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Betting on quality micro-cap stocks may fetch you superior returns, if you have the patience to hold those for a long term. Nearly 85 per cent of micro and nano-cap stocks, having less than Rs 265 crore market capitalisation, delivered better returns than the overall market's returns in the past 10 years, according to Morgan Stanley.
The Wall Street firm studied the returns on 1,613 stocks traded during March 2002 and March 2012 in India and found wealth creation was best in micro-cap stocks. Companies de-listed or merged with other companies during the past decade were excluded from the analysis.
The median 10-year return for 1,613 stocks was 18.4 per cent compounded annual growth rate (CAGR), while the average price return for the sample was 18.7 per cent CAGR, Morgan Stanley found in its analysis. The median return from equities exceeded the 10-year government bond yield or the risk-free rate, which was 7.5 per cent in March 2002, by almost 11 percentage points. In comparison, average return for stocks having a market cap less than Rs 265 crore was 23 per cent CAGR.
Interestingly, the average return from the top 20 stocks in 2002 is 13 per cent CAGR, worse than the market median. Not just that, 11 of these stocks underperformed the market.
"Buying today's largest-cap stocks does not assure better returns. Ten of the top 20 stocks by market cap in 2002 no longer feature in the list of top 20 companies," said Ridham Desai, managing director and head of India equity research, Morgan Stanley, in a strategy note.
The lesson from history is to back companies that improve on their return on equity (RoE) and judiciously accumulate capital, according to the firm. Also, growth alone is not enough; valuations too, matter. On an average, stocks with rich valuation in 2002 failed to deliver superior returns in the 10-year time frame and vice versa.
However, there are counter- arguments to this analysis. "One should look at returns of all stocks listed in March 2002. That would give a better picture. For example, in 1995, scores of companies in sectors like granite, leather, teakwood and plantation had hit the market. Where are those companies now?" questioned an investment strategist at a Mumbai-based brokerage, who declined to be named. "The other fallacy in this argument of big versus small is that a 500-pound gorilla can't be compared with a nimble-footed orangutan," he added.
So, what about the current decade? "Arguably, returns are likely to be a tad lower. Valuations are higher than in 2002 but not rich by any measure. The starting point on RoE is also attractive. The only unknown is the growth in earnings," Desai said.
Various metrics tracked by Morgan Stanley suggest the market is expecting long-term earnings growth to slow down from the levels of the last decade. "The market metrics are implying a return of around 15 per cent, lower than in the past decade," Desai said.