How risky are small and mid caps, really?

The Calm Investor | Small Cap Investment Strategy

Synthetics & Chemicals, SOL Pharmaceuticals, Prime Securities, Mardia Chemicals, Industrial Oxygen, FGP ltd, Asian Coffee, Rico Auto Industries, Modiluft...What do these companies mean to you?

How about these: Value Industries, Crest Animation Studios, Chettinad Cement, Agro Dutch Industries, Matrix Laboratories, Aztecsoft, Salora International, Golden Tobacco…Do they ring a bell?

Unless you were an active stock picker two decades ago, you probably didn’t recognise the first set. Or a decade ago, for the second set.

Now take a look at this chart.

The Calm Investor | NIFTY 500 You’ve probably seen it before. The NIFTY 500 (the index made up of the largest 500 companies by market cap) outperforms the NIFTY (top 50 companies by market cap). But because there is no free lunch, the NIFTY 500 is more volatile than the NIFTY.

So, just buy the 500 companies that make up the NIFTY 500 and hold, right? Sure, there’s more volatility but look by how much they beat the benchmark index.

Wrong. Charts like these misrepresent actual performance of the underlying assets, especially of small and mid caps. Here’s how.

Chart below shows the number of companies churning from the NIFTY 500 each calendar year since 1999 (the index was formed in 1998).

The Calm Investor | NIFTY 500 Exclusions

Since 1999, 930 companies have been excluded from the 500-stock Nifty 500 index.

On average, 36 out of 500 companies have been replaced annually. 2002 and 2016 saw 20% (one of every 5 companies) being replaced. 2010 saw only 18 replacements.

What causes these replacements?

From the methodology document for the NIFTY 500:

To be considered for inclusion in NIFTY 500 index, companies must form part of eligible universe. The eligible universe includes:

  • Companies ranked within top 800 based on both average daily turnover and average daily full market capitalisation based on previous six months period data
  • Companies traded for at least 90% of days during the previous six months period

NIFTY broad based indices are reviewed twice every year based on six month data ending January 31 and July 31. Eligibility criteria for newly listed security is checked based on the data for a three-month period instead of a six-month period.

Notice the number of companies that fail to meet these criteria and ‘disappear’ each year. Almost like they were beloved characters in Game of Thrones.

Takeaway 1: In any given year, 1 in 10-12 companies just disappears, taking your investment value in it, close to, if not all the way, to zero.

That might still not appear too bad until you consider what a long-term buy-and-hold strategy would face.

The Calm Investor | NIFTY 500 Survivors

Looking backwards from the companies that form the NIFTY 500 today (April 2019), 487 of them were in the index a year ago, 408 of them in 2014, and so on. This means 13 of the Nifty 500 in 2018 did not make it to 2019, 43 of the 500 in 2014 did not make it to 2019, and so on.

If you’re a buy-and-hold investor, over 300 of 500 companies will not survive two decades, over 150 of 500 will not survive a decade, and over 90 will not survive even half a decade.

Takeaway 2: Buying and holding a concentrated portfolio is all very well but most companies do not survive, let alone thrive over long periods. Unless you get your stock-picking bang on, expect high mortality

What of the survivors? What were your chances of decent returns from them?The Calm Investor | NIFTY 500 Returns

Table shows, of the current NIFTY 500, how many were available in each year, what percentage of them delivered non-negative returns, and the median return from these survivors in that year.

Notice how the pool of the current NIFTY 500 shrinks the further back in time we go. This we already saw in the survivors vs non-survivors chart above. But also notice how the higher the percentage of stocks with +ve returns, higher the median return of the entire set of stocks.

There is a high correlation between % of positive returning stocks and median returns in any given year.

Takeaway 3: Barring a proven ability to pick winning stocks, especially in small and mid caps, it is a lot easier to deliver positive returns in a year when the broader market does well than when it doesn’t

The high volatility of small and mid-caps is well documented as a tradeoff for higher returns. The volatility, however, does not capture the added risk of high mortality of such stocks. Expectations from a concentrated investment strategy built around small and mid-caps need to take this added risk into account.

Further Reading

Since the broader markets decide our returns, might there be a way to know when to stay invested, and when to stay in cash? Go ahead, time the market.

3 thoughts on “How risky are small and mid caps, really?

  • April 12, 2019 at 5:21 pm

    Interesting post, thank you. A Nifty500 ETF on the other hand would have delivered 15% CAGR in the last 17 years (according to the graph you have there). Investing in a passive market portfolio may have merits after all!

  • June 5, 2019 at 3:44 pm

    Won’t the ETF also sell and in most cases book losses, when stocks are removed from the index?

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