Why Small Cap Stocks are Falling

Narratives in the financial markets can change very quickly.

One day everyone is thinking a 'certain thing' is a good idea and the next day the consensus belief is the exact opposite.

Nowhere is this better illustrated other than the small cap space over the past few trading sessions.

In the past five trading sessions, the BSE small cap index is down over 5.5%.

This fall comes on the back of a record run where individual smallcap stocks showed no signs of stopping and churning out multibagger returns in under a month.

Fact is inflows in the smallcap funds have trumped the inflows in mid and largecaps over the past few months.

Even the fundamentals of companies in the smallcap space have shown a recovery.

Investors were already concerned whether the smallcaps in their portfolio have run up too high?

Well, they found the answer now.

Every other portfolio is down around 8-10% in the past few trading sessions.

With that context out of the way, let's understand why smallcap stocks have seen a sharp fall and whether there's more downtrend.

#1 SEBI's 'Clear' Message

For months, valuations concerns were raised regarding the prolonged rally in small cap stocks.

Madhabi Puri Buch, the chairperson of the Securities and Exchange Board of India (SEBI), highlighted these concerns on Monday, emphasising the stretched valuations observed in both small- and mid-cap stocks.

This warning has somehow contributed to the sharp drop in small cap stocks.

Last month, the SEBI asked mutual fund houses to put in place a framework to safeguard the interest of investors who invested in small and mid-cap funds amid the froth building up in the segments.

The market regulator is reviewing its rule that mandates small- and mid-cap funds to invest at least 65% of their assets in such stocks if fund managers find it is "restraining risk management".

#2 Mahadev Betting Case

The Enforcement Directorate's ongoing investigation into whether proceeds from the Mahadev betting case were routed into the small-cap and SME segments have also added to the negative sentiment.

According to reports, the directorate of enforcement (ED) searched for money laundering networks linked with Mahadev Online Book, and it was revealed that Dubai-based hawala operator Hari Shankar Tibrewala is involved.

After searching his premises, it was revealed that Tibrewala, through his Dubai-based entities, was investing the betting proceeds in the Indian stock market by way of the FPI route.

Reportedly, he also employed many of his associates as director in various companies which were involved in the layering of the betting proceeds by investing them in the stock market.

Following these developments, shares held by Tibrewala were locked in the lower circuit.

What Next for Smallcaps?

We reached out to lead smallcap analyst at Equitymaster Richa Agarwal, on what she has to say about smallcaps stocks in the current market environment.

Here's what she said...

• While the fundamentals of companies in the smallcap space have shown a recovery, it's the liquidity and valuation expansion that is driving the gains. This is evident from the rise in Smallcap to Sensex ratio.
  
  At the start of 2023, the Smallcap to Sensex ratio was at 0.46 times, as compared to a long-term median of 0.43 times. In February 2024, the ratio is way past that average. At 0.63 times, the Smallcap to Sensex ratio has already breached the previous peak of 0.58 in 2018.
  
  The earlier corrections from the peak have been in the range of 50% to 70%. The recovery from the last crash in smallcaps took 3 years. And that pales in comparison to 9 years post 2008 crash. As such, caution and not greed would be the right sentiment to approach smallcaps at present.
  
  While Smallcap to Sensex ratio is flashing 'Caution' sign, the insider activity in Indian stock markets is not comforting either.
  
  At Rs 1.1 trillion, insider selling this year has been almost 2x of insider selling in 2020. And almost six times higher than 2018.
  
  Opposite trends in insider activity and institutional activity, in the context of high valuations, has led to a dilemma of whether to stay put or get out.
  
  I believe the answer is none of this.
  
  The right strategy to play in smallcap space would be to be highly selective.
  
  That would mean booking gains where earnings don't support valuation expansion.
  
  And looking for undiscovered players that big investors are yet to get a whiff of. For it is here that you are likely to find the rare combination of growth and margin of safety in the current market.
  
  Sticking to a selective approach has led investors ride over thousand percent gains in stocks like Hawkins, Page Industries, Persistent Sytems and Balkrishna Industries in the past cycles for smallcaps. While these stocks are considered junior bluechips now, there was a time they were ignored stocks.
  
  And there is no dearth of high potential businesses in smallcaps that are still in the 'ignored' bucket, even in the current rally. Being under the radar of big investors, these stocks offer relatively a lot more margin of safety as compared to highly chased and overvalued set of smallcaps that institutions are buying.

In Conclusion

The promise of chaos in the small cap space is playing out nicely.

If you are having your breath taken away by the minor-blip in the stock market rally, don't look at the charts.

Smallcap stocks have historically dropped 50% in under a week. While they've also delivered multibagger returns at a faster pace.

Smallcap stocks make the stock market volatility look tame.

This brings me to my conclusion from various data points - it takes the wisdom of Warren Buffett's "never sell a great asset" mentality and the "keep buying over time regardless of price" rule.

Your financial advisor may not like it, but small cap stocks have taught an entire generation to be fantastic investors.

Use the bear market to make even more money.

Until next time and till then, here are some of our recent articles on small cap stocks.

• 3 High Potential Smallcaps for 2024 Watchlist
• Smallcap PSU stocks to watch out in 2024
• 5 Smallcap Stocks that Crushed FY23 Annual Profit in the First Half of FY24
• Top 5 Smallcap Stocks with Rising Promoter Holding
• FIIs are Buying these 5 Smallcap Stocks. Take a Look...
• Top 5 Smallcap Stocks Showing Resilience in this Falling Market
• 5 Smallcap Stocks that Could Go Bust in 2024

Happy Investing!

Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such. Learn more about our recommendation services here...