The problem with non-quality-focused Small Cap investing- And how to fix it.

Did you know: India has recently seen a 5X rise in individual traders, while 90% lose money! [Source: SEBI data on Futures & Options, FY 19-22]

And many of them are trying small cap investing. Did you know, the Indian small cap stock with the largest no. of retail shareholders is owned by 35 lakh people*? [*hold less than Rs 2L of nominal share capital. Source: BSE, as on Dec 31, 2023]

And the ROE of that company? A poor: -1.16%.

So what gets so many to invest in stocks like this? Excitement? Greed? Herd mentality?

You've surely noticed, recently, many small cap stock valuations have shot through the roof, way beyond their fundamentals. And this is often where the danger lurks. Let's unpack how we assess fundamentals.

It's all about the quality check. Eventually, successful small firms have a few things in common: lower leverage, better profitability & efficiency, consistent earnings, sound decision makers.

Have you studied & checked these boxes for your holdings? What is the ROE- Is it more than 15%? Has this company taken a lot of debt, or is the debt-equity ratio acceptable? Is the management behind the business solid? Is the earnings variability high or low? And do these metrics even differentiate the good from the not so good?

We did an internal study, comparing higher quality small cap stocks (represented by Nifty Smallcap250 Quality 50 Index) vs Nifty Smallcap 250 Index, excluding these higher quality stocks. Guess what we found...

1. Higher quality small cap stocks displayed, on average, ~2X higher return on equity (ROE) vs others (those not filtered for quality). What's more, they carried ~3X lower debt too! [Data considered from 2011 to FY23. Source: Internal, NSE.]
2. Small caps not filtered for quality were 8X more likely to lead to a permanent loss of capital than their higher-quality counterparts. [Data considered from 2010 to Dec 2023. Source: Internal, NSE.]
3. And then, when the market corrects itself, small cap stocks not filtered for quality^ showed higher chances of taking a nosedive, while the higher quality small caps enjoyed investor confidence & recovered faster in 19 out of 20 years- showing better chances to do well in the longer term. [Data considered from Apr 2005 to Feb 2024. Source: Internal, NSE. ^represented by Nifty Smallcap 250 TRI]

The lesson? Quality matters. ?

The mistake most small cap stock buyers make? Not even checking for these quality metrics before investing.

Because it’s not easy, it needs effort, time and is not instantly convenient (unlike most other things we’ve gotten used to ??)        

Let's also talk about price checks i.e valuation. Howard Marks said: "Investing well is not only about buying good things. It's about buying things well." Wise words.

You may be confident about quality, but do current valuations match what that small cap stock deserves?

Okay, this may not seem easy. So, if you are not sure how to assess quality, valuations, profit potential & other parameters by going through numerous data points across too many companies so you can select the stocks that you feel good about, what can you do?

1. Choose small cap mutual funds that prioritize quality.
2. Invest via only SIPs/STPs to spread your investments across time & price levels.
3. Don't invest based on past performance alone. Past returns belong ONLY to the ones who invested in the past.
4. If you can't do the analysis needed for #1, consult a MF Distributor who can do it for you. These experts have helped crores of Indians plan to create wealth & earn better financial outcomes.

And most importantly, never forget- irrespective of quality, small cap stocks or even small cap mutual funds will see volatility... It is in their inherent nature to suffer through fluctuations.

Evaluate whether they suit your risk-appetite, don't just invest because others are doing so, or because of recent past performance.

Making money from your investments should be the outcome of a well-defined process backed by the right behaviors and principles. If it is just based on tips, gut decisions, and market noise, you’re likely staring down the barrel.

And if you were doing this, listen to Munger: Invert.