My Contrarian View on Smallcap Stocks

I came across the following amusing quote recently.

• During the past year, it was possible to become fiscally flabby through a steady diet of speculative bonbons.

This was none other than Warren Buffett addressing his readers way back in his 1968 partnership letter. Bonbon, if you are aware, is a chocolate shell that's filled with jelly or some such thing.

So, what Buffett is trying to say is that a lot of investors minted money the previous year by investing in highly speculative stocks.

He compared the consequences of eating too much chocolate on one's health to the consequences of speculating too much on the health of one's portfolio.

You see, Buffett massively underperformed the market in 1967. A lot of funds earned close to 100% returns that year, outperforming Buffett in a big way.

But Buffett wasn't convinced these funds were following sound investment principles.

In fact, he was of the view that a lot of them were engaging in high risk, speculative investments.

However, his advice fell on deaf years with advocates of the high-risk strategy insisting otherwise.

Buffett had learnt from his teacher and mentor, Ben Graham, that speculation was neither illegal, immoral nor fattening (financially).

However, there were a lot of investors out there who had turned fat or flabby financially by eating a lot of speculative bonbons.

He has used this metaphor to state that while speculation could be fun in the short term, it can make you unhealthy in the long run.

He then went on to add how he continues to eat a steady diet of oatmeal and won't come anywhere close to eating the speculative bonbons.

Of course, when a market crash comes, even Buffett's portfolio could take a knock, but it won't be the kind of indigestion that would cause a lot of damage for those eating only speculative bonbons.

This is because his strategy is safe and incorporates elements like intrinsic value and margin of safety. So he won't be as badly affected as the speculative guys.

Well, this is exactly how we recommend stocks at Equitymaster. We, like Buffett, are on a steady diet of healthy food like soups and salads and stay away from burgers and French fries.

You see, smallcaps and penny stocks are having a dream run of late. The BSE Small Cap index is up more than 30% in four months. It has also reached a new all-time high.

While this is certainly something to cheer about, this is also a time for caution. Let me tell you why.

You see, out of the 968 stocks that form a part of the BSE Small Cap index, can you guesses how many have gained since the lows of March earlier this year?

95% of them. Yes, that's right.

This means that even a random portfolio of 20 smallcap stocks created towards end of March, would have had 19 winners and only one loser.

Does this mean that out of almost 1,000 stocks, only 50 are of poor quality and the rest are all investment worthy? Absolutely not.

To prove it, I did another study.

The BSE Small Cap index had a nasty fall between January 2022 and June 2022. The index was down some 24% during this period.

Any guesses how many of the stocks fell during this time period?

A whopping 90% of them. Yes, that's right. Even if you had put together a portfolio of 20 stocks with the best fundamentals, chances are that 18 of those stocks would have still suffered decline during this time period.

The takeaway is clear.

Not all stocks that go up when the BSE Small Cap index goes up, are investment worthy. A large number of them are speculative as well.

Likewise, not all stocks that go down when the index goes down are speculative in nature. A good number of them are investment worthy.

The trick to doing well in investing is having the ability to differentiate between investment and speculation and then having the discipline of staying away from speculative counters.

You need to continue to take a diet of soups and salads and stay away from French fries and burgers.

I believe one of the big reasons a large number of people like us is because of our huge aversion to anything that has to do with speculation.

Our recommendations go through the most stringent quality filters. We see to it there's a considerable margin of safety in the valuations when we recommend stocks.

Stocks with no profits but only future promises or the ones that are high quality but command super premium valuations, are not for us.

Investing in these stocks is akin to eating burgers and French fries. They may be super tasty and fun while they last but could leave you vulnerable to many health-related issues later on.

Our stocks on the other hand are like your soups and salad. They may be bland and boring but could prove extremely rewarding over the long term.

Now this doesn't mean that you should completely stay away from speculation i.e. not eat burgers and French fries at all.

You should. But you shouldn't make it your staple diet. As long as you are having it occasionally i.e. making speculation only a small part of your overall portfolio, you should be fine in my view.

But overindulge i.e. speculate too much, and the long term consequences could be disastrous.

So if you want to save yourself from a huge bout of financial indigestion, you must invest in the financial equivalent of salads and soups. You must pay attention to business quality and also ensure you are not overpaying for stocks.

And this becomes even more important in times like these where greed and FOMO have the tendency to make us take reckless decisions.

So, tread carefully and you should be fine over the long term.

Happy Investing.

Warm regards,


Rahul Shah
Editor and Research Analyst, Profit Hunter
Equitymaster Agora Research Private Limited (Research Analyst)