What Should be Your Next Course of Action in Smallcap Stocks?

Opinions on what the market will do next and what should be the next course of action is extremely divided as expected.

There are some who are anticipating the markets to fall further while there are others who believe that this could be a good time to start accumulating fundamentally strong small caps.

The current correction takes me back to July 2018 when the BSE Small Cap index had entered into a bear market for the first time after crossing 20,000.

The situation then was similar to the situation right now when the index has entered into a bear market after reaching a lifetime high.

Now, suppose that someone wants to take advantage of the current fall in the small cap index and wants to put together a portfolio of 20 stocks for the next 3 years.

Should he do so? Besides, what are the kind of stocks that he should have in the portfolio?

In all honesty, while history does not repeat itself in the stock market, it certainly rhymes. Hence, it will be a good idea to check out how a portfolio of 20 stocks would have done over the next 3 years in a similar bear market in the past.

I just alluded to the bear market of July 2018 where the BSE Small Cap index had crashed more than 20% after crossing a lifetime high of 20,000.

Well, let us use this bear market as a case study for whether it makes sense to invest in the Small Cap index after a fall of 20%.

Here's what I did. I put together a portfolio of 20 small cap stocks back in July 2018 and tracked its performance over the next 3 years.

The reason I took 3 years is because it is an ideal time period in my view. Neither too short term nor too long term. It gives enough time for a bear market to end and for a new bull market to start.

So, a fall of 20% from the top is a good time to start building a portfolio in my view.

What about the stocks though? What kind of stocks should be included in the portfolio?

Well, here also, I'd like to keep it very simple. I will include only those 20 small caps that are available at a PE ratio of between 10 and 20 and have as little debt as possible.

The idea is to include fundamentally strong companies that are available at attractive valuations.

A PE range of between 10 and 20 is indeed attractive in my opinion as it is neither too cheap nor too expensive. A PE below 10 may lead to a lot of value traps in case you are not careful while a PE greater than 20 makes the stock price too sensitive to the company's earnings growth rate.

Hence, a PE ratio of between 10 and 20 consists of stocks that aren't too challenged fundamentally and where even a small improvement in earnings growth over historical trend, can lead to a sharp jump in the share price.

It is these characteristics that led me to create our 20-stock portfolio.

Now, if I am allowed just one financial ratio to assess the fundamental strength of a stock, I'd like it to be the good old debt to equity ratio.

A consistently debt free company is a company that's usually consistently profitable, has a product or a service that is regularly in demand by its customers, and has a management team that usually prioritises stability and safety over high growth.

And these are all the qualities that you need in your stock.

Hence, in addition to a PE ratio of between 10 and 20, I also insist on a debt-to-equity ratio that's as close to zero as possible. I want each of the 20 stocks in the portfolio to be nearly debt free.

So, here's what we are doing. We are going back in time to July 2018 when the Small Cap index had suffered a more than 20% drop and we are building a 3-year 20-stock portfolio of small caps with a PE ratio of between 10 and 20 and debt to equity of almost zero.

This is what the 20-stock portfolio would have looked like:

Company Name	Company Name	Company Name
Rites Ltd.	Navin Fluorine International Ltd.	Engineers India Ltd.
Bharat Dynamics Ltd.	Tejas Networks Ltd.	Maharashtra Seamless Ltd.
Nocil Ltd.	Persistent Systems Ltd.	Balmer Lawrie & Company Ltd.
Avanti Feeds Ltd.	eClerx Services Ltd.	JB Chemicals & Pharmaceuticals Ltd.
Kaveri Seed Company Ltd.	VST Industries Ltd.	D.B. Corp Ltd.
TV Today Network Ltd.	Cyient Ltd.	Godfrey Phillips India Ltd.
Greaves Cotton Ltd.	Force Motors Ltd.

Do you know the returns that this equal weighted portfolio has given over the 3-year period between July 2018 and July 2021?

Well, it stands at an impressive 82%. Yes, that's right. A simple portfolio of 20 small caps that are both fundamentally strong as well as attractively valued, would have outperformed the 68% returns earned by the BSE Small Cap index during the same period.

Hence, an investment strategy of investing after a 20% fall in the BSE Small Cap index, has certainly worked out in this case.

In fact, at almost 19% CAGR, even the BSE Small Cap index has given good returns during this period. However, at 22% CAGR, our 20-stock portfolio has done better than the BSE Small Cap index.

Ok, what do you think about these 20 names now.

Company Name	Company Name	Company Name
Mahanagar Gas Ltd.	Aditya Birla Sun Life AMC Ltd.	Godfrey Phillips India Ltd.
Supreme Petrochem Ltd.	eClerx Services Ltd.	Amara Raja Energy & Mobility Ltd.
EKI Energy Services Ltd.	BASF India Ltd.	KRBL Ltd.
Alivus Life Sciences Ltd.	UTI Asset Management Company Ltd.	Gujarat State Petronet Ltd.
Finolex Cables Ltd.	Zensar Technologies Ltd.	Graphite India Ltd.
VST Industries Ltd.	Triveni Turbine Ltd.	Jubilant Ingrevia Ltd.
FDC Ltd.	Rites Ltd.

Again, looks like a decent portfolio, isn't it?

This hypothetical portfolio was created back in June 3022 when again, the BSE Small Cap index had taken a more than 20% tumble from its highs i.e. the same situation that we are in today.

Besides, the criteria were also the same i.e. a PE ratio of between 10xand 20 and almost zero debt status.

So, how did this portfolio do between June 2022 and now (17 February 2025)?

Well, it almost doubled in value. Yes, that's right. Buying after a 20% fall in the BSE Small Cap index has again proved to be a rewarding strategy with the portfolio doubling in value.

It's worth highlighting that even the BSE Small Cap index did quite well during this period and notched up gains of almost 86% point to point. Yet again, our simple 20 stock portfolio outperformed the BSE Small Cap index.

Based on these two events, it is clear that investing in fundamentally strong and attractively valued small caps after a more than 20% fall does have a chance of working out well over a 3-year period.

And if this is evidence enough for you to start thinking of building your own 20-stock portfolio, here are the names you can have on your watchlist.

Company Name	Company Name	Company Name
Zee Entertainment Enterprises Ltd.	Avanti Feeds Ltd.	Force Motors Ltd.
Gujarat State Petronet Ltd.	Gland Pharma Ltd.	Shriram Pistons & Rings Ltd
Sun TV Network Ltd.	Finolex Industries Ltd.	Chambal Fertilisers and Chemicals Ltd.
Mahanagar Gas Ltd.	Cyient Ltd.	Redington Ltd.
UTI Asset Management Company Ltd.	Quess Corp Ltd.	Ircon International Ltd.
Aditya Birla Sun Life AMC Ltd.	NCC Ltd.	Welspun Living Ltd.
Amara Raja Energy & Mobility Ltd.	Vardhman Textiles Ltd.

So, these are the stocks that you can keep on your watchlist if you are looking to invest in small caps at the current levels.

The last two times the index fell 20% from the top, a portfolio with the same characteristics as these 20 stocks, did really well over a 3-year period.

Will history repeat itself? Will these stocks also give similar returns over the next 3-years?

Truth be told, there are no guarantees in investing. All you can do is follow a sound process and then hope for the best.

And if it is some consolation, our process is indeed sound.

We are not considering investing at all-time highs but after a significant fall. Plus, we are also looking at building a portfolio of fundamentally sound companies trading at attractive valuations.

So, if the small cap index does well over the next 3 years, there is a strong chance this portfolio will also do well.

If you still have some doubts, you can always consider partial buying right now and the remaining after some more correction, which may or may not happen.

The choice is yours. Please note there are no certainties in investing, only probabilities. And this is how you should always approach the market, with a probabilistic lens.

Happy Investing.

Warm regards,


Rahul Shah
Editor and Research Analyst, Profit Hunter
Equitymaster Research Private Limited (formerly Equitymaster Agora Research Private Limited) (Research Analyst)