Most retail investors have a habit of including large cap stocks, usually blue chips, in their portfolios without using an appropriate asset allocation technique.
This is the main cause of the generated alpha being unattractive in most situations and typically underperforming the markets to a greater extent.
How, therefore, can an investor actually outperform the markets and produce a significant alpha? Investors should concentrate on smaller companies in the mid cap and small cap segment because they have greater growth potential.
This makes sense because a stock with a huge market cap that has already been found by the markets is unlikely to produce a significant alpha in the future.
Even though these are unquestionably high-quality firms that may provide stable returns and stability for a portfolio, small retail investors will not see big returns from these stocks because the valuation multiples are already at their top levels.
Stocks like Nestle, Britannia, Dmart, and Dixon, which trade between 60 and 96x one year forward earnings, are a classic illustration of high premium PE multiples.
While none of these companies are bad and will continue to produce steady returns in the long run, a small retail investor won’t be able to allocate capital effectively by purchasing such stocks at such high valuations.
For this reason, most retail portfolios only include extremely tiny or marginal holdings of blue chip stocks, which are unlikely to provide any big absolute gains that are more significant for retail investors than relative returns.
However, small caps, which are largely unnoticed and offer a higher risk-reward for investors, should be considered by investors who want to generate a strong alpha and build concentrated portfolios.
So how should one approach this plan if they wish to use money here?
Understanding a company’s business model is the first step in executing this strategy. The second step is determining how scaleable the business will be in the future, and the third step is determining the promoter’s desire for growth and candour in providing future financial information.
When examining a small cap company’s business model, one must consider whether it has a distinct offering, operates in an industry with little competition, or has significant competitive advantages in a particular market.
Second, one needs to comprehend the scope of the opportunity moving forward and the company’s capacity for future expansion. The promoter’s zeal and appetite for growth, which is the third and most crucial aspect, ultimately helps a firm grow quicker than its competitors in the market.
A few tiny businesses that have produced significant alpha for investors include Sirca Paints, whose market cap increased by three times in 40 months from 540 crores in 2020 to 1620 crores now. The market cap of Knowledge Marine & Engineering Works Ltd., which was only 168 crores in 2022, has now increased to 972 crores—a 6x increase in just 18 months.
Both of these businesses have a sound business strategy and a healthy margin profile, but more importantly, they are in an industry with virtually limitless growth potential. As soon as the markets recognised these advantages, both stocks saw a significant increase in rating. These returns cannot be compared to large cap equities because of the enormous benefits received by retail investors who made investments here.
But before we go any further, a word of caution: Investing in tiny cap firms takes more thorough research, more skulduggery, and, most crucially, a high risk tolerance, therefore one must be very picky in this situation.
But in a developing and diverse economy like India, where many new business owners are emerging, there is a huge opportunity to invest in such small and midcap companies.