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Avoid the Smart Money When You're Investing in Smallcaps

Nov 28, 2023

This is Where You can Find Smallcap Bargains

Knowledge alone is not enough to change behaviour.

In the stock market, history may tell us that greed is not good. When stocks goes up too much in too little time, they're bound to come down.

But such is the recency bias that it is often too late before investors realise this.

Well human nature does not always act in its best interests.

Isaac Newton once remarked while surveying his losses in South Sea bubble:

  • "I can calculate the motion of heavenly bodies, but not the madness of people".

You may get the same feeling looking at the valuations of some familiar names in smallcap space.

Smallcaps have risen to level that is concerning, given the short time frame in which these gains have come.

The smallcap to Sensex ratio, at 0.57x, has been flashing a warning sign for some time now. This was the level from which the smallcaps saw a sharp decline in January 2018.

Even excluding the Covid crash, the smallcap index had corrected by 40% in the previous down cycle.

I'm not predicting doom for smallcaps. They are like the pick and shovels in the golden rush that the Indian economy is all set to enter.

So what should smallcap investors do?

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I believe it's time to take partial, if not full profits off the table in cases where valuations are ahead of fundamentals.

I also believe it's not the time to ignore smallcaps, especially the already ignored smallcaps.

Allow me to explain...

It's a fact that smallcaps have rallied a lot. While some of this is due to fundamentals, a disproportionate share of this rise can be attributed to huge money flowing in the smallcap space in the last few months.

I'm speaking of thousands of crores, beating the inflows into largecaps. This is unprecedented, and also unsustainable.

But before you let all this information affect your allocation, here is something interesting you should know.

You see, this huge institutional buying in smallcaps has segregated the smallcap universe into two distinct parts.

The first is full of all the overhyped, overvalued, and ripe for correction stocks.

In the second part, also the less talked about, you have all the ignored, overlooked, and under-the-radar stocks.

These under-the-radar stocks have still not run up high like other popular smallcap stocks. These are the stocks where institutional holdings are nil or negligible.

It's not because these are bad businesses. In fact, some stocks in this space may have huge upside potential in the long term.

So why have big and institutional investors ignored them?

The reason is their small size.

You see, some smallcap stocks don't have the liquidity to handle huge money inflow in a short time frame, simply due to the fact their number of shares and value of shares traded on a daily basis is less.

As far as the first category of liquid smallcap stocks is concerned, the institutional money has already kind of exceeded the capacity to put in more money.

It's no wonder that some fund houses in the smallcap space have stopped accepting fresh investments into their smallcap schemes.

But you don't have to follow them.

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Instead, I suggest focusing your attention towards great investment opportunities that are almost ignored by the broader market.

Even if the smallcaps correct, history suggests that allocation towards less liquid and less popular businesses with high potential in the smallcap space, can generate huge returns, irrespective of how the smallcap index moves.

For instance, between 2008 to 2017, the BSE Smallcap index offered 0% return.

If you could foresee this information about smallcap index, chances are you would have stayed away from this space.

And would have subjected yourself to a huge opportunity loss.

You see, over the same period, the less popular smallcaps delivered upto 1,000% returns.

Balkrishna Industries rallied by 861%.

Hawkins Cooker went up by 1,251%.

Page Industries delivered an impressive 2,942% gain.

Now today, these companies are well known. But back in 2008, very few investors were putting money in these stocks.

So, when the market is near the top, look for ignored stocks with strong business fundamentals, not popular stocks.

Chances are you would find valuations lot more reasonable in the second bucket.

This is not just a conjecture, but something supported by data.

My team and I recently analysed 1,744 smallcap companies listed on the BSE stock exchange.

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We divided these companies into two buckets. First, where institutional holdings were over 20%. Second where institutional holdings ranged from nil to 20%.

We found that wherever mutual funds and other institutional holding was more than 20% of the stock, those stocks had median Price to Earnings or PE ratio of 33.78.

Whereas for stocks where institutional holding was less than 20%.., this figure was about 25. For individual stocks in the second bucket, the valuations were even more palatable.

What this means is that stocks with heavy mutual fund and other institutional holdings are very expensive. On the other hand, the stocks where there is negligible to low institutional stake are available at reasonable valuations.

Clearly, the margin of safety within the smallcaps is much higher in stocks with relatively lesser institutional holdings.

Now smart money and institutional investors may not be able to invest in the second bucket, due to the huge amounts of money they deal in.

But this is one area where you as a common investor have an edge. Make sure you use it well.

Warm regards,

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

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1 Responses to "Avoid the Smart Money When You're Investing in Smallcaps"

Dr RAJAN GARG

Nov 29, 2023

Clearly, the margin of safety within the small caps is much higher in stocks with relatively lesser institutional holdings.

ONE OF THE GREAT ARTICLE WRITTEN BY YOU.
ACTUALLY EVEN IF COMPANY IS WITH HIGH PE, AND MARGINAL OR NO DFII HOLDINGS, ARE MORE POTENTIAL WORTHY OF FUTURE RISE. WHENEVER [ DFII ]THEY ENTER AT LATER STAGE , PE EXPANSION WITH EPS GROWTH WILL MAKE THEM MULTIBAGGER STOCK.

AVANTEL IS A GGREAT EXAMPLE.

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