Small-Caps: just volatile, or are they also risky?

Indian markets have had a fantastic run during the last quarter, particularly due to a spectacular performance from the Small Cap Index that delivered around 20% returns. It is interesting that 46% of stocks have run up more than 20% during the last quarter—underlining the broad-based euphoria. With this kind of performance, it’s natural to hear murmurs around “risk of equity investing” at these levels – more particularly in small caps. But, is small-cap investing really risky or is it just volatile?

Volatility implies that prices correct and rise, rapidly and erratically due to a variety of reasons, ranging from investor sentiments to domestic indicators to global causes and liquidity. Most academics refer to volatility as a risk to consider while investing. But is price movement really a risk?

Risk refers to the potential financial loss inherent in any investment decision. It is the probability of permanent capital loss which usually takes place due to shortcomings in the business or the industry or both, rather than market movement (volatility).

To a large extent, both these phenomena tend to go hand-in- hand in the short term, with most investors believing that volatility is indeed risk. However, in the long term, one realizes that these two phenomena are completely different—while one needs to protect capital against risks, one can use volatility as an opportunity to create disproportionate wealth.

To understand whether small-cap investing is truly risky or not, we have to first to understand the two types of risks: systematic and unsystematic. Systematic risk is broadly external factors beyond control that affect more than just one stock, they affect the entire market or industry. Unsystematic risk is one that is stock-specific risk, which affects a said organization alone. However, these risks can be avoided by thorough due diligence, research, and understanding how any stock and related industries work. So being vigilant is important.

But are these risks only specific to small-caps? History suggests otherwise. We’ve seen large reputed organizations fall prey to both these risks, for example when Yes Bank crumbled due to its poor corporate governance standards (unsystematic risk) or when HEG/Graphite corrected substantially due to a change in the steel-graphite cycle (systematic risk).

Large-caps are not immune to risks, they are just less volatile, because they are normally well covered by brokers, traded into by institutions and have adequate float. The lack of information available on small-caps, the lack of discovery, the lack of free-float and the untested managements of small-caps is what leads to excessive volatility, but this is also what leads to superior returns.

Small-caps, like large-cap investing, is only risky when one doesn’t understand the underlying business. Like Warren Buffet famously said, “risk comes from not knowing what you’re doing”.

Using volatility for wealth creation: Businesses do not function in a linear manner and often go through execution challenges because of multiple external factors. Resultantly, their underlying stock prices also go through various swings during this journey. From an investors perspective, it’s extremely important to understand this non-linearity of business and factor this in the underlying valuations when buying a particular business. This itself helps it see through the volatile phase of the stock prices. Another aspect that one may look at it while taking advantage of volatility is to stagger one’s investment and build it up. In the short run, stock prices do tend to behave erratic (volatile) for reasons beyond the business fundamentals.

For instance. if one looks at Titan’s journey from being a small cap company with a mere ₹1,018 crore market cap in 2005 to a staggering ₹2.68 trillion market cap today– this journey over the last almost 18 years has been laden with a lot of volatility with the stock price going down by more than 30% at least seven times! It would have been a missed opportunity for investors who found the small-cap Titan to be ‘risky’ because it fell more than 30%!

Simply put, small-caps don’t generate superior returns because they are riskier. They do so because they are more volatile.

Pawan Bharadia is managing director, Equitree Capital Advisors.