The Third Best Time in Two Decades for Investing in Smallcaps

Mar 9, 2020

Richa Agarwal, Research analyst

Let me get straight to the point today - Amid the Coronavirus outbreak, small caps are an asset class you simply cannot afford to ignore.

As markets succumb to the coronavirus outbreak, this could be the third best time in two decades to consider investing in smallcaps.

Let me explain how...

Since April 2003 - the earliest data available for the smallcap index - there are 29 times when the weekly decline in the smallcap index has been in the range of 7% or more.

28th February 2020 was one such day.

That's a frequency of 3.2% - making it a rare occurrence.

Of these 29 times, there are 8 times when investing in the smallcap index would have offered returns of 15% CAGR or more over a 3-year period.

And that's when smallcap to Sensex was 0.42 times or lower. (0.44 is the median average of smallcap to Sensex since April 2003 - again, earliest data available on the smallcap index.

Smallcap to Sensex Ratio

Now here's the most interesting part...

Twice it has so happened that the 3 year CAGR for the smallcap index post the outbreak was more than 50%...

And each time, the smallcap to Sensex ratio has been 0.36-0.37 times.

So, what does this mean in the context of the recent coronavirus?

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Recently, the smallcap index witnessed a correction in the range of 7% in a week. And at present, the smallcap to Sensex ratio stands at 0.36 times.

What this means is...

If you bet on solid stocks in the smallcap space, you stand a solid chance of...

Earning returns of 50% CAGR or more...

And if investing during Coronavirus still scares you, this is one table you need to look at:

Returns on Smallcaps During and Post Virus Outbreaks in Last Two Decades

    Smallcap Index^
Virus Outbreak Estimated Period Returns During Outbreak Smallcap to Sensex Ratio (Median ~0.44) 1 Year Return Post Outbreak
SARS Jan -March 2003    
Avian Influenza Jan - Aug 2004 -9.8 0.37 198.0
Ebola Dec 13- Feb 14 4.5 0.31 45.6
Zika Nov 15- Feb 16 -15.4 0.44 43.4
Covid -19 Jan 20 - ? -0.6 0.36 ?
^ No data available on Smallcap index where blanks
Returns are in %

As you can see, the smallcap index has outperformed Sensex everytime when it comes to 1 year returns post virus outbreak.

While I do not recommend stocks from a one year perspective, the valuations are so attractive now that I wouldn't be surprised if one year returns on solid smallcaps post the outbreak beat the Sensex performance by a wide margin.

That said, the best approach in these times is to not let go of conservatism... and look for smallcap stocks that are fundamentally strong and offer strong upside when the coronavirus situation is under control.

Short Presentation: For Those Looking to Buy Stocks

Here's the investing strategy that you should stick to while investing in smallcaps...

  • Invest only in stocks with great fundamentals backed by solid management teams - businesses that have the capacity to survive downturns shall the crisis continue for long.
  • Have a long horizon period
  • Follow a robust risk management framework.

I cannot insist enough how critical the last point is - it means one must have a diversified portfolio with limited exposure to a single stock and sector, and to equities as an asset class.

For smallcaps, the overall allocation to a single smallcap should be limited to 2%-3% of one's portfolio. Further, overall allocation to smallcaps as an equity class should not be more than more than 10%.

Always Allocate in a Deferred Manner

Irrespective of how confident you are about the businesses you wish to buy - it is a good idea to increase your allocation to stocks in a deferred manner. Especially keeping the stock specific and broader market valuations in mind.

For instance, the Sensex valuation could be an important yardstick for your overall allocation to stocks. And you could take partial exposure to expensive but good quality stocks before increasing exposure to them on further dips.

In light of this enormous opportunity in small caps, I am holding an emergency summit this evening @5PM. Sign up for my summit free by clicking here - and I will see you this evening.

Warm regards,

Richa Agarwal
Richa Agarwal
Editor, Hidden Treasure
Equitymaster Agora Research Private Limited (Research Analyst)

PS: Over 11,000 of Richa's readers have signed up for her summit, are you missing out? Click here to sign up for the Rebound Riches Summit going live at 5 PM today.

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