Most people lose money chasing Multi-Baggers. You don't have to.

“Invert, always invert: Turn a situation or problem upside down. Look at it backwards. What happens if all our plans go wrong? Where don’t we want to go, and how might we end up getting there? Instead of looking for success, make a list of how to fail instead — through sloth, envy, resentment, self-pity, entitlement, all the mental habits of self-defeat. Avoid these qualities and you will succeed. Tell me where I’m going to die, that is, so I don’t go there.” -Charlie Munger

I have worked on the sell side for more than a decade. The fascination that investors have with equity markets morphs into a yearning to capture multi-baggers. When I was a research analyst, I was often asked for stock recommendations where stocks were priced below Rs. 50 or in low single digits. Investors believed that if they could buy a stock cheap (by price, not for what it’s worth) and ride it until the prices rise multi-fold, they would have fulfilled their hunger for returns. The allure of ‘riding a stock’ was enchanting.

This desire to buy stocks reached its peak when stock markets were roaring. I remember investors scampering to buy any ‘low-priced’ small-cap stock in the fabulous small-cap dream run year of 2017. In fact, in the biggest bull market in India yet, from 2003 to 2007, I have seen dealers pitching penny stocks by selecting them alphabetically because whatever they touched went up!

This is a deadly concoction. The allure of fast, high, and easy returns from buying ‘cheap’ stocks. And buying them when most of them have already run up so much they believe that they will continue to.

Charlie Munger, the immortal legend of investing, supplied a great nugget. “Tell me where I’m going to die, that is, so I don’t go there.”

What are the critical mistakes in small-cap investing where returns meet their demise?

1. Buying without understanding: Doing business in emerging markets is challenging. Successful small firms require numerous factors to align – low leverage, profitability, and consistent earnings, among others. These are the hallmarks of "Quality companies," a vital trait in small-cap investing.
   
   
2. Timing the market: Small caps are more volatile due to heightened competition and smaller buffers. Timing these stocks is tricky; after the 2017 peak, nearly two-thirds of small caps fell by over 50%¹. Timing these moves is a challenging task.

How do we solve for investing in small caps? Do we even need small-cap investing?

In the last 18 years, the Nifty 50 Index has earned 14.6% CAGR, the Nifty Smallcap 250 Index has earned 16.4% CAGR, and the Nifty Smallcap 250 Quality 50 Index has earned 20.1% CAGR. This means Rs 1 lakh invested in the Nifty 50 Index became Rs 12.7 lakh, in the Nifty Smallcap 250 Index it became Rs 16.7 lakh, and in the Nifty Smallcap 250 Quality 50 Index it became Rs 30.7 lakh.

On the opposing end is the SEBI data which highlights that 90% of traders and investors lose money in stocks. Many of them are ‘trying’ their hand at small-cap investing. How do we know this? The largest shareholding by the public (more than 90% of the float of outstanding shares) is all small-cap companies.

So, what is the ‘right way’ to invest in small caps?

1. Solve for quality. The most critical element of buying smaller firms is to buy right. Invest in firms that have not borrowed huge sums of money and are able to generate profits consistently. By doing so, as you can see above, you can generate a great investment experience. Quality helps avoid disasters. In a study that we conducted, we found out that poor-quality small caps are 8 times³ more likely to cause a permanent loss of capital versus high-quality firms (less indebted and with a consistent track record of profitability). As Munger said – ‘Tell me where I’m going to die….”
   
   
2. Using SIPs. The small cap index today made a new lifetime high. Starting a SIP at market highs gives an inbuilt, better-behavior nudge. Initial units acquired at high prices will generate low returns in the short term causing one to lower expectations of returns and to stay invested for a longer period. Starting an SIP at market highs can fare better because -
   
   
   • • Whenever markets fall from peaks, you start to accumulate more units (falling NAVs).
     • These higher units will get the benefit of rising NAVs when the market rises again.
     • Wealth = More units x Higher NAVs

Long-term SIPs in Quality Index have given similar returns irrespective of the market being at peaks or lows and considerably better returns compared to the broader index.⁴ When markets are expensive, even more focus on quality is needed. When small caps are at all-time highs, the right thing to do is to start a SIP. It’s significantly better than not doing anything.

In conclusion

While investing in small caps

1. Focus on Quality: Prioritize firms with solid fundamentals.
2. Use a staggered approach: Invest via SIPs, especially when markets are at all-time highs.

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¹ Data Source: Bloomberg, 15^th Jan 2018 to 23^rd March 2020
^{2 ,4} Data Source: NSE, DSP April 2005 to Nov 2023
³ Data Source: DSP Data from this presentation
5 Data Source: https://www.dsij.in/article-details/articleid/4888/top-ten-companies-with-highest-public-holding