Are Small-Caps And Mid-Caps Hurting Your Portfolio?
Beaten down small cap stocks
With the BSE Sensex and Nifty hitting all-time highs along with Bank Nifty, broader market investors have suddenly realised that their portfolios may have underperformed. Yogesh Supekar focuses on the reasons behind the underperformance of the broader markets and explains what steps investors should take in the current market situation.
The key benchmark indices are at an all-time high and this is a pleasant surprise for many of us. Given the various challenges the markets have faced in CY22 after the pandemic-related recovery, it was almost unthinkable to expect BSE Sensex to touch an all-time high in November 2022. The Ukraine-Russia war situation and the rapid rate increase owing to record inflation were a perfect recipe for market correction. Both these issues are yet unresolved and still we have market recovery on our hands. This again emphasises the fact that the equity markets are forward looking.
What the scenario is telling us is that the war in Ukraine may not impact the markets as there is no surprise element left and at the same time even though the markets are expecting a recession there is a good chance that this phase of downturn will be much milder than previously feared. As the finance minister of UK stated, the country may already be in the throes of recession and the markets seem to have discounted the recessionary environment. However, the reason why the markets are rallying is that majority of the participants believe that interest rates have peaked and that the rate hikes will not continue for too long.
With this monster of recession looming large in the background, there is a high probability of interest rate cooling down in the near future. Now that is something that should excite investors. The recent recovery in the markets though has a catch. Only a handful number of stocks have come out of the woods and pushed the key benchmark indices to all-time highs. The required enthusiasm is missing in the broader market as is shared in the Large-Cap stocks. It is not that the Small-Caps are entirely missing out on the rally but the breadth is missing as, say, in CY 2021.
We find that at least 161 small-cap stocks that are constituents of the BSE Small-Cap index made a fresh 52-week high in November this year. However, the year 2022 has not been that rewarding for the broader market investors. Says Abhay Raut, a long-term investor: “I realised that my portfolio is up by 7-8 per cent in CY 2022. When I read the headlines that the key benchmark indices are at all-time highs, I was wondering why my portfolio was underperforming the markets. The BSE Sensex is up by nearly 9 per cent on YTD basis. I realised then that I have primarily invested in small-cap stocks, and that explains the underperformance.”
“The BSE Small-Cap index is up by 6 per cent on YTD basis. It means there is marginal underperformance in the small-cap stocks. I also observed that my investments in the small-caporiented mutual funds have also not done as well this year compared to the funds that invest primarily in the large-caps. For instance, Kotak Small-Cap Fund is down by nearly 3 per cent in the past one year while at the same time Kotak Equity Opportunities Fund is up by 9 per cent. The performance is divergent for small-caps and large-caps. It is really confusing at times,” he adds.
“The question is whether I should continue to maintain my position of high allocation to small-caps or should I trim my position and shift to large-caps?” he wonders. Indeed, there has been some divergent movement in the broader markets and the large-caps. Large-caps have clearly outperformed the smallcaps in 2022 after small-caps’ huge outperformance in 2021. The BSE Small-Cap index is up by 207 per cent since the March 2020 lows while the BSE Sensex is up by 125 per cent in a similar period. The record rally in small-caps since March 2022 led to unrealistic expectations from the small-caps and now that the small-caps have corrected, investors are waking up to a reality check.
The Divergence Phenomenon
Since January this year we have seen BSE Small-Cap index dip by 22 per cent versus BSE Sensex that slipped by 16 per cent in June. However, since the recent bottom in June, the BSE Sensex is up by 22 per cent while BSE Small-Cap index is up by 21 per cent. This year we saw the broader index gauge slip more than the key benchmark index and at the same time the broader gauge recovered less than the BSE Sensex. It is not the first time that we are witnessing a divergence in performance or underperformance in the broader markets. The BSE Small-Cap index in CY 2018 was down by 24 per cent while the BSE Sensex was up by 4.6 per cent.
In fact, in two years i.e. 2018 and 2019 we saw BSE Sensex climb by 19 per cent and BSE Small-Cap index slip by 26 per cent. The conviction in small-cap investing during that phase was at the lowest levels possible amongst investors. However, after 2019 the small-cap stocks bounced back with a vengeance. According to Darshan Patil, an investment advisor, “The underperformance in small-caps and Mid-Caps is just a temporary phase. I can see that several small-caps and mid-caps are forming a base to bounce back. The more time they spend forming the base, better will be the quality of the bounce.”
The below table highlights some of the most popular small cap stocks that are beaten down and have underperformed heavily. It is always a good strategy to buy stocks with higher margin of safety. Margin of safety can be higher in quality business however the stock prices are down owing to some negative development.
Naveen Kulkarni
Chief Investment Officer, Axis Securities PMS
“We Advise Investors to Follow a Thematic Approach”
Why is there a divergence in performance in largecaps, small-caps and mid-caps?
In 2022, the Indian market outperformed other global and emerging markets by a notable margin, thanks to the country’s robust economic outlook despite multiple headwinds such as volatile macroeconomic developments, faster regime changes and volatile FII flows. On an YTD basis, our benchmark index is up by 5 per cent. Meanwhile, the S and P 500 and emerging market index are down by a whopping 16 per cent and 22 per cent for the same period. The mid-cap index is up by 2 per cent and the small-cap index is down by just 5 per cent for the same period. The leadership of the benchmark indices keeps changing in different market cycles.
The year 2021 was the best performing year for the equity market in which mid-cap and small-cap indices were the biggest gainers, rallying by 46 per cent and 59 per cent, respectively. The year 2022 is translating into a roller-coaster ride in the equity market across the world. The market has witnessed significant volatility led by liquidity reversal, policy tightening, the Russia-Ukraine geopolitical crisis and rising inflation. While these developments inflicted notable changes in the market regimes, especially with higher commodity prices of base metals and crude oil over the first half of the year, a trend reversal was seen in the second half of CY22 with the majority of commodity prices cooling off.
This was primarily due to policy tightening and the expectation of a slowdown in global growth. Last year the market experienced quicker rotation in investment style and sector preference, and the value theme dominated the first half of CY22, exhibiting a rising inflationary period. In the second half, the market saw a pickup in the growth theme, which was led by a cooling off in commodity prices, robust domestic demand and reasonable valuation after market correction. This quicker rotation in the investment style and sector preferences has led to divergence in performance. However, all the three indices have moved in tandem on an YTD basis.
Will the broader market outperform in the coming year?
The Indian economy stands in a sweet spot of growth and remains the land of stability against the backdrop of a volatile global economy. We believe the relative outperformance of the Indian market will likely sustain in 2023 as well and would be led by favourable macroeconomic factors and better-thanhistorical fundamentals of Indian corporates. While inflation continues to be a major challenge in the developed world, inflation in the domestic economy seems to be manageable. Good monsoons, higher reservoir levels, cool-off in commodity prices and a healthy labour market indicate that the domestic economy would accommodate the prevailing inflation smoothly. The majority of the high-frequency indicators are trending upwards and the uptick from the pre-pandemic levels is visible, indicating the resilience of the Indian economy.
While the country’s macro set-up is positive, the fundamentals for Indian corporates have also become better. Profitability across the board has improved significantly. The cumulative and rolling net profit of the NSE 500 universe for the last four quarters till Q1FY23 touched an all-time high of `10 lakh crore, and loss-making sectors too have turned positive and contributed notably to the net profitability. Moreover, after a muted performance for several years, the ROE for the broader market is improving as well. The quality of assets of private as well as PSU banks has improved significantly compared to the levels seen a couple of years back. Thus, in light of these positive attributes, we firmly believe that the outperformance of Indian equities seems highly sustainable in the upcoming years.
How can one build a market-beating portfolio using small-caps and mid-caps?
We advise investors to follow a thematic approach to build a portfolio of diversified sectors with a good combination of defensive and economy-linked cyclical stocks where the earnings’ visibility is very high. Further, the stock selection will be based on superior return ratios to manage the risk. We also advise our investors to follow a disciplined approach to periodical review.
“Usually, we have seen that small-caps tend to bounce swiftly after consolidation. Nifty may consolidate near all-time highs and there is chance that small-caps will start to outperform. When small-caps rally, they tend to recover faster and hence investors should not worry much about the underperformance of the small-caps. Several popular names and low-priced shares such as BCG, Subex and Trident are forming a strong base and consolidation is taking place reasonably well. Patient investors can hold on to their small-cap holding with a medium to long-term view for outperformance,” he adds.
Consolidation in Place
It is interesting indeed to observe the consolidation happening in several small-caps and mid-caps even as the large-caps hog the limelight. However, it can be extremely difficult for investors to tolerate underperformance even if it is temporary. Says Makarand Dharma, an equity investor with not more than a couple of years of experience: “I have 10-12 stocks in my portfolio and all are trading in the negative zone while the large-caps are touching all-time highs. I listened to my friend’s suggestion who said that small-caps always deliver better returns and hence I parked by money into small-caps. Now that large-caps are outperforming, I am really confused on portfolio stance.”
“I don’t think I am mentally strong or matured enough to face underperformance in my portfolio even if it is temporary. Investing in small-cap stocks is not easy as I thought. I want to see some green in my portfolio and I hope I see it in the early part of 2023,” he adds. There is no doubt that small-caps are volatile and when they underperform it can be painful for the portfolio returns. The drawdown can be huge for small-caps and the volatility can be unnerving most of the times, at least for the beginners. Says Gunavant Vaid, a high net worth individual (HNI) investor who prefers small-caps and microcaps for market outperformance: “Investors have moved from risky (volatile) stocks to less risky stocks i.e. from small-caps and micro-caps to large-caps. It is a temporary phase. Investors should always take a view of more than five years while investing in the equity markets. This is even more important when investing in micro-caps and small-caps.”
"The way we would look at it is primarily bottom up but at the same time, there are sectors that are only represented by smallcaps and where there are some pretty exciting opportunities. These would include sugar, paper and textiles. Sectors where there is clear transformation is happening in terms of the way businesses are conducted are the biggest examples that one can give in terms of what impact smallcaps can have if they have conviction."
Anthony Heredia
MD & CEO, Mahindra Manulife
Conclusion
Liquidity is the key for small-caps and mid-caps to outperform. As the interest rates increased, the liquidity took a hit and investors parked their funds in so-called safe havens – largecaps. Now that the market is expecting a peaking of interest rates in the US, we can expect some revival in small-caps and mid-caps as the liquidity conditions can improve drastically. Even though some of the investors fear that the markets usually correct in December, data suggests otherwise. In the past 20 years we have seen on an average that December has been the best month for equity markets in India. With India specific triggers in place and world starting to look at India confidently as an alternative to China, we may see some fireworks in the coming months in the broader markets. Further, the manufacturing sector in India is booming as we speak. Several small-cap and mid-cap companies in the manufacturing sector can be looked at with bullishness. The Indian government has set a target to increase the share of manufacturing from 16 per cent of GDP to 25 per cent of GDP. This will translate into huge opportunities for the listed companies in the manufacturing sector. Increasingly so, there is consensus amongst global investors that investments in infrastructure development have increased India’s competitiveness. The bullishness in equity markets is expected to persist in spite of rich valuations because the profitability of corporate India is improving, and the leverage is at a multidecade low of barely 1.2x debt to EBITDA.
There is huge scope for capacity expansion as capacity utilisation is closer to historical highs. At this moment with cleaner balance-sheets for PSUs, the lending activity can be expected to increase. High frequency indicators like GST collection, peak power demand, recovery in air travel, sales of apparel, commercial vehicles and housing as well as capital expansion announcements paint a bullish picture on the macro front. Given the underperformance of the broader markets and the overall positive outlook on the Indian equity markets, it is only a matter of time before the small-caps and mid-caps of the world catch up in the coming month or so.
One of the best ways to identify trending small-caps is to study those stocks that are trading at or close to 52-week highs. Smallcap stocks from such sectors as railway, defence and manufacturing can be looked at positively. For high-risk investors, the allocation for broader market stocks can be as high as 50 per cent with 50 per cent comprising large-cap stocks. For active portfolio investors this is the best time to tactically shift focus from large-caps and allocate more monies to the broader markets. Partial profit booking in large-caps and fresh buying in quality beaten-down small-caps can generate alpha for investors.