December 8, 2010

There is always a risk

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 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.

Short update on the paid service
I have been surprised by the phenomenal response to the paid service. I ended up getting a response far in excess of what I had planned and could handle. As a result, I have taken off the subscription forms till I am able to meet the demand I already have.

Added reminder – if you have subscribed to the mailing service, please remember to check your mail box and use the link to confirm the subscription. If you have already confirmed the subscription, I have sent an email about the service details. Please remember to check the email for details.


Anonymous said...

Balmer lawrie and cos MD for the logistics division have been held for accounting frauds.
As you already know, this division account for most of the profits for the company,if i am right, around,70-80%,so whats your take now :) ??

Raja said...

Hi Rohit,

Yet another good post.

I have been trying to read all your old posts for sometime now. But something or the other always keeps me away from doing that.

So, i have this suggestion. Is it possible to put all your posts into some kind of pdf file and make it available as a download on you blog ? (There are some free apps which can do that on the net like zinepal . com )

That will help newbie readers like me immensely, specially to be able to read them without requiring to be connect to the net.

Also, I loved your post on the 'buy and hold' investing very much. And would be waiting to hear more such company analysis in future.
One more company suggestion from my side ? What do you think of Gillette India as a buy and hold investing prospect. At the right price of course.


rayhaan said...

hi rohit a.k.a OH ghost of my english teacher!, i repent for not attending your classes and chilling out in the hopefully a more understandable version of my last comments
just had a few questions- u think it's a good idea to have a look at money matters.? I mean as long as the accounting is alright and no serious liability is imposed on the firm, it might still make a good investment.what do you think?
Q2.please have a look at Empire industries.i mean it sure reminds of a former pick of yours has some freaking awesome numbers(consistent roe in the 20s, good margins and cool free cash flow numbers !)
Q3.Speaking of crazy situations , YOU might like to have a look at dhandapani finance,its an nbfc trying 2 go thrOUGH a deep CORPORATE DEBT RESTRUCTURING. Even though the chances of a bankruptcy are there, it might just prove to be a multibagger if the CORPORATE DEBT RESTRUCTURING goes through without hurting the shareholders too much , in this age of bailouts who knows? (i believe the results of the CORPORATE DEBT RESTRUCTURING process should be out in January.By the way i shot them an email seeking various details of the restructuring and they shot 1 right back asking me my client id/portfolio no. Is it a good idea to give it away? In case you are wondering ,the co. has come under new management) . in short , the market capitalization of the company is 5 crores while there is total debt of 144 crores and sundry debtors of 140 crores approx.(many ofthese are NPA ,these are September 2009 figures) so basically as they say in the world of vulture investing its either feast or famine! i mean I understand there is a real risk of bankruptcy here,but in this age of bailouts this does seem a good stock to track. really eager to hear your views.
p.s dude how about a post on the dangers of investing in small and mid caps sometime soon?

Rohit Chauhan said...

Hi anon
A JV had a fraud and the MD of the JV was removed. the company has taken a write off for the losses in the JV . if i remember it was around 10-15 Crs

I have not changed my views of the company as the intrinsic value has not been impacted.
these are risks one has to live with