Amid of corona virus recession I have seen that individual investors who manage their own portfolio are more inclined toward large cap stocks. Just for sake of lower downside risk and assured dividends. It might also because, when recovery happens large caps are first to rally.
In this article I am going to show you why it is better to invest in mid cap and small cap stocks to get higher return over the large cap stocks.
Although investing in large companies only might be good strategy for institutional investors because they cannot bear large volatility in returns. But by buying large caps small investors are hampering huge return potential that is only available to them. (because of small portfolio size)
Complexity In Analysis
No company have ever achieved multi billion dollar valuation with just one production facility and one type of product.
Take example of Tata Steel [ Market Capitalization : 6 Billion $]
Tata Steel operates in : India, Netherlands, Europe, Thailand, Malaysia.
Subsidiaries associates and joint venture : 255 (combined).
Divisions : Pig Iron, Billets, hot rolled steel, cold rolled steel and numerous such products.
Supplies products to : Automobile Industry, Construction, Infrastructure Industry.
Now just to analyze one large cap you have to keep track on economic conditions in India, Europe, Thailand, Malaysia. Each has different set of economic and geo-political issues.
Success of steel is linked to success of other 4-5 industries. If any of that industry went into slump it affects result of Tata Steel.
Each divisions has its unique business economies and different international business policies related to import and export.
Mining of iron ore and coal can be harmful to environment so environmental laws of all supplying countries have to be tracked.
In short large business like Tata Steel have so many variables which makes impossible to track for any individual investor.
But on the other hand take any small business which has few product and has one or two production units concentrated in particular geographical area. All you have to do is find out how efficiently these units are working, viability of business models and most influencing factors in that particular industry
It is really that simple to analyze mid cap and small cap companies.
Inefficiencies In Market
Inefficiency here is referred to undervaluation and overvaluation of stocks in market.
Large cap companies are tracked by numerous equity brokers, investment banks, foreign institutional investors, domestic institutional investors and of course different sources of media(especially business news channels).
As large number of talented and huge account holders are tracking stock it becomes almost impossible to get irrationally undervalued opportunity in the market to buy stock.
But no one looks at small and mid cap especially lying in out of the trend industry. So there is huge opportunity to get value there. Because your competition to buy stock is not with institution who have huge information and knowledge advantage but here you are competing with other retail investors which gives more probability to make money.
Scalability
Most of the large cap companies are market leaders with average 30-40% market share in industry. So for company to double itself it will have to acquire 70-80% market share which is next to impossible for single company.
On the other hand
Most of small cap stocks are operational in particular area but many business model of these companies can be successfully copied in another geographical areas. In other words they have huge scalability.
So there is more room for expansions for small and mid cap than in large cap.
Saturated Markets
You will never see 100 billion $ company in agriculture tool manufacturing sector because sector itself is not that big. Large caps are only found in very large sectors like construction, utilities, steel, cement, computers.
Barring one or two all these sectors are matured sectors growing at pace of overall economy .
If overall sector is not growing at even 10% CAGR then how can a particular company will grow at 15%
Investor will surely notice that most of the large companies generally grow at CAGR of 12%.
But have you ever heard about premium underwear selling company Page Industries this has shown growth rate of 25-30% for straight 10 years. It became possible because sector had tailwind. There are thousands of such small opportunities in market.
Leverage Of Institutional Buying
Foreign Institutional Investors(FII) and Domestic Institutional Investor(DII) do not invest money in small cap stocks as their large portfolio size compared to market capitalization is very large. But as company grows in size these institutions start to acquire huge stake in company. Because of two reasons first, now they can buy shares in large quantity with enough liquidity. Second is over the past company has grown in size clearly indicates sustainability of business model.
This helps early investors as they get to enjoy wild swing in price caused by institutional buying.
Institutional buying also catch attention of brokerage houses and stock got into buying recommendation which again create fresh demand for stocks.
Earnings and PE Expansions
When company delivers consistent good earnings then market value stock higher even though earnings are not growing at very fast pace. So this is basically (Price To Earning Ratio) PE expansion.
It happens because of certainty factor and less volatility which virtually reduces risk of shareholder.
PE expansion is more prominent In large cap and to some extent mid caps.
Example of PE expansions :
Most of large caps as stated above belongs to saturated industry and have acquired large market share thus there is little room for earnings expansions. And there is one problem with PE expansions that if company failed to deliver anticipated results then stock can fall sharply(although it happens rarely).
In small cap and mid cap if you invest for much longer period of time then you can take advantage of earning expansions and then after then after some years PE expansion also.
Bottomline
Crowd is not always right. If everyone is running after particular thing doesn’t make it right thing. I think same is happening with large cap companies because if we think about above points it is always better to invest in mid cap and small cap stocks rather than large cap stocks.
