What to Expect from Small-cap Stocks This Year 

Dear Viewers,

The year FY22 has ended. And this was yet another year when the Smallcap index surpassed the gains in the Sensex.

For the record, in FY22, the BSE Smallcap index witnessed a gain of 34%, beating the Sensex by 2x.

In FY21, the Smallcap index had surged 122% versus 77% gains in the Sensex.

Since the Covid crash, the total gains in the smallcap index until FY22 stands at 223% versus 128% in the Sensex.

So is this time to be cautious with smallcaps. Or will FY23 be yet another year when Smallcaps outperform?

Let's see what Smallcap index to Sensex ratio suggests.

The Smallcap to Sensex ratio stands at 0.51 times. This is higher than the long term average of 0.43 times.

What this means is the easy money in smallcaps is made. And it would be prudent to exit or book partial gains in the positions where valuations have run ahead and fundamentals struggle.

At the same time, it is worth mentioning that the ratio is still well below the previous peaks. In the previous peaks, this ratio was at 0.58 times in January 2018, 0.55 times in November 2010, 0.68 times in January 2008, and 0.8 times in August 2005.

So there is a scope of decent upside even with respect to current Sensex levels until the smallcap index peaks.

As someone who believes in India's long term growth story and the possibility of the Sensex touching 1 lakh in this decade, the scope of wealth creation in the smallcap space is even more promising. As per the median, if Sensex does touch 1 lakh, the smallcap index could touch 43,000 versus around 29,000 at present.

Investors should also keep in mind that there has been consolidation in the smallcap space, with stronger players gaining an edge over less competent peers, who have either disappeared, or are shrinking.

The balance sheets for stocks in smallcap index looks much cleaner now.

And the cash flow from operations has never looked this good in the last 5 years.

And after a long lull, capex revival is coming back with banks having cleaner balance sheets and relatively easier access to credit to strong players in the smallcap space at benign interest rates.

So while I'm positive about this space, there are a few things you must ensure to be on the winning side in smallcaps.

You must focus on smallcap companies that are not just showing earnings revival but are backed by solid balance sheets as well. You could further enhance your probability of success by betting on market leaders and backed by promoters with an established track record of execution.

Yes, there are some clear market leaders in the smallcap space too. These include companies like Moldtek Packaging in rigid packaging space, Mayur Uniquoters in artificial leather space, Kabra Extrusion Technik in plastic extrusion machinery, Kaveri Seed the largest listed player in hybrid seeds and the first in the world to have more than 1 lakh acres in production area, CCL Products as the largest instant coffee exporter and private label manufacturer across the globe, Oriental Carbon the ONLY company in India to manufacture Insoluble Sulphur with 60% share of the domestic market, Rajratan Wires with 50% market share in India in a very niche segment of tyre bead wire manufacturing, Sheela Foam with close to 30% market share in the organised mattress market, Nocil the largest rubber chemical manufacturing company with 40% market share in India.. and the list goes on.

Please don't consider these stocks as Buy recommendations. The point I'm making is that within smallcaps, you will come across players that are largest in their niche and indispensable to their clients in B2B or B2C segments. And these companies deserve special attention in smallcap space.

Coming to some lessons I have learn and would like to share for better returns in smallcap investing...

Peter Lynch once said that in this business if you're good, you're right six times out of ten. This is especially true for smallcaps, where volatility and small size turn out to be very unfavourable during an interim downturn.

What can help you survive such times is a prudent asset allocation.

There is not a single investor, no matter how legendary, who did not end up with failed investments.

It could be a case of bad decision making, industry related negative developments, disruption, or the management taking bad decisions, or something totally unexpected and unrelated to the business.

What separates legends from ordinary investors is not the lack of losers, or the bet on big gainers, but how less they lose when they lose, or how big they gain when the stock performs.

In the end, it all boils down to asset allocation.

A stock crashing by even 80% may not turn out to be too bad for you unless you are overexposed to it. So always keep the probabilities in mind, stay humble and allocate wisely.

It's okay to build on a position overtime with more conviction, rather than overloading on a stock based on a speculation. Investing is not just about winning big but staying in the game. A well-diversified portfolio ensures survival.

If you do the hard work, make the right choices, do the right things, and stay disciplined, you will find companies that will eventually get over the near term volatility and headwinds and go on to generate lasting gains.

While a 100% success ratio in investing, more so in smallcaps would be an overambitious and unrealistic target, you could improve the probability of winning by having a long term investing mindset, so that compounding can work its magic.

But this strategy only works if you invest in the right team which brings me to the next criteria.

The importance in management quality in successful long term investing.

Investing is like a business. Managements in that sense are your business partners. If you look at investing from this perspective, it's obvious you want to invest in jockeys who are think big, have decent skin in the game, are intelligent, and good at execution.

Most importantly, you should invest in people with integrity. Otherwise the intelligence of the management could work against you as a minority shareholder.

Pick any big winner in the stock markets, in India or globally - Amazon, Tesla, Facebook, Avenue Supermarts...

Why did hundreds of businesses die in dot com crash, while Amazon went on to become a global behemoth? Why did Future Retail and Avenue Supermarts ended up so differently despite being in the similar industry?

It is obvious that the journey of these stocks would not have been the same, without their promoters' vision and execution.

It sure needs some work to assess the management quality, than buying on the next hot tip you come across on social media. But a little work here can catapult your luck in a big way. Once convinced, you can invest and forget. All the hard work is done by the management. You can enjoy the fruits.

The next important criteria to enjoy a great run in smallcaps is building the capacity to suffer.

This may sound as a contradiction to my positive long term view on smallcaps. But here's the thing.

There is a 100% chance that you will be tested when markets turn volatile.

It could be a pandemic out of the blue, or the sudden onset of war. Some event could make your portfolio crash 20% to 40% within days or weeks.

If that causes you to panic and exit, you will never get to see the rebound in quality businesses.

This reminds me of the downcycle in smallcaps that started in January 2018. At the bottom, the smallcap index had crashed by over 50%.

But as we saw in the first chart, the rebound more than made up for that crash. But only those who had the capacity to suffer could enjoy the cycle. What helps to develop this capacity is hard work and conviction you develop while picking the stocks.

So while there may not be enough low hanging fruits in smallcap space at present, the potential for big returns from select smallcaps is huge. If you follow this template, you are likely to turn the odds of success in your favour.

That's all for today's video. If you find it useful, please like, comment, and share. And do subscribe to Equitymaster's channel for more such content.

Thank you for watching.

Goodbye.