Smallcap Stocks: Is the Party Ending?

"Apna time aayega nahin, apna time aa gaya hain".

Our time has already come.

This is the feeling I get about the India story when I either watch a business interview, read a business newspaper, or even talk to people.

But this is not the global consensus when it comes to the India growth story. Among the emerging markets and the global pecking order, India is a preferred investment destination.

So if most of the big money managers are bullish, why am I not?

Well, it's not that I'm not bullish on the structural story of India and the Nifty compounding in the years to come. It's something else. I have believed that when everybody is bullish on stocks, it's not a good time to buy.

If you ask your barber if you need a haircut, there is a one in a million chance he will say a no. This is like asking a stockbroker if you should invest in the stock market. His livelihood depends on saying yes.

In the stock market, the barbers and stockbrokers are the fund managers and CIOs of mutual funds.

Why would a mutual fund manager tell people to stop SIPs as the markets are very overvalued.

The thought about what you are reading now came to me from an interview I saw of S Naren of ICICI Prudential AMC. He is one of the few CIOs in India I admire. The man calls a spade a spade.

He is one of the very few mutual fund guys who has the audacity to come on national television and tell the public at large that it doesn't make sense to invest in certain sectors or the stock market.

Investors talk about structural story of India but most of the times ignore many important things that are happening right in front of them.

Let me spell out a couple of points which are being ignored by most people on Dalal Street.

1. Promoters Selling is at its Highest Levels
   
   In my view, nobody knows more about a company but the promoters, especially in the case of first-generation promoters. Every other day, you hear some or the other promoter selling a little part of his stake. The picture below says it all.
   
   
   I'm sure the promoters know something more than mutual fund managers. It's their own company after all.
2. SME IPOs: Is there a Method to the Madness
   
   A Chennai based VFX studio that came up with its SME IPO at Rs 660 m a few weeks ago saw a subscription of 286 times. Basilic Fly Studio received bids of Rs 140 bn for its IPO.
   
   The euphoria isn't limited to IPO bids but it continues on the listing day. and after it too. Sungarner Industries was up 200% on the first day while companies like Shoora Designs and Bonada Engineering doubled investors wealth on listing day. Is it really so easy to make money?

A lot of people talk about the whole concept of long-term investing where in the long run stocks always go up. Well, if you invest in the front-line index, may be yes.

However most individual stocks tend to move in cycles. This element of cyclicality is very important in small and mid-cap stocks. So it's very important to be cognizant of macro events happening around us.

Things like rally in oil prices which could lead to tremendous headwinds for the economy and individual stocks. This came be a vicious cycle. If crude oil goes up, it puts a pressure on our deficit. The currency depreciates and imports become costlier.

What Should Investors do with Midcap and Smallcap Stocks?

Here is a broad guideline I've developed for midcap and small-cap stocks.

Valuations of Midcap and Smallcap Stocks	Decision
2 standard deviations above 5-year mean	Sell
1 standard deviation above 5-year mean	Sell half and Hold on to the rest
Mean valuation	Hold
1 standard deviation below 5-year mean	Buy
2 standard deviations below 5-year mean	BUY aggressively

Standard deviations are usually used to find the Z-score of stocks. This number can be found online.

This is a broad perspective on what investors should do. Keep in mind that factors such as earnings growth and future growth prospects are also important.

Keep Market Cyclicality in Mind

Another interesting point is the concept of sector rotation in the market.

Now sector rotation is of course applied to specific sectors being in or out of favour. But why not look at sector rotation from the lens of marketcaps. Think out it as marketcap rotation.

Midcaps and smallcaps are often looked at in terms of valuations. If the valuations are favourable, institutions buy a bunch of these stocks as a basket. Capital rotates from largecaps to mid/small caps and vice versa based on factors like liquidity and valuations.

Currently the wind is flowing towards mid and smallcaps as the euphoria builds up.

However, in such an upbeat mood, it's extremely important to stay cautious.

Conclusion

I believe now is the time to...

• Increase cash levels by cleaning up your portfolio with the valuation guideline above.
• Exit stocks of average/below average quality companies.
• Don't commit funds where the valuations are not comfortable.

Markets never fall with a warning. It's fine to miss the last leg of any rally rather than to 'time the top'.

Finally, always remember the old market wisdom which informs us that the market comes up the stairs but goes down in the elevator.

Warm regards,


Aditya Vora
Research Analyst, Hidden Treasure