The last six months have been a ball. If you were smart or lucky (or both) to have picked the right midcap or small cap stock, you could have seen a 100-200% return by now or may be even more.
In the initial stages, it is quite likely that the diligent and focused investors picked these stocks after doing a decent amount of analysis and research about the underlying business and the company. It is also quite likely that these investors were not expecting the stock to double or triple in such a short period of time.
What the smart investors do in the beginning, the herd does in the end.
I have been amazed to see the euphoria and enthusiasm about the mid caps, small caps and even no caps (companies with no profit or business). In the last few months, I have seen articles in economic times and other such papers encouraging investors to get into such stocks – right after these stocks had gone up 100% or more.
The near term versus long term
I would recommend that you do a small exercise. Go to finance.google.com or any such website and look at the price action for several midcap and small caps. You will find a hockey stick graph.. a flat line for couple of years and then a huge swing in the last few months.
It’s quite possible that the fortune of several such companies has suddenly turned and they deserve a higher valuation. However I find it hard to believe that all of a sudden, all these mid caps and small cap companies deserve an en-masse re-rating
There is always a risk
I have no idea if these stocks will rise in the coming months or continue to drop in price. One point is however clear – A lot of these companies have a higher level of business risk than the large cap companies.
A lot of these companies are no.3 or 4 in the industry. They do not have a competitive position that is as strong as the no.1 or no.2 player. As a result, if the demand slows or if there is cost inflation, the profits of these companies would be the first to get a hit. If such a scenario happens, then the stock price correction could be swift and brutal.
Unfortunately a lot of investors have forgotten this point in the last few months and only see the returns while ignoring the risks
What to do about these risks?
The first point in investing in mid and small caps is that one should have the appetite for high volatility and risk which comes with these types of stocks. If you are going to get scared with a 20% or higher drop in the stock price, then these stocks are not appropriate for you.
The second point to keep in mind is that some ideas in this segment are bound to fail. The governance and competitive position of these companies is quite poor. As a result some of these companies will hit a bump, from which they may never recover or take a very long time to recover. In such cases, one has to bite the bullet , sell and move on
Finally, if you have done your homework and know the company will do well in the long run, then just ignore the market noise and either sit pat or if you have the guts, then buy more when the price drops due to some short term sentiments.
Personally, if I was starting out new, I would avoid mid-caps and small caps altogether. I would focus on the big companies, learn about them and invest in those companies in the beginning.
Sure, I will make lower returns and will not be able to boast that I had a multi-bagger, but then in the end at least I will have a bag left when others lose their bag, shirt and all other parts of their clothing.
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