India's Third Giant Leap

This Leap Could Potentially Generate Gains
Far Bigger than Anything We Have Seen in Our Lifetimes

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What to Expect from Small-cap Stocks In 2023

Dec 27, 2022

What to Expect from Small-cap Stocks In 2023

The year 2022 is coming to a close.

It's a time of reflections and making fresh resolutions.

Also, a time to be prepared for whatever comes.

You see, ever since China lifted the lockdowns, Covid cases have boomed.

This has led to production cuts. Be it auto or home sales, the statistics does not look encouraging for the dragon economy.

And while deglobalization is the flavour of current times, the macroeconomic scenario looks uncertain.

I am not predicting a doom and gloom situation.

But knowing the unknowability of how macro environment could behave amid multiple events of global significance, I wish to be prepared for the developments that could influence the smallcap space.

But here are some reflections first.

This was a year of dichotomy, if you compare Sensex returns to that of smallcaps. While the former recorded a flattish gain of 1%, the Smallcap index lost 9% since the start of the year.

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For the record, in 2022, BSE Smallcap index witnessed a gain of 63%, versus just 24% gains in the Sensex.

Since the Covid cash, the total gains in the smallcap index stand at 207% versus 130% in the Sensex.

So will 2023 mirror the current year? Or is this time to be cautious with smallcaps?

Let's see what Smallcap index to Sensex ratio suggests.

The Smallcap to Sensex ratio stands at 0.46 times. This is slightly higher than the long-term average of 0.43 times.

Despite a poor show in 2022, the ratio suggests that there are not enough low hanging fruits in the smallcap space. In other words, the easy money in this space has been made.

And if you are still at a handsome notional gain on a stock where the growth path seems unclear and valuation makes you uncomfortable, or insiders are taking profits off the table, perhaps you should follow them.

At the same time, it is worth mentioning that the ratio is still well below the previous peaks.

In the previous peaks, this ratio was at 0.58 times in January 2018, 0.55 times in November 2010, 0.68 times in January 2008, and 0.8 times in August 2005.

So there is a scope of decent upside even with respect to current Sensex levels until smallcap index peaks.

So what should you expect from smallcaps in 2023.

I for one am cautiously optimistic.

I believe in India's long term growth story. Not to mention in the possibility of Sensex touching 1 lakh mark this decade.

Even if I stick to long term median, if Sensex does touch 1 lakh mark, the smallcap index could touch 43,000 mark versus around 27000 mark at present.

And this is just the upside potential in the smallcap index.

This segment of the market does hold promise of multibagger stocks.

The upside in well selected smallcap stocks could be much higher.

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Investors should keep in mind that that there has been consolidation in the smallcap space, with stronger players gaining the edge over less competent peers, who have either disappeared, or are shrinking.

The balance sheets for stocks in smallcap index looks much cleaner now.

And the cash flow from operations has never looked this good in last 5 years.

After a long lull, the capex revival is here with banks having cleaner balance sheets and relatively easier access to credit to strong players in the smallcap space at benign interest rates.

So while I'm positive about this space, there are a few things you must ensure to be on the winning side in smallcaps.

You must focus on smallcap companies that are not just showing earnings revival, but are backed by solid balance sheets as well.

You could further enhance your probability of success by betting on market leaders and backed by promoters with an established track record of execution.

Yes, there are some clear market leaders in the smallcap space too.

These include companies like Moldtek Packaging in rigid packaging space, Mayur Uniquoters in artificial leather space, Kabra Extrusion technik in plastic extrusion machinery (and 15% market share of Battrix in Li ion batteries in its segment), Kaveri Seed as the largest listed player in hybrid seeds and the first in the world to have more than 1 lakh acres in production area, CCL Products - the largest instant coffee exporter and private label manufacturer across the globe, Oriental Carbon - the only company in India to manufacture Insoluble Sulphur with 60% share in the domestic market, Rajratan Wires with leading market share India in a very niche segment of tyre bead wire manufacturing, Sheela Foam with 30% market share in organised mattress market, Nocil - the largest rubber chemical manufacturing company with largest market share in India.

The list of big fishes in a small pond is huge.

Do note that I'm not recommending a Buy view on the above names.

The point is, within smallcaps, you will come across players that are largest in their niche and indispensable to their clients in B2B or B2C segments. And these companies deserve special attention.

Coming to some lessons I have learn and would like to share for better returns in smallcap investing.

Peter Lynch once said that in this business if you're good, you're right six times out of ten. This is especially true for smallcaps, where volatility and smallsize turn out to be very unfavourable competition during any interim downturns.

What can help you ride such times is a prudent asset allocation.

There is not a single investor, no matter how legendary, who did not end up with failed investments.

It could be a case of bad decision making, industry related negative developments, disruption, or the management taking bad decisions, or something totally unexpected and unrelated to the business.

What separates legends from ordinary investors is not the lack of losers, or the bet on big gainers, but how less they lose when they lose, or how big they gain when the stock performs.

In the end, it all boils down to asset allocation.

A stock crashing by even 80% may not turn out to be too bad for you unless you are overexposed to it. So always keep the probabilities in mind, stay humble and allocate wisely.

It's okay to build on a position overtime with more conviction, rather than overloading on a stock based on a speculation. Investing is not just about winning big but staying in the game. A well-diversified portfolio ensures survival.

If you do the hard work, make the right choices, do the right things, and stay disciplined, you will find companies that will eventually get over the near term volatility and headwinds and go on to generate lasting gains.

While a 100% success ratio in investing, more so in smallcaps, would be an overambitious and unrealistic target, you could improve your probability of winning by having a long term investing mindset, so that compounding can work its magic.

But this strategy only works if you invest in the right team which brings me to the next criteria - The importance of management quality in successful long term investing.

Investing is like a business. Managements in that sense are your business partners. If you look at investing from this perspective, it's obvious you want to invest in jockeys who are think big, have decent skin in the game, are intelligent and good at execution.

Most importantly, you should invest in people with integrity. Otherwise all the intelligence of the management could work against you as a minority shareholder.

Pick any big winner in the stock markets, in India or globally - Amazon, Tesla, Facebook, Avenue Supermarts...

Why did hundreds of businesses die in dot com crash, while Amazon went on to become a global behemoth? Why did Future Retail and Avenue Supermart ended up so differently despite being in the similar industry?

It is obvious that the journey of these stocks would not have been the same, without their promoters' vision and execution.

It sure needs some work to assess the management quality, than buying on the next hot tip you come across on social media. But a little work here can catapult your luck in a big way. Once convinced, you can invest and forget. All the hard work is done by the management. You can enjoy the fruits.

The next important criteria to enjoy a great run in smallcaps is building the capacity to suffer.

This may sound as a contradiction to my positive long term view on smallcaps. But here's the thing.

There is a 100% chance that you will be tested when markets turn volatile.

It could be the next wave of Covid or lockdowns, inflation heading out of control, global recession or the sudden onset of war. Some event could make your portfolio crash by 20% to 40% within days or weeks.

If that causes you to panic and exit, you will never get to see the rebound in quality businesses.

This reminds me of the downcycle in smallcaps that started in January 2018. At the bottom, the smallcap index had crashed by over 50%.

As I shared in the initial statistics, the rebound more than made up for that crash. But only those who had the capacity to suffer could enjoy the cycle. What helps to develop this capacity is hard work and conviction you develop while picking the stocks.

So while the smallcaps are not exactly in a cheap zone from valuations perspective , the potential for big returns from select smallcaps is huge. If you follow this template, you are likely to turn the odds of success in your favour.

I wish you all a very rewarding and Happy New Year.

Warm regards,

Richa Agarwal
Richa Agarwal
Editor and Research Analyst, Hidden Treasure

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