Interestingly, the average growth of 90 per cent for small-caps is better than the negative growth posted by S&P 500 during this period.

In contrast, the average growth of 90 per cent for small-caps is much less than the 190 per cent growth recorded by Franklin India Prima — a fund that specialises in mid-cap and small-cap stocks. Both these factors point to the importance of stock selection and allocation. With appropriate stock selection and allocation, returns from small-cap stocks can be enhanced.

Growth and research

Small-cap stocks constitute a sizeable segment of the market — about 10 per cent, both in value and in numbers.

In terms of numbers, there are about 200 stocks to choose from. Since institutional investors largely avoid this segment because of liquidity constraints, they are vastly under-researched. This is one of the theoretical justifications for their superior performance. There are other reasons too. India is a growing economy, where the growth opportunities for smaller companies are greater than in a developed economy. In other words, stocks of small-cap companies offer investors better growth opportunities.

A look at the stocks that figure in the list of winners suggests that both these assertions are true. Growing companies, such as Dr Reddy's, Hero Honda Motors, Britannia Industries, Dabur India, Sun Pharma, Bharat Forge and UTI Bank, figure in the list.

Equally, stocks of under-researched companies, such as Swaraj Engines, Goodricke Group, Raasi Cement, Jagatjit Industries, ITI, Himatsingka Seide, Raymond and Berger Paints, are part of the list.

A number of stocks from the information technology sector figured in the list in 1998 and 1999. However, their inclusion in no way influenced the performance of small-cap stocks. Of the top fifty small-cap stocks in 1998, 41 were non-IT stocks.

Of the top-fifty small-cap stocks in 1999, 33 were non-IT stocks. Clearly, the small-cap success has been much more than an IT phenomenon.

Suitable for small portfolios

The small-cap story continues to be promising. The economy will continue to grow, and the prospects now look better than at any time in the recent past. In addition, small-caps will continue to be avoided by institutional investors.

In fact, equity mutual funds are increasingly growing in size, limiting their eligibility to participate in small-cap stocks. That is, small-cap stocks will remain under-researched and under-owned by institutional investors.

These factors indicate that the small-caps may continue to outperform the mid-caps and the large-caps. The price performance also suggests that instead of flocking to mid-cap stocks, small investors would be better off including small-caps in their portfolio.

Anecdotal evidence in the form of mutual fund performance also suggests that such investors would benefit by considering such smaller stocks.

For example, mutual fund schemes with smaller corpuses, such as Alliance Capital Tax Relief in the past and HDFC Tax Plan 2000 in recent times have benefited by investing in small-cap stocks.

Even funds such as Birla Equity Plan and Birla IT have delivered strong performance in recent times by focussing on small-cap stocks. The performance of smaller funds such as these over time reinforces that small-cap investing can be profitably practised.

Risk containment

Of course, risk containment measures are necessary for such stocks to be included in a small investor's portfolio. Companies with dubious quality management need to be struck off the list. Stocks with exceedingly poor liquidity and traded too infrequently may also need to be avoided.

However, with the adoption of each such risk-containment measure, the potential returns would decline. The gap between the returns from large-cap and small-cap stocks would narrow. In fact, this is the risk associated with any investment strategy based on a post-mortem performance analysis.

Still, there is a large difference in this case. The analysis points out to the striking out-performance by small-cap stocks over several years. Analysis also points to the larger number of stocks that have outperformed over the years. This suggests that investors can look forward to above average returns even if they adopt risk containment measures.

Importantly, the analysis points to the necessity of inclusion of small-cap stocks in a larger proportion in a small investor's portfolio. It does not advocate the avoidance of large-cap and mid-cap stocks.

The promise of the small-cap, however, is reassuring in this era of compressed returns from all instruments. In the end, even if the returns from investing in small-cap equity prove to be just two percentage points above those from large-cap equity, small-cap investing would be justified.

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