Small, midcap stocks back in action post SEBI’s circular, but finding a multibagger comes with risks

By Raghvendra Nath

The recent news around SEBI guidelines has put the focus back on the Broader Markets. In the last few months, we have seen a big rally in small caps and midcaps. This has come after more than two years of continuous battering and series of underperformance they had witnessed. However, the last 6 odd months have been great for the investors and the funds alike where they have seen their investment valuations go up substantially. 

A large number of small cap stocks have even doubled or tripled in value during this period. The current frenzy to buy the small and midcaps stocks is such that nobody has a watch on the fundamentals, but the majority are only concerned with riding the wave. People should, however, realize that if the waves have crests, they also have troughs. In case of small cap stocks these waves can get amplified very easily in a short duration of time. 

There are traders and then there are investors. The perspective of traders is generally short term where they mostly rely on short term analysis of trends and Invest for immediate gains. Investors on the other hand would always look at the fundamentals of any company and invest based on their growth potential and if their stock price is right. 

Generally, in any small cap stock, the free float, which is the shares available for trading, is fairly small because of a lower capital base as well as higher promoter holdings. Lack of liquidity results in larger gyrations in the stock prices and the price movements are prone to market sentiments, making small caps a speculator’s delight. On a good day, a trader can end up making substantial gains. However, when the trends reverse, the losses can be equally large. 

From an Investor’s standpoint, good quality small cap and midcap companies can potentially grow at extremely healthy rates for many years to come. It could be because the company is operating in a niche market with a high growth rate or because of the base effect. Investing in such high quality and high growth companies can be highly profitable and these stocks may become multibaggers of the future. But finding such gems is not so easy. Unlike large cap stocks which are well researched and widely owned, very little is known about these small and mid-cap stocks. The reason is that very few brokerage or research houses track them. This effectively means that if an investor is looking to invest in small cap and mid cap stocks, he should have the necessary skills to analyse the company and should also have access to the vital information on the company.

Investors should sieve through the data to avoid companies that may look attractive but are not. There could be innumerable pitfalls when investing in a below average small cap stock.  For instance – the assets and liabilities could be understated; revenues and incomes could be overstated; companies may have subsidiaries where orders are diverted; loans and advances given to related parties; and there could be so many other issues that may make such stocks risky. When investing in smaller companies one should be aware that the potential of making mistakes or missing key facts is high. Just because a small cap stock has doubled or tripled in value does not make it a high quality name. 

If you are not a speculator and want to profit from small cap stories, you have two options – either have the skills to pick up the best companies operating in their respective niche segments and monitor them aggressively or to invest your money into small cap mutual funds where fund managers can look after the portfolio.

(Raghvendra Nath is the Managing Director of Ladderup Wealth Management. The views expressed are the author’s own. Please consult your investment advisor before investing.)