Big Triggers For Small-Caps
The year 2020 has been a great one for those investors who have shown a preference for broader markets. The overwhelming performance of small-caps aided by SEBI's guidance of reshuffling of multi-cap mutual funds has triggered interest in small-caps afresh. Geyatee Deshpande analyses the performance of smallcaps while Yogesh Supekar shares why it makes sense to allocate more capital to small-caps in the current environment
Fantastic is how the small-caps performance has been in 2020. Actually, the overall markets, including the large-caps, have shown tremendous recovery this year. The Sensex is up by 33 per cent since the March lows. BSE Mid-Cap index and BSE Small-Cap index are up by 35 per cent and 40 per cent since their March lows. There has been a visible outperformance in mid-caps and small-caps in the past few months. And if the recent outperformance in small-caps is not exciting enough for investors, bulls have been provided additional fodder in the form of SEBI’s diktat to the mutual fund industry to increase allocation to mid-caps and small-caps in the multi-cap mutual fund category.
This announcement by SEBI is expected to create fresh liquidity of about Rs 40,000 crore for mid-caps and small-caps. In fact, small-caps are expected to get a lion’s share of this fresh allocation as they have low allocations in multi-cap funds at this point of time. The positive sentiment in small-caps is expected to cheer up retail investors big time. Retail investors usually show preference towards small-caps on account of the perception that small-cap stocks generate large returns in quick time. Says Sagar Punjabi who has been investing in markets since 2000, “In my demat account I purchase only small-cap and mid-cap stocks. At times I take position in micro-cap companies for aggressive returns.”
“For large-cap exposure I prefer ETFs and large-cap mutual funds. With the new SEBI ruling, I am as excited as anyone and am planning to increase my overall allocation to small-cap stocks. The best part about small-cap investing is aggressive returns in less time. There is a very good chance of bagging a multi-bagger when you invest in small-caps. I haven’t had that multi-bagger experience of investing in large-caps yet. Largecaps are good for stability and diversification but small-caps are essential for fast and high returns on a consistent basis,” he adds.
“After two to three bad years for small-caps the new Bull Run in small-cap IT and pharmaceutical stocks is going to be exciting. The outperformance is there for everyone to see in small-caps. I hope to make the most of the rally,” he further states. However, while there is no doubt that the small-caps’ recent performance has been superlative, investors need to be cautious while picking small-cap stocks in the portfolio. They would have to identify the sweet spot within the small-cap space. Right now this spot can be found in certain sectors and in those small companies that are showing consistency in earnings’ growth.
Sectors Showing Momentum
As the momentum is in favour of small-cap stocks we see that several of them are hitting their respective 52-week highs. As expected, most of the small-cap stocks that are scaling new highs come from healthcare, IT and chemical sectors. This just goes to highlight the secular rally in these sectors. Following is the list of stocks from these three sectors that are trading within a 10 per cent range from its 52-week highs.
Overall, out of 680 small-cap stocks that are constituents of the BSE Small-Cap index we find that almost 130 stocks have touched their respective 52-week highs. This means that almost 20 per cent of the BSE Small-Cap index constituents are making new highs in the current market conditions. Out of these 130 stocks, nearly 19 per cent or 25 stocks belong to the healthcare sector within the small-cap space and are within 10 per cent of their respective 52-week highs. Stocks of small-cap IT companies comprise 16 per cent of the total 130 stocks that are trading near their 52-week highs.
In total there are 21 stocks from the IT sector that are within the 10 per cent of their 52-week highs while as many as 19 smallcap companies from the chemical sector that are constituents of the BSE Small-Cap index are trading near their respective 52-week highs. It is not that the momentum is picking up only for the small-caps. It is also strengthening for the large-caps as well. The table below highlights the number of stocks that touched their respective 52-week highs since the beginning of the year, month-wise.
What is worth noting is that the markets have recovered from the ‘corona dip’ and the number of stocks hitting their respective 52-week highs is almost similar to that of the pre-pandemic levels, across market capitalisation. Also, worth noticing is the fact that the number of small-caps trending high is significantly higher than that of large-caps and mid-caps. This could be because of the higher number of stocks available in the basket; nevertheless, the higher number of stocks making new highs highlights the importance of tracking small-caps closely.
Within the small-cap space, investors can take a stock-specific approach and identify investing opportunities wherever one finds companies that have monopolistic market shares. For example, IEX has greater than 90 per cent market share in power trading, MCX has greater than 85 per cent market share in commodity trading and Pidilite Industries has greater than 65 per cent market share in adhesives. Similar stories of monopolistic market share companies can be focused on while identifying small-cap investing ideas.
Tracking the Results
With the bullish sentiment pushing small-caps higher it is easy for investors to get carried away and invest in poor quality stocks. Exuberance may lead to poor investment decisions. What investors need to do at this moment is not to lose focus on the quality aspects of small-caps. Quality can be gauged by high RoE, high RoCE and acceptable valuations. The quality of quarterly results also needs to be an important factor while making investment decisions in small-caps.
The following companies have declared ‘positive’ results in the small-cap space: Pilani Investments, Panacea Biotec, Morepan Labs, Tanla Solutions, Indoco Remedies, Nucleus Software and Shipping Corporation. In the latest quarter it is seen that the performance of several micro-cap companies is outstanding such as Venus Remedies, Garnet Construction, Tarmat, VLS Finance, Cosmo Films, LKP Finance, Xelpmoc Design, Kriti Nutrients, KM Sugar Mills, Bafna Pharmaceuticals, Onmobile Global, Mangalam Drugs and Organics, etc. While there are some outstanding performances in the recent quarter in IT and pharmaceutical space within the small-cap space, the performance across the small-cap space is not impressive.
A huge number of small-cap stocks have declared negative results in the latest quarter, namely, Spice Jet Allcargo Logistics, Swan Energy, NBCC, Purvankara, Nilkamal, Mishra Dhatu Nigam, Sterling and Wilson, Asian Star Company, Alok Industries, India Bulls Real Estate, JBM Auto, CG power, Jindal Stainless, Future Lifestyle, Jai Corporation, etc. Investors thus have to tread cautiously while factoring in the quality of results. Today, more than ever, tracking quarterly performances of these listed small-cap companies has become important as the results will reflect the length and breadth of the so called V-shaped recovery in the economy.
As expected, the defensive sector stocks in small-cap space have done well. Other sectors may stage recovery as the economy attempts to crawl back to normalcy. One of the most prudent ways to study consistency in the performance of the small-cap stocks is to understand the QoQ performance as well as the YoY performance. Those companies that have declared QoQ as well as YoY growth in net profits are worth considering for further investment analysis. The following table highlights those small-cap stocks that have shown growth in net profits on QoQ as well as YoY basis.
The SEBI Ruling
Multi-cap funds will have to invest minimum 25 per cent each in large-caps, mid-caps and small-caps. Previously only 65 per cent was mandated to be invested in equities with no restriction on capitalisation. The ruling says that the multi-cap funds have to adjust the portfolio by February 2021.
SEBI Regulation: Pros and Cons
Let us understand why the investing community is gung-ho about the new SEBI regulation. A closer look into the data represented in the table provides a sense of how big the opportunity may be for small-caps investors. Additional money of up to Rs 27,990 odd crore to be invested in small-caps by February 2021 can be extremely bullish for this space and especially for quality small-caps that are already in the MF portfolios. According to one of the leading brokers, it may take continuous buying for 2-3 months by multi-cap funds in BSE 500 stocks that are currently considered small-caps to meet the SEBI guidelines.
While it looks logical to go long on small-caps, investors ought to also ascertain at this point of time the various aspects that could go wrong. It is not entirely impossible for SEBI to roll back its decision due to concerns raised by several MF players. MF players are worried that the allocation as recommended by SEBI may create problems in a market correction phase where the redemption pressure is usually very high. Small-caps are normally low-liquid scrips and carry a high impact cost. Whenever there will be redemption pressure in multi-cap funds, the mutual fund houses will find it difficult to sell small-caps immediately and raise cash. The selling pressure in small-caps may sharply bring down the prices of small-caps, thus adversely impacting the performances of multi-cap funds. That said, rolling back the decision by SEBI is an extremely low probability event. SEBI has also clarified that the existing multi-cap schemes may be merged with other in-house schemes if the fund house thinks that the existing allocation as recommended by SEBI may not be sustainable. In that case, if, for example, 50 per cent of the multi-cap funds decide to merge their existing schemes with the large-cap schemes or some other schemes, small-cap stocks may still attract a sizeable capital inflow.
However, any such indication of multi-cap mutual fund schemes merging with other schemes will be a dampener on positive sentiments for small-cap investors. Small-cap investors should also worry about the fact that the profit pool for mid and small-cap has shrunk and the valuations have started to look stretched. Any investor taking an aggressive bet on small-cap at this point of time will have to estimate whether the SEBI notification is merely a sentiment booster for the short term or whether there is going to be material difference over a longer period of time. Only time will tell whether the impact will be durable and positive for small-caps or not.
However, the improved sentiment in the short term will force so-called smart money and retail investors to park their funds in quality small-cap stocks just to be able to beat the markets. Another interesting aspect for small-cap investors will be to observe mutual fund activity in the small-cap space. A low number of 15 small-cap stocks contribute 52 per cent of the top small-cap holdings of various mutual funds. This concentration in select small-cap stocks may get broad-based and that augurs well for investors as more small-cap winners may be churned out of this process. The following table highlights the top holdings of various mutual funds.
Head of Retail Research, HDFC Securities
"Small-Cap Stocks have their Cycles"
What are the common mistakes investors make while choosing small-caps?
Investing on the basis of tips, hearsay and peer group expectation are the main mistakes made by investors. They need to be aware of the upside potential and the pitfalls of investing in small-caps, mainly small size, defocused attention of promoters, corporate governance and fundraising difficulties. To overcome these they need to spend more time on researching the company and its promoters and its precedents and develop skills for spotting the triggers and concerns in all such companies.
Why does investing in small-caps make sense? What is your outlook on small-caps?
In a country like India where the spirit of entrepreneurship is quite prevalent, alpha generation and wealth-building opportunities lie in well-run small-cap companies in industries that are growing well or taking off. Hence, a portion of your investible money needs to be placed in small-caps though this ratio depends on the size of your funds, your risk profile and spotting or tracking abilities. Small-cap stocks have their cycles and may take time to start performing. However, if your entry is not high-priced and you have the patience, a rightly picked stock can bring you great returns over time. The small size or base also acts as a big trigger for small companies that are in the right spot at the right time.
In the short to near term there will be heightened volatility in small-caps as one can expect some churning in portfolios. Chances are one may see some huge swings in the small-cap space in the coming days. All said and done there is a good probability that one may see huge demand for quality smallcap stocks that are futuristic, have proven business models and possess earnings’ visibility. Quality small-cap stocks could well be the flavour of the season for the coming quarters. Monitoring closely the quarterly results in small-cap stocks can provide great insights for investors. To check consistency in the quality of earnings, investors can check if net profits, net sales and net profit margins have improved on both QoQ as well as YoY basis.
Even though the money is expected to flow in small-caps, it will be foolish to assume that all small-caps will gain owing to the liquidity. Mutual fund managers will stick to quality parameters and will not buy stocks that they do not want to. Hence, going overboard on small-cap stocks just because of the new regulation may be overambitious. Investors will have to discipline themselves and stick to quality. Small-caps will be in focus for the coming quarters not only because of the SEBI guidelines but also because these set of stocks are the ones that promise to deliver on higher growth. Mutual fund managers often invest in small-caps to generate alpha.
Liquidity gush, underperformance in 2018 and 2019, reasonable valuations and positive sentiment will ensure that small-caps will be in the limelight over the coming quarters. The logic behind small-cap investing is these stocks are under-researched and hence there is always a possibility that they may be underpriced. Secondly, small-cap stocks are riskier and therefore the returns can be expected to be higher in the long term. The low base effect also works beautifully to help produce multi-baggers. A close look at several of the nano-cap stocks and small-cap stocks’ earnings highlights the impact of the low base effect on stock prices. Small-caps are always looked at with suspicion by investors and have been accused of being not investor-friendly owing to lack of corporate governance standards and consistency in performance in terms of earnings.
Also, in case of any economic downturn, the risk of small-caps not surviving is very high. Small-caps are also not very liquid stocks. These are the only negatives associated with small-caps stocks. Hence, sticking to quality as discussed earlier and paying attention to corporate governance issues while being diversified in the portfolio are the keys to successful small-cap investing. Investors can construct a diversified small-cap portfolio with focus on those sectors showing a secular bull trend such as IT, pharmaceuticals and chemicals. Also, owing to government spending in the infrastructure space, there is an opportunity for small-cap stocks with good balance-sheets in the infrastructure space to do well. Investors can scan for opportunities in these trending sectors to beat the markets over the coming quarters.
Methodology For Picking Small-Cap Stocks
To come up with a ranked list of small- cap stocks, we took into consideration four crucial parameters. The first includes market capitalisation. The second and third parameters obtained from the Profit & Loss Account include Sales and Net Profit. We also considered the PAT margin for ranking the stocks as it indicates how efficient a company has been in converting the given sales into profit. Each parameter was then ranked by awarding it a carefully determined Methodology For Picking Small-Cap Stocks weightage based on its significance. We then segregated the companies into three categories as follows:
Turnaround Performance : These companies include those that successfully managed to turnaround the losses incurred in FY19 into profits in FY20.
Improving Financials : Although these companies still reported losses in FY20 as they did in FY19, they succeeded in reducing these losses by a notable amount. This indicates that they are on the road to recovery.
Thriving Companies: This list includes all the remaining small-cap stocks and their financial performance.
A consolidated ranking was done in each category. All the raw financial raw is sourced from Ace Equity
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