The Right Way To Choose Small-Cap And Mid-Cap Stocks
Despite steep underperformance by small-caps and mid-caps over the past couple of years there is a perception amongst investors that these categories are the ones with greater potential for returns. Yogesh Supekar details the steps that need to be taken in order to build a portfolio of small-caps and mid-caps while Karan Bhojwani throws light on the performance of the broader markets
Benjamin Graham
"Investing isn’t about beating others at their game. It’s about controlling yourself at your own game."
The derivatives market volumes reached record highs in 2019 and this is testimonial to the fact that volatility is on the rise in global equity markets. Indeed, 2019 can be marked as a year of stirring announcements where the ‘blow hot, blow cold’ comments from US President Donald Trump induced heightened volatility in the global markets. Along with the increased volatility, what was noticed in Indian equities was the deep under-performance of small-caps and mid-caps in 2019. The underperformance was severe considering the fact that the small-caps and mid-caps underperformed even in 2018.
That makes it two years of solid underperformance by the broader markets. This polarised behaviour of the market was never seen before by a majority of market participants. Come the second half of 2019, already a consensus was getting built about the valuation gap between the broader markets and the large-caps being at its widest and that the extreme relative under-performance of the broader markets would be reversed.
Clearly enough, the trend and along with it the sentiments have changed when it comes to small-cap and mid-cap investing. As we move further into 2020, there are ominous signs that the small-caps and mid-caps may more than catch up with large-caps. In such a market environment when the broader markets are expected to outperform, investors can be expected to build a portfolio of small-caps and mid-caps with a portfolio beta greater than 1.
Buying Small-Cap and Mid-Cap Stocks
Timing is quintessential when it comes to generating excess returns in the markets consistently. While it is almost impossible to time the markets accurately, it pays hefty dividends to have your ears close to certain patterns or trends, proper identification of such trends can help investors generate market-beating returns. Timing smallcaps and mid-caps can generate not only higher returns but also quick returns. It is observed that small-caps and mid-caps begin to rebound in growing economies faster than the large-caps.
Says George Heber Joseph, CEO and CIO, ITI Mutual Fund, “The right time to invest in small-caps is when pessimism is the highest and the absolute valuation is very cheap for the small-cap segment of the market. Every 5-7 years the equity markets give an opportunity to invest in small-caps at a very attractive valuation. In the years 2003, 2008 and 2013 small-caps were very attractively valued and we believe the year 2020 is again providing a fantastic opportunity to invest in small-caps at very cheap valuations. The differential valuations between large-caps and small-caps are at a decade high and this offers a significant opportunity to investors to invest in small-caps and make significant alpha over large-cap stocks.”
Portfolio Beta
Portfolio beta is a measure of the overall systematic risk of a portfolio of investments. It is the weighted average of the beta coefficient of all the individual stocks in a portfolio. If a portfolio consists of stocks with a relatively high beta or more than 1, they are more sensitive as compared to the market as a whole. These portfolios will go up more than the index when the markets are bullish and go down more when the markets are bearish. Hence, an investor will attempt to add stocks with high beta to his portfolio when the market outlook is positive and will look to add stocks with low beta (less than 1) when the market outlook is negative.
Choosing Small-Caps and Mid-Caps — Here are some tips:
1. Search for companies facing new opportunities : It can work in favour of small-cap and mid-cap investors if they can identify any company faced with new business opportunities created by paradigm shifts in the industry. For example, both a small-cap and a mid-cap paper manufacturer have a lot to gain when a plastic ban is announced and implemented nationwide.
2. Growth investing and small-cap, mid-cap investing are synonymous: A small-cap and mid-cap investor is in essence a growth investor. A growth investor is one who believes that his or her competitive edge in estimating the value of growth assets is better than others in the market. Hence before investing in small-caps and mid-caps, one needs to understand in depth, the concept of growth assets. Growth assets are the assets owned by various companies across market capitalisation that have the potential to generate cash flows in the future, which can increase the value of the firm.
So it is essential to identify the growth assets owned by the small-caps and mid-caps. Only those small-caps and mid-caps should be included in the portfolio that reflect promising growth assets and satisfy the other stock selection criteria. Also, investors have to be careful of not overpaying for the growth. The price of growth need not be higher than the value of growth. It is important for investors to focus on growth rates in earnings and estimate the high-growth periods that the company under study is expected to experience. The value of growth for any company will depend on the levels of growth, the length of high growth periods, and most importantly, how much higher is the return on capital over the cost of capital.
Prudent investors can adopt GARP (growth at reasonable price) strategy while selecting small-caps and mid-caps. GARP strategy is an equity investment strategy that combines tenets of both growth investing and value investing to identify quality stocks. One of the filters adopted while implementing GARP strategy is to focus on stocks where the PE ratio is lower than the rate of earnings’ growth in the future.
3. Invest in companies before the institutions notice them: This is easier said than done. However, it can be extremely profitable if one can get hold of quality small-caps and mid-caps where the institutional holding is close to nil. If one can take extra efforts and identify stocks that fit the buying parameters of institutional investors, the probability is high that the stocks selected for your portfolio get chosen by institutional investors. Once liquidity kicks into the small-caps and mid-caps the prices can jump higher in no time, thus rewarding the investors handsomely.
4. Create a portfolio of small-caps and mid-caps: While small-caps and mid-caps are perceived to be risky as they are relatively much more volatile when compared to large-caps, the good news for small-cap and mid-cap investors is that a welldiversified portfolio of small-caps and mid-caps have shown similar behaviour as in the case of diversified large-cap portfolio when it comes to volatility. Of course the volatility is on the higher side for a small-cap and mid-cap portfolio when compared to a diversified large-cap portfolio although the difference is negligible. Thus, the trick here is to construct a portfolio of small-caps and mid-caps and have adequate number of stocks to provide the much needed diversification benefits. Without smart portfolio management small-cap and mid-cap investing may prove to be futile exercise and may lead to losses.
5. Avoid big losses: When you buy small-caps and mid-caps the trick to generate larger returns in the long term is to avoid making huge losses in those counters that are not doing well. It is common to see quality small-caps and mid-caps fall by 20 to 30 per cent; however, when the stocks correct by more than 50 per cent, the damage may become irreparable. Sticking to quality small-caps and mid-caps while always focusing on earnings growth is the key to avoid big losses. Regular monitoring of portfolio stocks and churning is required. As smaller companies are more susceptible to corporate governance issues and have been accused of relatively unprofessional management, it is important to check the track record of the management. At any hint of corporate governance one can exit the counter without any further delay.
Technical Outlook Mid-Cap & Small-Cap Indices
Nifty Midcap 100
The index has registered an all-time high as on the weekend of January 19, 2018 and thereafter it entered into a corrective phase by forming sequence of lower tops and lower bottoms. The correction halted near 78.6 per cent Fibonacci retracement level of its prior upward move (13,658.15- 21,840.85). For the down move which began from January 2018 to low of August 23, 2019, the index took almost 83 weeks. The recent pullback, which started on the weekend of August 23, 2019, has helped the index to retrace 50 per cent of its last fall in just 24 weeks. This suggests that recent upward move is impulsive in nature. Moreover, the recent rally from lows is its strongest rally since 2018, having gained almost 23 per cent.
What do the moving averages indicate? Majorly, the index is displaying a bullish trend as it is trading above its short-long term moving averages, that is, 20-week EMA, 50-week EMA, 100-week EMA and 200-Week EMA. The 50-DMA crossed over the 200-DMA 15 days ago, called the ‘golden crossover’, which is a long-term bullish signal. The leading indicator of 14-period weekly RSI is currently quoting at 67.67 and it has given a two-year flat zone breakout, which depicts further positive momentum.
The weekly and daily MACD stays bullish as it is trading above its zero line and signal line. Moreover, the Know Sure Thing (KST) has given breakout of inverted head and shoulders’ pattern. Going ahead, the index needs to move and sustain above its previous swing high level (18,463). Overall, we expect mid-cap stocks to accelerate outperformance. Hence, we advise investors and traders to focus on quality mid-cap stocks and utilise dips to accumulate these stocks.
Nifty Smallcap 100
The index had witnessed a correction of about 47 per cent from January 2018 highs to lows of August 2019. The index, after registering a low as on the weekend of August 23, 2019, formed a sequence of higher lows and also, as on the weekend of December 27, 2019, has given breakout of downward sloping trend line on the weekly time scale. Thereafter, it has witnessed followed up buying and this can clearly be witnessed from it having maintained its winning streak for the sixth week in a row. Currently, the index is trading above its 20-week EMA (5,914.65), 50-week EMA (6,027.05), 100-week EMA (6,318.65) and 200-week EMA (6,274.603), which indicates a medium-long term uptrend.
Among the momentum indicators, the 14-period weekly RSI is currently quoting at 67.09 and it is in the rising trajectory, which indicates a bullish bias. The weekly MACD stays bullish as it is trading above its zero line and signal line. On the weekly chart, the MACD is above its zero line for 18 weeks and above the signal line for nine weeks. Moreover, the daily ADX is very strong at the 41.89 level. The -DI is below the +DI and ADX is above the -DI and +DI. This shows the technical strength inherent in the index.
Going ahead, we believe the index will accelerate its upward march and head towards its swing high of the 6,822 mark, which was registered in April 2019.
Viram Shah
CEO and Co-Founder, Vested Finance
“The Global Outlook for Small-Caps and Mid-Caps looks Positive”
How have the mid-caps and small-caps performed in the US markets over the last three years?
Over the last three years the performance of both mid-caps and small-caps in the US has been mediocre. They have lagged behind the large-caps. If you look at Vanguard ETFs that invest in mid-caps and small caps (tickers are IJH and VB, respectively) they both have given annualised returns of about 9-10% over the last three years compared to the 15% returned by the S & P 500. The Russell 2000, an index which tracks small-caps, has given a return of 8% over the last three years.
What is the outlook for global smallcaps and mid-caps for 2020?
The 2020 outlook for global small-caps and mid-caps looks positive. The declining interest rate environment has historically benefited small-caps and mid-caps more than large-caps. Further, large-caps across the world have been affected by the US-China trade war. However, smaller companies are more locally focused and hence isolated from trade war happenings. Further, the S & P 600 is a benchmark used to evaluate the performance of small-cap stocks and usually trades at a higher price-earnings ratio than the S & P 500. This is due to the higher growth expectations from small-caps. Recently, the gap between the two indices has narrowed to record levels. This makes it very likely that small-caps will outperform in the next year.
Conclusion
Small-cap and mid-cap investing is great. However, the results (investment returns) are purely a function of what investment process you adopt while investing in small-cap and mid-caps stocks. A lot (excess returns) will depend on when you buy these categories of shares. It is observed that when an economy is in a recovery stage the small-caps and mid-caps tend to outperform large-caps. Timing does matter when it comes to equity investments but matters even more when it comes to small-cap and mid-cap investing. For those who are not good at timing the market, regular investing and investing in a staggered manner is highly recommended. When it comes to small-cap and mid-cap investing, the importance of discipline and diversification becomes even greater.
Small-caps are usually concentrated in a few sectors as compared to large-caps and hence a much larger portfolio (number of stocks) is required to remain diversified. Also, more man hours of research is required when it comes to small-caps and mid-caps as relatively less information is available as compared to large-caps. As only a few analysts track small-caps and mid-caps, investors should be prepared to do independent research on their own. It is advisable that investors go beyond the financial statements and gather relevant information from local newspapers, customers and competitors to have an edge or an advantage. Another rule that applies to general equity investing that needs to be followed even more strictly in case of small-caps and mid-caps is ‘investing for long term’. It is important that investors take a long-term approach when it comes to small-caps and mid-caps!