Is 'Sanju Baba' Behind the Crash in Small Cap Stocks? - The 5 Minute WrapUp by Equitymaster
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Is 'Sanju Baba' Behind the Crash in Small Cap Stocks?

Jul 9, 2018

Ankit Shah, Research analyst

Did you watch Rajkumar Hirani's latest biopic Sanju?

I've not watched the movie. It's based on the life and struggles of notorious Bollywood actor Sanjay Dutt.

Frankly, I have zero interest in watching a biased and glorifying account of Bollywood's drug popping, gun toting bad boy.

But as you may know, my curiosity about human behaviour is insatiable. So I read about Sanju baba and his many misadventures.

You see, there was no rationality and moderation in Sanju baba's life. His life story is full of turbulence, high emotions, and extreme ups and downs. He didn't do anything in half measures.

Doing drugs, dating women, buying deadly weapons... he did everything in extremes.

What more, I found out that he was also involved in the steep correction in small cap stocks. More on that in a bit.

But first...

The Reward System in Your Brain

Without getting into the nitty-gritties of neuroscience, I'd like to explain how pain and pleasure signals work inside the brain and how drug abuse creates addictive behaviour.

Your feelings of pain and pleasure are your brain's way of communicating what is good for your survival. Accidentally touch a piece of burning coal and your brain screams 'danger'.

On the other hand, eating good food or winning a game creates sensations of pleasure. That's your brain telling you it's good for your survival. So, do more of it.

Feelings of pleasure -> Associated with life-sustaining activities -> Remember and do more of it

Now, drugs like cocaine or heroin stimulate this same pleasure circuit in the brain. When the drug enters your bloodstream, your brain is flooded with 'fake good news'. It produces a euphoric effect. You feel like you're on top of the world.

The 'high' feeling caused by drug abuse dwarfs those produced by naturally rewarding activities.

But this pleasure sensation is not created by a life-sustaining activity. It's nothing but a fake manipulation of the pleasure system.

Once the effect of the drug subsides, the person collapses into a mental abyss of depression and lifelessness. So he craves more of the drug.

This creates a self-reinforcing behaviour of drug addiction and makes it extremely difficult for victims to come out of this vicious cycle.

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Sanju Baba and the Crash in Small-Cap Stocks

So what's the connection between Sanju baba and small-cap stocks? And how is he responsible for the crash in small-cap stocks?

The way I see it, I see a lot of similarities between Sanju baba and small-cap stocks.

You see, while the Sensex is still hovering close to its all-time high levels of January 2018, small cap stocks have a very different story to tell.

Small-cap stocks have been in a deep correction mode. They are inherently very volatile, moody, and have a tendency to go to extremes... just like Sanju baba.

When they're in a bull run, they scale dizzying levels of euphoria. And when panic sets in, they drop like a stone.

Look at this chart...

The Rise and Fall of the Small-Cap Index

You see, over the last one year, the BSE Smallcap index has gone from euphoria to panic.

The bull rally in smallcap stocks last year was fueled by a flood of liquidity into the Indian markets. This flood of money acted like a drug.

And once the effect of the liquidity drug wore off, small-cap stocks have been in distress.

But this is not the first time that small-caps are behaving like Sanju baba...

Look at this long-term chart of the BSE Smallcap index...

The Extreme Ups and Downs of Small-Cap Stocks

You see, small-cap stocks have had a tumultuous ride all the way.

From the low of July 2004 and to the very top of the great bull run that peaked in January 2008, the BSE Smallcap index rose nearly eight times.

But once the effect of the liquidity drug wore off, small-cap stocks collapsed and lost as much as 79% by March 2009.

You can see that similar patterns have followed time and again.

What does this mean for you? Should you stay away from small-cap stocks?

I don't think so.

I understand that market corrections are unpredictable and often painful. But don't let the ongoing correction in small-cap stocks make you wary of this space.

In fact, once you understand how small caps work, you can make the very best of their extreme moves. If you look at the other side of the coin, this is precisely the reason why they offer opportunities to create mindboggling wealth. (More on that in today's Chart of the Day.)

At my premium newsletter Insider, I have full access to a wealth of investing ideas from across the Equitymaster research vault, including Richa Agarwal's small-cap stock recommendation service Hidden Treasure. And I'm at full liberty to cherry-pick the most profitable ideas from it.

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Chart of the Day

Small-caps seem to be displaying withdrawal symptoms right now. It's like Sanju baba trying to wean himself off drugs. Expectedly, it's a painful process.

But trust me... such corrections are a healthy part and parcel of the game of investing.

In one of my earlier editorials, I had shown how the BSE Sensex is not a truly representative market barometer. While the Sensex continues to stay steady close to its all-time high levels, the rest of the market has corrected significantly.

Today, I've carried out a similar study on the BSE Smallcap index.

Here's what I found...

The average (both mean and median) correction of the BSE Smallcap index stocks has been 38% from their respective 52-week highs.

Small-Cap Stocks Are Down 38% from Their 52-Week Highs

I arranged the small-cap companies based on the extent of their correction from their respective 52-week highs. I came across some insightful revelations...

  • About 23% of the small-cap stocks have corrected more than 50%.
  • 65% of them have corrected more than 30%.
  • Just 51 stocks have shown relative resilience and corrected 10% or less.

I hope this offers you a big picture perspective of what's going on in the small-cap space. You're not the only one witnessing your small-cap investments in the red. But what you do now will differentiate you from the average investor.

When the average investor sees his stock portfolio in the red, he tends to get engulfed by a sense of fear and gloom.

It's a natural response. We all hate to see losses and failures. It's painful and frustrating to see your shareholdings go below your cost price. Or to see your gains wiped out.

When faced with the pain of loss, the general human tendency is to find ways to reduce this pain. This is why most investors respond to this situation by reducing their engagement in the stock markets.

They track their loss-making positions less frequently. They stop discussing it with their friends and colleagues. They avoid booking losses in positions that demand such an action, and quietly hope and pray that the share price will rebound and go above their cost price.

But here's the bitter truth...

Your emotional need to reduce psychological pain may not help maximise your portfolio gains. Only by embracing the pain and wiping off the mental fog can you expect to outdo your fellow investors.

You see, this is the very reason why legendary investors like Warren Buffett manage to spot winning investment opportunities when most other investors are in are deep fear, panic, and gloom.

I believe that the ongoing market correction could offer some fantastic buying opportunities for disciplined and patient small-cap investors.

Happy Investing,

Ankit Shah
Ankit Shah (Research Analyst)
Editor, Equitymaster Insider

PS: For over 16 years, our Safe Stocks recommendation service, StockSelect, has guided its subscribers towards financially sound futures. Today, you have the chance to get access to its proven research and recommendations that generated double, even triple digit returns. Click here to begin your journey towards a wealthier life...

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