What to Expect from Smallcaps this Year

2022 was a big speed breaker for BAAP (buy at any price) and growth at any price investors.

With cheap money out of the picture, a lot of high-flying stocks saw the wind beneath their sails disappear.

However, the market sentiments are shifting again.

After the big sell off in March this year, many smallcaps have rebounded...and how.

The BSE smallcap index is now flirting with all-time highs. The upswing has been much higher, in specific smallcaps.

In my monthly Hidden Treasure performance review, I wrote to my subscribers that twenty stocks under coverage had gained 10% or more in just one month. And five stocks had gained more than 20%.

Well, that's the nature of smallcaps. When the market's sentiments are adverse, they take the hardest knocks. But when markets are upbeat, even the slightest nudge can send them soaring.

It's good to see smallcaps rallying. But this comes with a sense of caution.

Markets are cyclical. There may be a point when the company valuations run ahead of fundamentals. That's when the market turns downwards.

How close are we to that point?

Well, this point will be different for each business depending on their fundamentals and valuations. But in this editorial, I'll share my view on smallcaps in general.

First, the market sentiment.

At present, Sensex is just 2% shy of its lifetime high. It's trading at a PE of 23.06. This a level saner than the peak PE of 36 in 2021. Still it's at a premium to its long-term median of 20.2 and not too far from some of its previous peaks.

Here's a very simple prediction for the Sensex in the next five years.

You see, the Sensex's earnings have grown at a CAGR of around 13% over the last 2 decades.

If I expect the earnings to grow at the same rate over the next five years, and use the median PE multiple of 20.2 times, the Sensex could be close to 96,000. Let's assume 100,000 for the sake of simplicity.

Now I'm more focused on smallcaps as editor of Hidden Treasure. So let's see what this could mean for smallcaps.

Unlike the Sensex, PE ratio for smallcaps does not make sense. That's because there are over 4,000 stocks in this category. And many of which are loss-making junk stocks. Investors with basic knowledge of fundamental analysis will not touch those.

In fact, the number of small-cap stocks clearing basic checks of a strong balance sheet, acceptable liquidity, good management quality, and minimal or zero pledging, would be much less than 100. And that's the shortlist you should consider.

So, for the lack of a sensible PE number, let's use another metric: Smallcap to Sensex ratio.

The smallcap to sensex ratio stands at 0.49 times as of today. The previous peaks range from 0.54 to 0.76 over the last two decades.

This means there is still room for smallcaps to rise before investors turn fearful.

Now if I have to make a projection for smallcap index, I'll use the median Smallcap to Sensex ratio and base case projection for the Sensex.

The base case prediction for the Sensex is 100,000 in five years, the projection for Smallcap index comes at around 44,000. The index is a little above 30,000 today. The upside in the individual smallcaps could be much higher.

At the current level of 0.49, the smallcap to Sensex is at a premium to long term median of 0.44. So you won't find many low hanging fruits in smallcap space. If you are not diligent and selective while picking smallcaps, your investment journey could be doomed.

That said, in my view, it does not make sense to wait on the sidelines yet but invest in fundamentally strong small-cap stocks in India that offer enough comfort of sustainable growth over the next five years.

At the same time, it's a good time to use this momentum for profit booking in some cases as well, where the growth prospects and balance sheet do not support valuations.

I'm doing exactly that in Hidden Treasure.