Blue Chips Are Passe. Get into these Stocks for Outstanding Gains in 2020

Dec 5, 2019

Rahul Shah, Editor, Profit Hunter

A small quiz to begin with.

Which of these 2 indices do you think has done better over the last 15 years - the Sensex or the BSE Small Cap index?

Well, the answer is not as straightforward as it appears. The small cap index is made of smaller, fast growing companies. Hence, there's a strong chance the small cap index would have done well.

However, what is equally true is that the failure rate amongst small cap companies is also higher. More small cap companies fail than blue chips.

And this cancels out the strong gains a few manage to achieve over the years. Therefore, it appears that the Sensex must have done better.

Well, here's the answer in the form of their movement over the years.

The Sensex and the Small Cap Index: A Keenly Contested Fight

The Sensex and the Small Cap Index: A Keenly Contested Fight

At first brush, it appears that the Sensex is winning this one, albeit only marginally.

However, if we consider the data up to December 2017 and not beyond, we see the Small Cap index winning by a significant margin. An outperformance of 35% to be precise.

Seems like there's no clear winner here. Sometimes, the Sensex has had the upper hand and at other times, the BSE Small Cap index.

The chart highlights another interesting point...

Whenever one of the indices has opened a big gap over the other one, its fall has also been much worse than the other.

Case in point being the huge correction the Small Cap index has seen since December 2017. It rose much faster than the Sensex between 2014 and 2017. However, most of that outperformance is now a thing of the past. The Small Cap index has fallen 30% between then and now as compared to the 19% gains recorded by the Sensex.

Something very similar happened post December 2007 as well. The Small Cap index left the Sensex far behind only for Sensex to make a strong comeback. Parity was restored the very next year.

Does someone sense a mean reversion here?

Just as the stock market reverts to its long-term average valuations, do these indices mean revert to a specific ratio between the two?

Here's what I got after plotting the data of the ratio between the Sensex and the BSE Small Cap index over the last 16 years.


Looks like 2.3x is the golden mean. The ratio of Sensex to the BSE Small Cap index has averaged 2.3x in the last fifteen years.

Any time in the last 16 years the ratio has gone significantly higher or below this number, it has corrected itself and moved closer to the 2.3x mark.

If the ratio has gone much higher than 2.3x, the Sensex has underperformed its Small Cap counterpart over the next 1-2 years. This is to ensure that the ratio goes back to 2.3x.

And whenever it has gone much below 2.3x, the Small Cap index has tended to underperform the Sensex over the next 1-2 years to restore parity to 2.3x.

Where does the ratio stand right now?

It is at 3x.

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And this is mainly because of the outperformance of a huge 50% by the Sensex over the last couple of years. Do note that the Sensex is up 19% point-to-point and the Small Cap index is down 31% in the same period.

This 50% outperformance has taken the ratio to well above the long-term mean.

With the ratio now at 3x, I think it is time for the tables to turn. There's a strong chance the Small Cap index will outperform the Sensex over the next 1-2 years.

In fact, the last time the ratio was this high was back in 2014 when it stood at 3.2x. What happened over the next couple of years?

The BSE Small Cap index put in a stellar performance, recording 80% gains point-to-point vis-a-vis the 23% gains recorded by the Sensex.

Therefore, it may not be a bad idea to shift some of the money from blue chips into small cap stocks and have the odds in your favour.

So, if you have a portfolio where blue chips account for 80% of the value and Small Caps 20%, it may not be a bad idea to change this to 70:30 or maybe even 60:40 in case you want to take slightly higher risks in exchange for slightly higher returns.

If the historical data is any indication, you will be rewarded with strong gains over the next 1-2 years.

In case you are wondering what is the logic behind the 2.3x ratio, I don't think it matters much.

What matters is how consistently the Sensex and the Small Cap index have moved over the years to keep the sanctity of this ratio intact.

It is the efficient market system at play I believe. After all, the companies in both the indices are part of the same ecosystem and are likely to have similar topline and bottom line growth numbers on an aggregate basis over the long term.

Which is why there's a high chance the long-term mean will keep hovering around the 2.3x mark and could provide a good thumb rule for you to decide your allocation between blue chip stocks and small caps.

Warm regards,

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

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2 Responses to "Blue Chips Are Passe. Get into these Stocks for Outstanding Gains in 2020"

Swayam doshi

Dec 14, 2019

Blue chips have been overbought so they are not going to go up much further too soon., as in due to the volatility caused by trade war and elections in our country people bought blue chips to be safe. They have become very expensive and their P:E is too high to be affordable. So have to look for small or medium cap growth stocks.

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Sriram S

Dec 8, 2019

Hi,

Looking forward to suggestions.

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