»Profit Hunter by Equitymaster

On This Day - 5 JULY 2021
The Smart Money is Warning of a Bubble in Mid & Small Caps. What Now?

Rahul Shah, Editor, Profit Hunter

  • 'In the short run, the market is a voting machine and not a weighing machine.' - Benjamin Graham

The question to ask in the current market environment is this...

Have investors voted overwhelmingly in favour of a bull market just as they voted strongly in favour of a bear market back in March 2020?

The smart money or the so called fund managers definitely seem to think so.

If a leading business daily is to be believed, some of the leading asset managers have flagged off concerns over steep run in the mid and small-cap space.

'The euphoric rise in many poor-quality small cap names driven by retail participation is a cause for concern', warned one fund manager.

'Investors' portfolio should be more skewed towards multicaps and largecaps at this juncture and those overweight on midcaps should reduce their exposure', opined another.

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There are a few others with more or less the same point of view.

The mid and smallcap space has definitely had a stellar run over the last one year or so.

While it can be argued they are not in a bubble yet, there's no denying these stocks are no longer as attractively valued right now as they were a year back.

Thus, with both the smart money as well as data pointing in the same direction, how should an individual investor approach this space now?

Should he completely liquidate his mid and small cap positions or should he keep focusing on his bottom up approach to stock picking and ignore the broader market valuations?

Before I answer this question, what do you think of an approach that has given a CAGR of 22% since October 2018 while remaining 50% in cash most of the times?

And also, what do you think of a strike rate of almost 80%, i.e. getting 8 out of 10 to close in the positive.

If you approve of these results then here's the gist of my strategy and how I designed it for my subscribers.

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You see, a lot of investors think of small companies as highly speculative and use it for speculation and not investment.

They prefer taking positions in speculative counters like Suzlon or Reliance Communications. They are fine even if they lose their hard earned money as they think of it as a hit or miss.

Then there are investors who believe in buying only the best quality small caps. They completely ignore where the broader market is on the valuation curve.

This again is a strategy fraught with huge risks.

Please note that the BSE Small Cap index was down a whopping 60% between from its peak in January 2018 to its bottom in March 2020.

And even quality small caps were not spared.

Thus, you can still suffer huge losses, even in quality smallcaps, if you were to ignore the broader market.

This is why I believe in a strategy that takes into account both the stocks at the individual level and the broader stock market environment.

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I too like to recommend quality stocks but I also prefer to reduce my exposure to stocks when the markets have run up a lot and are in danger of a big crash.

Likewise, I increase exposure to stocks after the market has fallen a great deal from its peak.

It's this approach that allowed me to take a big exposure to small companies back in April-May 2020 and is now asking me to play it safe after the run up of the last one year.

Therefore, to answer the earlier question on what the strategy should be as far as mid and small caps are concerned, well, it should be that of cautious optimism.

There are still stocks out there that are of good quality and available at reasonable valuations.

But since the small companies have run up a lot, I won't recommend taking a big exposure to them.

Warm regards,

Rahul Shah
Rahul Shah
Editor and Research Analyst, Profit Hunter

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