According to Shankar Sharma, investors in small-cap stocks must assume governance risk

 According to Shankar Sharma, investors in small-cap stocks must assume governance risk

Small-cap investors must be cautious and hope that not all of the companies in their portfolio have governance problems since they are unable to completely avoid them.

Renowned small-cap investor Shankar Sharma said that investors should accept losses as part of an occupational hazard and that they cannot escape governance concerns in small-caps. In a special Moneycontrol interview, Sharma also provided his risk-reduction checklist.

To enhance governance, companies must go through a cycle of misgovernance. Even auditors may be duped by a firm, and we, as minority investors, have no idea what goes on behind closed doors," Sharma said.

Using the Worldcom and Enron crises as examples, Sharma clarified that risk is present in both small- and large-cap businesses.

The greatest accounting scam in US history at the time, worth $11 billion, caused US-based WorldCom Inc. to fail in 2002. Top executives put pressure on subordinates to exaggerate data in order to make the firm seem more lucrative as part of the deception.

Renowned investors controlled both Enron and WorldCom, thus they were hardly insignificant businesses. Like Arthur Andersen, they had audits. Thus, we acknowledge it as a potential work-related risk," Sharma added.

Accounting errors have also put Brightcom, one of Shankar Sharma's investments, at the center of the controversy.

Smaller size firms are seen to be riskier to invest in than mid- and large-cap companies because, in Sharma's opinion, they are unproven and lack data governance. "To improve back into governance, many management must go through a cycle of misgovernance."

"Even if we lose 50% of the portfolio due to poor investments, we won't be very affected since the profitable investments will more than offset the losses from the bad investments, which may account for 5% of the total. You can only manage the problematic investments in your portfolio in that manner, Sharma said.

Sharma said that he meticulously examines the tax and dividend payments in addition to the caliber of the company's board when determining how investors might reduce risk.

"Back-of-the-envelope tax and dividend payments would verify that the firm is earning cash and not simply accounting profits, however these two hygiene checks are not 100% reliable. And from the perspective of a retail investor, there is sufficient justification to purchase a tiny stake in a business," Sharma said.