Smallcaps for Election Season, and Beyond

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The Great Indian elections, with all their high-octane drama, are getting close.

The dates have been announced and political parties have entered poll mode.

But what about the stock market... does election season affect its trajectory?

Well, the simple answer is yes, it does, in the short term.

However, once the elections are done, history tells us, the markets continue their merry way.

There could be exceptions when results are in complete contrast to market expectations. In 2004 when the incumbent NDA government was voted out, the markets crashed.

The fear at that time was that the new government would have communist parties as alliance partners. It was believed that such a government would reverse business-friendly policies.

These fears were unfounded as the market entered a long, record-breaking bull run which only ended in January 2008. Smallcaps outperformed largecaps in that bull market.

Could something similar happen this time around?

The expectation this time is for the Modi government to return to power again.

If this expectation is belied, then there could be a correction in the market. However, this is likely to be short-lived, considering what has happened in the past.

We at Equitymaster believe that the long-term investors have nothing to worry about.

Coming specifically to smallcaps, as I shared in a recent article, I do not think smallcaps are in a bubble. Some froth, yes. But it does not look like a bubble waiting to burst.

That's because the rally is not just liquidity driven.

The earnings for over 900 stocks in smallcap index suggest a growth (compounded annually) of over 20% in last four years.

Considering it uses pre-pandemic year as base, this is impressive.

Furthermore, the growth in earnings has come along with stronger balance sheets and capex activity. All these are good grounds for a rerating in smallcaps.

And if the results are as per expectations, there could be a short-term spike in the indices. In this case, it's very likely that small caps will outperform largecaps.

So, amid upcoming election season, how you should approach investing?

Consider investing in a group of stocks which are fundamentally strong, and are also indifferent to the 2024 elections.

In other words, stocks that are dependent more on the broader long term India growth story and are not directly related in any major way to the popular themes of the Modi government.

For instance, I would consider digitization a more indifferent theme to elections or ruling party as compared to solar stocks. Other such more resilient themes would be energy storage, data centers, premiumization in consumption sector, sustainability driven by global targets, China plus one, and entertainment.

Even if the Modi government does not return to power, then the businesses under these resilient themes can continue on growth path as they are not highly sensitive to policy support.

Coming specifically to smallcaps, I believe it's a good time to use this momentum for profit booking in some cases where the growth prospects and balance sheet do not support valuations.

But like I said, it does not make sense to wait on the sidelines but invest in quality smallcaps that offer enough comfort on sustainable growth over next five years.

Here's are few pointers I would recommend picking high potential smallcaps in this market.

• Are cash flows in alignment with earnings?
  
  Earnings can be manipulated easily, such as with depreciation policies, capitalising recurring expenses, changing inventory policies and so on. But it's difficult to manipulate cash.
  
  A consistent divergence deserves some digging in and due diligence.
  
  Cash flow from operation could be a bit out of tune with earnings. Depending on the nature of the industry, a peer comparison and comparison with past trends could be very insightful.
  
  I prefer small-cap stocks with positive cash flow from operations.
• Is the balance sheet suited for business to grow in a self-sustainable manner?
  
  For non-banking stocks, I prefer businesses where debt to equity ratio is less than one.
  
  That's because I like businesses that can grow in a self-sustainable manner. If a business needs too much external capital for growth, the quality of growth is questionable.
  
  Such businesses end up being at the mercy of interest rates and macro environments and may not be the best investment bets for the long term.
• Does the business generate healthy return ratios?
  
  A lot of investors pay attention to profits. Few are conscious of returns generated by a business.
  
  A business X requiring an investment of Rs 100 and earns a revenue and profit of Rs 50 and Rs 20, is likely to have a better economics compared to business Y that needs an investment of Rs 500 generating revenue of Rs 50 and profit of Rs 25.
  
  For X, the profit margin is 40% and return on capital employed (RoCE) is 20%. For Y, the profit margin is 50% and ROCE is 5%.
  
  So, it's not the profit margin but ROCE that is a better indication of the returns you will make on an investment.
• How do the valuations fare compare to long-term median valuations?
  
  Don't rush into an investment without due diligence for the price you are paying.
  
  You could compare with the long-term historical PE of the same stock, as well as with the peers in the same industry.
  
  Sometimes, depending on how high a price you have paid, good businesses can turn out to be bad investments.
  
  Finally, and most important...
• Is the management good enough to consider a partnership with?
  
  Long-term investors should approach investing like a business partnership.
  
  Unlike well established businesses that run on an almost auto pilot mode, for smallcaps, the management quality is the biggest make or break factor. Sometimes, amid a rally, people ignore this factor.
  
  Smallcaps should be treated not just as price tickers but businesses the prospects of which would be made or marred by the competence, integrity, and focus of the management.
  
  Avoid stocks with very high promoter pledging. This weakens the management control of the business. It could lead to selling pressure amid bearish sentiments in the stock.

So, that was about the process of selecting smallcaps in current times. If you can pick quality smallcaps at attractive prices, you are highly likely to do well in the long term, and in the election season.

Warm regards,


Richa Agarwal
Editor and Research Analyst, Hidden Treasure