Bottomline | Beware the small-cap frenzy!

A sure sign of frenzy in the stock market is when scrips of little-known entities start springing to life. And that is starting to happen now. What’s keeping the market still chugging along is that there isn’t much froth in the frontline stocks, and that keeps the benchmark indices firm and the optics positive. But scratch a little below and the worry signs emerge.

A look at the biggest weekly gainers in the past week tells the story. Some stocks in this list have gained over 30% in the past five sessions, and my hunch is not all on the back of any significant change in fundamentals. We pulled out the list of over 10% gainers in the past week. These are unusual returns. Imagine you get no more than 7-7.5% on a bank deposit for a year. Here you are getting 10% in a week. Multiply that into 52 weeks and that’s 520%. If that isn’t unreal, what is?

LITTLE TRACKED PERFORMERS

Most of the over 60 stocks in the gainers' list for last week are little-tracked counters. You will unlikely find any brokerage coverage of any of these, nor any institutional interest in them. That just heightens the risk for retail investors, as other than corporate filings they have little information to go by, nor do they have the comfort of institutional oversight.

Here's the list for a quick glimpse:

Source: Moneycontrol

DIRTY GAMES IN SMALL CAPS

Anyone who has been in the market knows the pump-and-dump games played by savvy investors and operators. Small caps with low liquidity are the favourite hunting ground for such schemers, as they lack the clout and muscle to move large caps, also given the imponderables (some large foreign investors or domestic institutions can ruin the party).

And very often, these savvy operators manage to get funds to back their bets. In such instances, a good chunk of the shares gets pumped and parked with such institutions, before being pumped to offload this to other not-in-the-coterie funds, HNIs and retail investors. Such activity picks up significantly in bull markets and that is how more often than not uninformed HNI and retail investors burn their fingers and lose their shirts. Make sure you steer clear.

The practice of follow-the-market master is also fraught with risks. Successful investors like Warren Buffett or India’s big bull Rakesh Jhunjhunwala haven’t always got their bets right, but an investment going wrong will likely hurt them less, as their portfolio construct may guard against it. So don’t blindly buy into what stock a famed investor may have put his money in. Savvy operators also often get taken for a ride by unscrupulous promoters of companies they invest in.    

Don’t blindly trust your investment advisor either. Always do some homework. I know of several investors (HNI and retail) who have been sold rotten apples by their advisors, knowingly or unknowingly. Large caps offer a cushion of safety as they are widely held, and widely tracked and therefore any positive or adverse developments get widely reported. So, you will have much more timely information for any course correction, if needed.

HIGHER MORTALITY IN SMALL CAPS

The likelihood of a start-up shutting down is high. No wonder angel and venture investing is considered high risk. Small caps are next on the risk ladder. These are businesses that might have potential but have still to prove themselves at scale. What’s more changes in regulations, policies and market dynamics will likely impact small businesses more severely than large businesses that have the wherewithal to navigate through tough times.

Their longevity is therefore questionable and you can’t just invest in them for long periods. A small-cap portfolio requires constant monitoring and if you aren’t savvy enough, best to leave this to a professional fund manager. Small-cap funds are a good option to invest in the space, but be mindful of the liquidity and NAV erosion risks—a key concern for Sebi at the moment.

Most funds track a benchmark index and that offers some comfort, as these funds must measure performance against such indices. Small-cap indices use market capitalization and liquidity criteria that help to an extent steer clear of many illiquid counters. But that said, even small-cap indices have seen significant changes in composition over the years. Some of the stocks that used to be in the NSE SmallCap 100 index about 10 years ago but are not on the radar of most investors today are listed below.

BIG IS BEAUTIFUL

Given how the market is perched today with frontline indices near all-time highs, the margin of safety is much greater in large caps. So, if you do wish to invest at these levels, that’s a better part of the market to be in. Invest in mid and small caps only if you have done your homework and have conviction in your investment thesis. Happy investing!