Smallcap indices over the past two years. Our conclusion: The market returns of the past two years show that there is no clear answer in favour of either school. But select small caps and mid caps can deliver such amazing returns that these deserve to be included in the portfolio of even the most conservative investors. But you have to be more careful while picking mid- and small-cap stocks. The choice of such stocks is infinitely greater than that of large caps. That makes it tougher to track them.

On the other hand, larger stocks may deliver better average performances. Since the inception of the BSE’s small- and mid-cap indices in April 2005, the Sensex has seen a growth of 120%, the BSE Midcap of 100% and the BSE Smallcap of about 90%. Every sector grew in this phase. All three segments have very impressive returns but the Sensex mega-caps have done better as a group than small caps and mid caps. Since some smaller stocks generated outstanding returns, by implication some smaller stocks must also have done badly to peg back index performances.

Small stock performance is therefore, more uneven. But the best small and mid caps have outperformed the high-flying Sensex stocks so decisively that it’s tempting to invest in them.

In the past six months, the BSE Midcap and Smallcap indices have outperformed the Sensex by quite a distance. While the Sensex has recorded 5% growth in the past six months, the BSE Mid-cap index has grown by 7%. The BSE Small-cap index has given even higher returns at 10%.

India is a growing economy, and the growth opportunities for smaller companies are more than in a developed economy. There’s no doubt that the Infosyses and Reliances of the future will come from the small- and mid-cap segments. No Sensex stock is likely to grow 1000% within the next two years. A few mid caps and small caps are almost certain to. What one has to do is identify them.

How many investors had bet on Infosys when it came out with a public issue in 1993? Not many, since the IPO was undersubscribed. Why go that far back in time? Not many investors bet on Praj Industries when it was trading at Rs 42 about two years ago. The stock has since graduated from being a small cap to a mid cap priced at over Rs 500. The first step in stock picking — any stock picking — is to look at valuations. That is, how is a stock priced compared to profits of the company.

On this benchmark too, small caps and mid caps are valued at lower PE ratios than their bigger comrades. Currently the Sensex P/E is about 17; compare it to the BSE Midcap P/E of 14 and BSE Smallcap P/E of 13. That makes it more tempting to include smaller scrips in your portfolio. But this may not continue for long.

“In the past few months, the valuation gap between small and mid caps with the large caps has begun to close in. This has been reflected in the rise of the first two indices,” points out Amitabh Chakraborty, president, equities, Religare. Small- and mid-cap stocks do carry the perception of larger risk and loss, especially in a bear market.

That’s when a small business is vulnerable and in the absence of institutional coverage, small-cap share prices can plummet. So just as Infosys completed its journey from small cap to large cap in a decade, creating crores in investor wealth, there are stocks that disappear from the market, pushing investors into deep losses. But on deeper examination, it appears some of the risks are exaggerated. MONEY TODAY looked at the performance of the BSE Sensex, BSE Midcap and BSE Smallcap indices since April 2005. When we crunched the data, we discovered that on certain levels smaller stocks may be safer than large caps.

First, the number of days on which the small- and mid-cap indices have shown positive returns is more than that for the Sensex. This makes the probability of loss on these two indices lower than that of the Sensex on any given day.

There is also a technical reason why small and mid caps are safer than large caps. These stocks are mostly subject to circuit filters. Trading in small stocks is stopped after they hit an upper or lower limit during a trading session. This limits the loss to 5%, 10% or 20% depending on the stock filter. However, a large cap is not subject to such freezes. As a result, the Sensex has higher daily volatility.

The combination of a larger number of winning days and lower daily volatility suggests that mid caps and small caps are safer than they are perceived to be. There are a couple of statistical calculations, which bear this out.

One measure of risk is dividing the standard deviation (SD) by the average or expected return — this is called the coefficient of variation (CoV). The SD is a measure of dispersion, which shows how closely each return is clustered around the average. For example, the average of the series 5, 7.5, 10, is 7.5 and so is the average of the series 7, 7.5, 8. But the SD of the first series is 2 while the second series has a SD of only 0.4 — the second series is less dispersed. A lower SD means lower CoV. The lower the CoV the better it is because the risk per unit of expected return is less.

When we calculate CoV for these three indices, the Sensex is riskier than the other two because it has the highest CoV. It has a relatively higher average but a much higher SD. What this means in simple terms is the chance that you will get a positive return from the small- and mid-cap indices is higher than with the Sensex. But the magnitude of the positive returns from small and mid caps may be lower than the magnitude of positive returns from the Sensex.

This holds true if you are investing in the index or index-based mutual funds and not when you are investing in a stock. For individual investments in small- and mid-cap stocks, the magnitude of loss or gain will be higher than that of a Sensex stock.

Why should investors move into the unchartered waters of the small and mid caps? Well, for one, it is not unknown territory any more. There is now increased institutional support for small- and mid-cap companies. Fund houses and FIIs, which had till now shunned these segments, are now picking up smaller stocks. “Investments in these smaller stocks can offer better returns to the investors in the long term,” says Sanjay Sinha, CIO, SBI Mutual Fund. This also means that these smaller companies are now better researched than ever before. Investors can access research reports by brokerages and investment analysts. “Small- and mid-cap stocks are going to be key drivers of the market in the days to come,” says Chakraborty.

Of course, this should not be construed as a vote against large caps. Small and mid caps should complement — and not compete with — large caps in an equity portfolio. Investors who already have a large-cap portfolio should diversify into small and mid caps. They should retain their core portfolio of large caps, maybe pare it down but not completely offload it. That way they can have the best of both worlds—the stability of large caps plus the vibrancy of small and mid caps.

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