Smallcaps are not the institutions' favourites - Views on News from Equitymaster

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Smallcaps are not the institutions' favourites

Mar 4, 2010

Institutional investors have a significant role to play when it comes to the movement of stocks. During good times, investments made by them could set a stock on fire. However, in bad times, they could literally turn the stock to ashes. Below we have shown two charts - the average holdings of domestic financial institutions (FIs) and foreign institutional investors (FIIs) over the past four years and how the same has changed during this period.

Data Source: CMIE Prowess
In the above chart, we have shown the average holdings of FIs in largecap (BSE-100 Index), midcap (BSE-Midcap Index) and smallcap (BSE-Smallcap) stocks. While FIs have gradually been increasing their stakes in largecap and midcap stocks, the same cannot be said about their interest in smallcap stocks. After the market crash in the early part of 2008, FIs' average stakes in smallcaps have been gradually reducing, while their stakes in midcaps and largecaps have been gradually increasing.

Data Source: CMIE Prowess

Moving on to FIIs - as compared to the domestic funds, FIIs involvement in the markets has been much more volatile. As you can see in the chart displayed above, FIIs were increasing stake in companies across the board until December 2007. However, post the market crash, the story is a bit different. While FIIs' stakes in largecap and midcap stocks declined significantly before rising again, their interest in smallcaps does not seem to have been on the same page. In fact, the average FII stakes in smallcaps have been declining since December 2007, similar to that of the FIs.

The reason for the same is something that we wouldn't know in specific, but we could make an educated guess.

The key reason could be of the broader markets being attractive on an overall basis last year (March 2009), when they hit their low levels. Investors across the board - including institutional and retail - seem to have preferred to grab the low hanging fruits. The fruits in this case would be the attractive largecaps stocks.

As and when it gets difficult for investors to search for attractive stocks from the largecap universe, they would tend to move on to smaller companies in search for bargains. Thus, the interest in mid and smallcap gradually rises.

However, this time around, smallcaps seem to have remained the unfavoured lot. At least, that what it seems like from the above displayed chart. However, does it seem as if the institutions have missed out on the smallcap rally? The answer is a definite yes. Does this mean that we could see a renewed buying interest in the smaller companies in the coming few months considering that the broader markets are fairly valued? That would be a difficult question to answer but the possibility of the same cannot be ruled out.

However, in our view, we believe that investors should take a bottom up approach towards investing in stocks. In one of our recent articles, we had highlighted a key reason as to why investors should take a cautious approach towards investing in midcap and smallcap stocks. The reason we felt so was on the back of stretched valuations which stocks from these two universes are garnering (as a whole and not individually). This argument holds true, especially when compared to the valuations garnered by the stocks of the larger companies in India.

Smallcaps and midcaps have moved up significantly over the past year. In the process, so have their valuations. When we compare the valuations of the larger stocks to that of the smaller stocks, the gap certainly seems to have narrowed down significantly.

While small and mid-sized companies tend to grow at a much faster pace as compared to their larger peers, we believe that many others factors should given much more consideration. These include transparency, corporate governance, disclosures, and management integrity, amongst others. As Warren Buffett puts it "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."

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