Data collated by PMS firm Marcellus Investment Managers shows that in the three-year run-up to entering the BSE500 index, these potential entrants outperform the index by 36% CAGR with the margin of outperformance increasing as they get closer to entering the benchmark index.
“However, this trend changes completely once these stocks enter the index. Quite contrary to their performance pre-entry, new entrants into the BSE500 on an average underperform the BSE500 by 11% p.a. over three years post the entry,” says Mukherjea, whose firm handles over Rs 11,000 crore worth of HNI and institutional funds.
Team Mukherjea cites four reasons why most companies which otherwise enjoy a superb run when they are small are unable to sustain the momentum once they get bigger and enter the BSE500 index.
1) Accounting/governance issues
When it comes to investing in smallcaps, the accounting and governance risks are higher due to the relatively high dependence on promoters and relatively low level of analysts’ coverage and institutional ownership resulting in these companies not being subject to extensive diligence, he said. As scrutiny increases, new issues crop up.
2) Capital misallocation
Capital allocation becomes one of the biggest make-or-break events for a company particularly as it grows bigger in size and accruals start becoming sizeable, Mukherjea said. In most cases, he said the promoters or the people at the helm of capital allocation decisions demonstrate behaviours which are prejudicial to the interests of minority shareholders. He says that most entrants in BSE500 are unable to sustain their returns on capital employed with rising size.
3) Succession planning
Smaller companies typically involve a single person at the helm of the affairs but as the company expands, the rising business complexities require delegation of key responsibilities to a wider set of people as well as an eventual passing of the leadership mantle to the new generation. These HR issues eventually become the key roadblock to scaling up the business, Mukherjea said.
4) Re-rating benefits ebbing off
Once smallcaps reach a particular size, they move up the valuation band. However, the role of valuation re-rating in share price returns diminishes as the company becomes bigger and growth becomes the key driver thereof, he said. Smallcaps often see massive re-rating before getting included in the BSE500 index as investors start rewarding it on growth prospects but it is typically followed by de-rating as fundamentals stagnate.
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