Are small-caps really the riskier choice?

When the going is tough, it is the “easy” that gets sold. If the story is simple and eloquent, it becomes easy to sell. This is precisely what the investment advisors do in every cycle. In down-cycles, they can make a good story out of “long-on-large” theme as investors seek refuge in safety. As investors perceive small-caps as risky, it is easy to sell the story of large-caps in stressed times. Investment advisors, in their rush to sell these easy large-caps, unfortunately end up painting the entire space with the same brush i.e. They sensationalise safety in large-caps and trash the small-caps as being toxic.

How should investors respond to such a narrative? Does the risk come from the size or from the balance sheet quality? The other spin that advisors give in their eagerness to sell is that large-caps will lead the recovery first while the small-cap space will struggle for longer time. Is that true? How did this play out in past cycles? Let’s expolre in depth:

Size doesn’t matter

As one veteran banker eloquently put, in this crisis amid Covid, there will be no winners, only survivors. But those who get to survive can hope to gain from the huge wave of consolidation (market-share gains) that will be triggered by weaker players’ exit. While investment advisors, dictated by the large-cap narrative, may try to project “size” as key to survival, in reality, it is the quality of balance sheet that will determine who survives and who doesn’t.

Quality of balance sheet will become the biggest differentiator in this crisis. This will not be limited to only small-caps; . It holds true across the spectrum, including large caps. Large companies with a weak balance sheet (high gearing ratio with unsustainably high debt) are likely to be weeded out as much as the weak ones in the smaller end of the weighing scale. So what one needs to worry is not on how large are the companies in one’s portfolio, but how good they are in terms of quality of balance sheet and quality of cash flows.

Even some micro-cap minions who are leaders in their own niche market-space with zero debt and positive free-cash flow business will emerge stronger from this crisis. ‘Strong will become stronger’ will be the over-arching theme across the spectrum, which will include the much maligned small-cap space as well, contrary to the ongoing narrative that puts emphasis on safety of large-caps.

Past experience

The next question that springs up spontaneously from advisors is, if quality is the key differentiator, why not stick to large-caps, especially when they are likely to lead the recovery? Here is where the pattern of past cycles can help us understand the nuances of recovery. In both the 2008 and 2013 down-cycles, while small-caps lagged the large-caps by few weeks (not months), the quantum of recovery in small-caps was substantially higher than that of large-caps in both these cycles.

Looking at the data points, in 2009, within three weeks of large-cap rally, small-caps turned and followed. The surprise lies in where both ended in December 2009. The Sensex delivered 81 per cent that year while small-cap index surged by whopping 124 per cent. No one can deny that the trade-off of three weeks is a small price to pay for the additional 43 per cent returns.

Similarly, in 2014, after a few weeks of lag, small-cap index delivered a stunning 106-plus per cent returns while the much-touted large-caps delivered less than one-third of the small-cap index returns (Sensex delivered 30 per cent in 2014).

It doesn’t stop here. Even the 2020 short-term data does not side with the ardent advisors, however much they try to de-sell small-caps, as can be seen from Chart (small-cap index is up by about 25 per cent as against an 18 per cent rise in Sensex in this quarter from April 1 to June 15, 2020).

In the investment business, unlike other businesses, what is difficult to sell makes more money for investors in the longer term. Money works harder in hard-sell products. Easy sells, of course, are appealing in the short term, but hardly a bargain in the longer run. Next time, when investment advisors push you to switch from small-cap schemes to large-cap ones, especially in a down-cycle, you know what to say. Of course, in small-caps, one has to digest higher volatility. That doesn’t mean higher risk (permanent loss) as long as one stays put through the crisis.

The writer is founder-CEO and Fund Manager , TrustLine Holdings Pvt Ltd

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