Retail Investors in Small-Cap Stocks Beware! These Are The Repercussions

While the increasing participation of retail investors in the equity market is heartening, certain features make Small-Cap stocks correct relatively much faster than Large-Cap stocks when the overall market corrects. Dr Ruzbeh Bodhanwala and Dr Shernaz Bodhanwala, faculty at FLAME University, Pune, dissect the current ‘frothy’ scenario 

There is a massive rise in retail participation in India with around 40 lakh new demat accounts opened in the month of January 2024. The total number of demat accounts as of February 2024 was around 14.83 crore. As per the data published by the Association of Mutual Funds in India (AMFI), the SIP flows into mutual funds are increasing with total assets under management (SIP AUM) at over ₹10 lakh crore as of February 2024. This strongly indicates a big shift in the financial nature of the Indian economy. This financial aspect refers to moving away from traditional asset classes like land, home properties, physical gold, etc. towards financial assets. [EasyDNNnews:PaidContentStart]

It is indeed heartening as the government’s efforts to bring the last mile person into the formalised economy and provide equal opportunities for all seem to be paying off. However, knowing where the new money is being deployed in the market is also important! A simple rule of economics suggests that when more money chases the same quantity of commodity, it will increase the prices. In the stock market, when too much liquidity is found to be chasing the same number of shares, it will lead to an increase in share prices. 

Madhabi Puri Buch, Chairperson, SEBI, has raised concerns about the overvaluation in certain pockets of small-cap and Mid-Cap stocks and the safety of investors’ interests. Retail investors need to understand that, in the long term, share prices are the slaves of earnings. Many people are ready to invest at premium valuations as they expect the companies to grow their earnings faster and generate a high rate of return on the shareholders’ funds. However, when these expectations are not met, it would lead to increased scrutiny and scepticism, and thus, the stock prices would correct in the longer term. 

As American investor and renowned author Howard Marks has said in his book ‘Mastering the Market Cycles’, “Everything else being equal, the bigger the boom—and the greater the excesses of the capital markets in the upward direction—the greater the bust. Timing and extent are never predictable, but the occurrence of cycles is the closest thing I know to inevitable.” In simpler terms, markets are prone to gyrate as the market cycles turn. When the tide turns, the prices of small-cap stocks correct much faster. Illiquidity and price volatility in small-cap stocks make it difficult for retail investors to plan their exit strategy. 

This makes investing in small-cap stocks a risky option. For new investors, we wish to clarify that the market capitalisation of a stock is defined as the stock’s market price multiplied by the number of outstanding shares. A typical feature of small-cap stocks would be one whose market capitalisation is small – they have a small investor base, low liquidity, low volume, high volatility, and thus high chances of price manipulation. Further, relatively very few institutional investors and analysts track these companies. These features make the small-cap stocks correct relatively much faster than the large-cap stocks when the overall market corrects. 

Historically, it has been observed that companies that can grow earnings at a higher rate would appreciate more than others, and thus, an increase in share price leads to a rise in market capitalisation. Small-cap stocks can grow at a much higher rate than large-cap stocks and thus have the potential to increase shareholders’ wealth at a very fast pace. This can be attributable to the smaller base effect. However, historical returns do not guarantee future performance, and returns for investors depend mainly on the price one has paid to acquire the stock. 

In this article, we analyse the performance of the top 1,000 companies based on PE and return on equity. We sorted the top 1,000 listed non-finance companies based on market capitalisation to analyse the stock price performance versus companies’ performance. We selected all companies with market capitalisation exceeding ₹1,000 crore and segregated these companies into three buckets. The top 100 companies are a proxy to large-cap (excluding financial companies), the next 150 companies are proxies to mid-cap, and the remaining 750 are proxies to small-cap stocks. Table 1 gives median market capitalisation and promoter holding values for each bucket. 

Table 1 

As can be seen, the median market capitalisation of small-cap stocks was around ₹3,383 crore, and the promoter holding was around 57 per cent. Hence, the free float is much smaller. It should be noted that companies with limited free float are prone to significant price volatility. We used return on equity (ROE) as a proxy to measure companies’ performance. ROE typically captures everything happening in the company, and it is a critical ratio for shareholders. Ideally, shareholders pay a higher price if they expect higher sales and profitability in the future, so a higher ROE should justify the high PE ratio. 

Table 2 

An analysis of Table 2 reveals that the PE has expanded across all three categories, with the maximum expansion in the small-cap category. The small-cap median PE ratio has expanded by 71 per cent over the last year. The PE ratio of large-cap has also expanded, but the expansion is limited to 48 per cent. The PE expansion of 71 per cent is justified if the sales, earnings, or ROE shows a similar kind of expansion. However, when we look at the change in ROE, it is communicated that from the median ROE, there is a contraction of 5 per cent to 11 per cent. 

This should be alarming to investors because a PE expansion not supported by corresponding growth cannot continue for long. This makes investing in small-cap riskier than investing in large-cap stocks. For large-cap stocks, the ROE has decreased, too. However, large-cap stocks have higher market depth, liquidity and long trading history, and are widely held, so if the markets correct, large-cap stocks correct slowly compared to small-cap stocks. Retail investors directly investing in stocks should be careful when investing in stocks with small market capitalisation and low liquidity. Before investing, it is best to seek expert advice from SEBI-registered investment advisors and diversify one’s portfolio.

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