This is the key reason why in most cases the alpha generated is not attractive and usually shows a higher degree of underperformance relative to the markets

Therefore then how can a investor really outperform the markets and generate a strong alpha ? The answer to this question is that investors need to focus on smaller companies within the mid cap & small cap segment where the growth potential is bigger

This is logically right as a stock which is already a large cap & is already discovered by the markets is unlikely to generate a large alpha going ahead

While such stocks are undoubtedly quality stocks and can give steady returns and offer stability in a portfolio, for small Retail Investors these stocks will not offer high rewards as valuation multiples here are already trading at peak multiples

A classic example of high premium pe multiples can be seen from stocks like Nestle, Britannia, Dmart and Dixon which trade between 60 to 96x one year forward earnings

While we are not denying that all these are great businesses & will continue to generate steady returns over the long term, for a small retail investor buying such stocks at such premium valuations will not help them allocate capital properly

It is exactly this reason that we see very small/marginal holdings of blue chip stocks in most retail portfolios which are unlikely to generate any significant absolute gains which is more important that relative returns for retail investors

But investors who want to generate a strong alpha & build concentrated portfolios should look at small caps which are largely ignored and offer a higher risk reward for investors

So how should one go about this strategy if one wants to deploy funds here ?

For implementing this strategy, one needs to focus on 3 key factors which include understanding the business model of a company, secondly what is the scalability of the business ahead and thirdly the promoter’s hunger for growth & honesty in delivering the numbers going ahead

When looking at the business model of a small cap company one must observe whether it has a unique business or where competition is limited or where it has some key competitive business moats in a particular business segment

Secondly one must understand what is the size of the opportunity going ahead & how much scalability potential is available with the company to grow ahead. And thirdly which is the most important factor is the promoter passion & hunger for growth which eventually helps a company grow faster than others in the market

Some small companies which have generated huge alpha for investors include Sirca Paints which was available at a market cap of ₹540 crs in 2020 is now available at a market cap of ₹1620 crs – 3x in 40 months. Similarly Knowledge Marine & Engineering Works Ltd was available at a market cap of just ₹168 crs in 2022 which has now shot up to ₹972 crs – 6x in 18 months.

Both these companies enjoy a strong business model, a strong margin profile but more importantly operate in a sector where growth potential is unlimited. As soon as the markets understood these positives, both the stocks got re rated handsomely. Retail investors who invested here have thus benefitted significantly which is why these returns cannot be compared to large cap stocks

But before we conclude a word of caution also, investing in small cap companies requires more deeper research, more scuttlebutt and more importantly a high risk appetite and hence one needs to be very selective here

However in a growing and diverse economy like India, there are many entrepreneurs coming up and hence the opportunity to invest in such small and midcaps is massive.

Avinash Gorakshkar, Head of Research at Profitmart Securities. Views expressed are completely personal and not of Mint.