Rising Momentum in Small-caps?


There is bit of tussle between two sects of the market. On one side, you have the quality enthusiasts like the coffee-can clubs who discredit the current rally in the small and mid-caps as something that will fizzle out once budget jamboree is over. And, on the other side, there are these broader-market bulls who believe that the worst is over for the small-midcaps and hope that the best is yet to come. They take comfort from the fact that even in days (in the last three weeks) when Sensex was down, the broader markets were inching up. This, coupled with the fact that the small-cap index has returned over 7%+ in the month of Jan against a very flat return for Sensex and Nifty, have added ammunition to their argument.

Only time will tell who will turn out to be right. Of course, lackluster budget has taken some steam out of the ongoing rally in small-mid caps. But it is unlikely to reverse the stronger trend, esp. when the lead indicators such as perk-up in power generation, turn in coal production, increase in port traffic, surge in manufacturing PMI (Purchasing Managers Index) for Jan etc. are pointing to a convincing turn in the economic activities. More importantly, this govt. has penchant to announce more powerful reforms outside the budget, like how it did the privatization of coal mining very quietly in early Jan without much fun-fare. If the govt. continues on this track by announcing more such reforms (like the impending legislation on the new labour code etc.), then one could be looking at a stronger year for small-midcaps. More so, if the following technical trends are anything to go by.

  • Selling intensity in small-caps have substantially subsided. There is evidence to believe that the infinite supply (persistent selling by HNIs and funds) that squeezed small-caps last year has played itself out and that in itself will act as a big push for small-midcap rally this year (without even factoring the “buying” that may come in).
  • In an encouraging change of trend for small-cap index, after making many attempts in the past to gain momentum, this is the first time after several months i.e. post July last year to be precise, it has successfully broken out of the range it has been stuck since then.

But there is a risk of Known-Unknown from Corona outbreak. One doesn’t know how this will play out. If it worsens, this could cloud the outlook in the short-term.

Happy Value Investing!

Has Luck Run Out for Bears in the Broader Space?

Of course, this question assumes that the action that has earnestly started in the small-mid cap space beginning this New Year, will sustain and gather pace in the coming weeks/months. Only time will tell whether that will be the case. We will not risk venturing into any prediction on that. However, there is reason to believe that after all that long lull and agonizing wait, life could be coming  back to the small and mid-cap segment. This basically stems from the fact that after making many attempts in the past to gain momentum, this is the first time after several months i.e. post July last year to be precise, it has successfully broken out of the range it has been stuck since then.

Strangely, it has brought more anxiety than relief. Why? There is this niggling question in investor’s mind that if the recovery in the economy is going to be muted, how will they (small and midcaps) sustain this rally? Looks like a very logical question. This question is causing avoidable anxiety to many small-cap investors. But the underlying assumption that there is a direct co-relation between the strength of recovery and the stock prices could be fatally flawed. Looking at the reasons for sharp slide in small-cap stocks in 2019, it was the fear of collapse in the financial system (esp. in the NBFC space) that resulted in precipitous fall in stock prices, not so much because of the weak growth in the economy. Going by this, what is more critical for the stock prices to revert back to their mean, is the return of some stability in the financial system, not any signs of stellar growth in the economy. So, the basic point is this. As happened in the earlier cycles, even a muted recovery in the economy in FY21 can bring disproportional upside in small and midcaps as it did, but in reverse, in FY20, if the improving signs of stability in the NBFC and other stressed space strengthen further over time. Not to forget the fact that even a moderate economic recovery will look enlarged optically on low base effect of last year. Add to this the high probability of India returning to it potential growth rate of 7%+ in the medium term (on positive effects of long-term reforms carried out in the Ist term of this administration), it is difficult not to build a bull case for the broader market.

Having seen low prices for protracted period of downturn, it may be very tempting for small-cap investors to use the fledgling rally to rush out, esp. when NIFTY is trading near life-time highs amid growing narrative on weak recovery in FY21. That will be a terrible mistake to make. As past cycles indicate, the sequential returns in small-caps after a prolonged downtrend will be substantial for subsequent two to three years at least, as can be seen in the below chart. This is time to stay invested (add if possible) in the broader space to benefit from long-term compounding.


As we had highlighted in our earlier note, following factors are likely to work in favour of broader markets now.

  • Stability returning to financial sector with signs of improving liquidity in the banking and NBFC space.
  • Increasing reform momentum from the Govt.
  • Low base effect supporting moderate earnings growth in FY21.
  • Friendly taxation measures (either on DDT or LTCG) expected in the upcoming budget.
  • Lower interest rate environment (notwithstanding the recent spike in inflation on seasonal surge in food prices)

In all probability, 2020 is likely to belong to small and midcaps, if initial signs in the New Year are anything to go by. Though the rally is unlikely to be smooth, the underlying trend will be nothing but up.

Happy Value Investing!!


Small-Cap Recovery: Shifting The Goal Post?


An eventful year is coming to a close. From market point of view, 2019 couldn’t have been more unique. It marks the first time in almost 2 decades that the BSE small cap index has delivered negative returns for two years in a succession. 2019 witnessed that rare event. Last time, such an event occurred was in 2001-02. In rest of the downturns, be it in 2008 or in 2013, the corrections in small-caps did not last beyond 13 months. As the year began, this recurring pattern prompted many experts to predict a sharp rebound in small-caps in the later part of 2019, which, of course, did not materialize, much to the disappointment of seasoned small-cap investors.

As the New Year begins, the goal post (of small-cap recovery) has now shifted to early or mid-2020. There is reason for optimism this time. If one goes by past cycles in the last 35+ years, one would not find a single down-cycle that lasted well past two years. Given this, it is very unlikely that the winter in small-caps will stretch beyond few more months at worse. More so, if one considers the following factors:

  • It has been nearly 4 months since the small-cap index has not gone back to test its earlier low level. This may be pointing to a slow and steady trend reversal.
  • Stability returning to financial sector with signs of improving liquidity in the banking and NBFC space.
  • Increasing reform momentum from the Govt.
  • Low base effect supporting moderate earnings growth in FY21.
  • Friendly taxation measures (either on DDT or LTCG) expected in the upcoming budget.
  • Lower interest rate environment.

Will 2020 belong to small and midcaps? Are small-cap & mid-caps at an inflection point? Hope we will find the answers not too far in the future.



Reforms: Time for the difficult ones?


Expectations are up on the reforms front as we approach the next budget. More so with Govt. showing some teeth now with respect to labor code. Govt. has introduced the new labor code bill in the lower house. If the labor bill passes the RS hurdle, it will be a big milestone in the reform agenda as this has been pending for decades. One of the key proposals in the labor code is with respect to Govt. taking executive power on fixing the threshold number for retrenchment (below the threshold, companies will not require Govt’s approval for retrenchment). If the threshold can be modified thro’ an executive action, not thro’ legislative approval (vide parliament), it will be a boost to investment. This in combination with the new tax code (15% tax for investments in new manufacturing) can be a game changer for attracting new investments in manufacturing, esp. in the back-drop of US-China trade frictions.

It doesn’t stop here. As some reports suggest, Govt. is closely looking at liberalizing the lease mechanism of agricultural land for industrial use. Though it is a state subject, if a central model code can successfully be adopted by interested state governments, then it can address one of the key structural supply side issues for unlocking manufacturing potential. While Govt. might do this quietly without brandishing this as a major land reform, the signs are there that the current administration is keen to get this out of the way.

If Govt. of the day can get these difficult reforms (land and labor) done, it will send a strong signal to investment community. This coupled with friendly taxation measures (either on DDT or LTCG) expected in the upcoming budget, one is looking at reform momentum gathering strong pace in the coming weeks and months. While market has started pricing-in this increased reform momentum, so far, this has been limited to select large-caps. Broader space is yet to see the benefits from improved traction in reforms. But, with early signs of visibility in closure of some of the stressed cases, both in NBFCs and in banks, thanks to quick responses from finance ministry (be in IBC amendments or special AIF fund for real estate stressed assets or recent SC ruling in Essar case etc.), it is question of time before the broader market picks up pace. In this context, current depressed valuation in the broader space is a great opportunity for investors with lot of patient capital.


Structural Spin to the Cyclical down-turn?


Millennials have a special place in this slowdown. Much of muck for the current ills in the economy is thrown at them.  Lot of things may go “over-the-top” for the Gen-Old, but for the millennials, OTT is central to everything they do. In fact, in our definition, OTT is not limited to only video or audio streaming services, but to even other  aggregator services like Uber, Swiggy or any such disruptions (as they lie “over-the-top” on the age-old platform). So far this is good. But where it takes a noisy turn is when analysts start giving an OTT spin to otherwise normal cyclical down-cycle to project a structural scare for such down-trends.

In times of slow-down, the scars of slump can be seen much beyond the realm of economy. During slow-down, it doesn’t surprise anyone to see the numbers sliding in various segments of the economy, be it consumption, manufacturing or services activities. The slump that surprises many is the slump in critical “thinking” during slow-down times, esp. when it comes to dissecting the long term sectoral trends. Slowdown colors the thinking so much that it starts seeing some of the otherwise normal cyclical down-trend as a structural one. This happens, because the analysts, in their over-enthusiasm, end-up over-estimating the short-term implications of a new trend, while under-estimating the long-term implications. This has occurred cycle-after-cycle. This down-cycle is no different except that this time analysts are hiding under OTT to give a structural spin.

One doesn’t need to go too far to understand how this played out in the past. Take for example, the IT slowdown in 2016. Normal cyclical slowdown in IT spending in US was amplified as a structural one using the new challenges the industry was facing that time from automation, machine learning and AI. Analysts took these disruptions and gave a structural scare which resulted in valuation de-rating in IT stocks in early 2016. What happened subsequently is there for everyone to see. Growth came back in 2017 and the noisy narrative on Automation/AI was slowly edged out by rosy prospects of increased IT spending. This led to re-rating of IT stocks. Seasoned investors who foresaw this ended-up gaining 2X-3X in some of the mid and small-cap IT stocks (as they were the worst hit by the structural scare).

Fast forward to now. OTT is a new monster now and as per arm-chair analysts, it is going to kill anything and everything that is going to come its way. The monster’s impact is more visible in the mayhem in the Radio, Broadcasting and in the Newsprint stocks. The structural scare is so much that some of the stocks in these sectors are going for a song, esp. from the mid and small cap ones. It doesn’t matter that the readership, listenership or viewership surveys don’t reflect those scary prognosis. EV is another one that is going to electrocute the entire auto industry as per some of the auto enthusiasts. It doesn’t matter we will take 30 years to build required charging infrastructure or it costs 3X the normal one if one goes by TCO (total cost of ownership). In both these cases, the market is amplifying the normal slowdown in ad-cycle (in the case of Radio, TV and Newsprint) and demand slowdown in the case of auto, feared by the noisy narrative of OTT and EV scare.

Going by the past cycles and by the past disruptions, such structural spins throw great life-time value opportunities for anyone who doesn’t suffer from slump in critical or contrarian thinking.  Of course, one can’t be blind to certain long-term changes. But when market de-rates to a level where mis-pricing goes to manic levels, there is lot to unlock in terms of future upside. Interesting times to watch out for!!

Happy Value Investing!!

Early signs?


Earnings reactions in the broader space have started to exhibit an encouraging trend. They are still irrational, but not as irrational as they used to be in the earlier quarters. Earlier, even great results met up with muted reaction from the market, leave alone iffy ones. No longer so. If the results are robust, they get rewarded to a reasonable extent. Of course, market’s negative reaction to even decent results, which is the hallmark of a downturn, is yet to change. This change in its reaction to stronger results, has led to rise in number of stocks, in the broader space, that are hitting 52 week highs for the first time in many months. Though, for now, these numbers are far and few. This trend, if it continues (that is a big if), can bring back some life into the small and mid-cap space in a gradual fashion.

It doesn’t stop here. There is another trend that could be a pointer to life coming back in the broader space, though it is too early to say. Market has made many attempts to gain momentum in the past few months. Every time it makes an attempt, some bad news comes in a miraculous fashion to mar the early signs of momentum. This month, it was SC’s blow to the telecom sector and the sensational turn of events at Infosys. Last month, it was PMC bank that did the damage. If at all there is anything to be inferred from these multiple attempts by the market to gain momentum, it is this – there is bottom in place now and it is question of time before luck runs out for the bad news and for the bears.

Add to this, the positive news-flow momentum that might come from the upcoming budget that is not far away.  The expectation from the budget will be high, given the rising reform-intent from this Govt. Some tweaking either in the long-term capital gains tax or in DDT may be on cards, besides the increasing chorus for cut in personal income tax. This coupled with Govt.’s growing inclination to side-step the fiscal puritan path to accommodate more growth oriented policies, market will start expecting more fiscal measures (stimulus) in the budget. This can help the market to successfully build and sustain momentum, which it has been trying for many months, but in vain. Interesting times to watch out for!!

Haven, not so safe?

Funds rushing to safety, thereby raising a potential risk of crowded trade in safe haven stocks.

The end-game for crowded trade is never cozy. It eventually crumbles and that too in a crucifying manner. We all know that. We don’t need to go too far into the history to get a sense of what happened to such trades. 2017 was one such year where momentum in small-caps slowly morphed into consensual crowded trade where fear-of-missing-out went berserk to create a bubble in that space. In crowded trade, momentum builds in a self-feeding fashion to set-off a bubble. This is probably is what we are witnessing in the select set of stocks in the name of flight to quality amid a brutal bear market in the broader space.

The role of business media in pumping up the buzz can never be under estimated. In 2017, one celebrated small cap fund manager (no prizes for guessing) got the disproportional airtime when small-caps were sizzling to scary levels. Of course, he fell into the seductive trap of new found media attention. Now, it is the turn of coffee-can clubs, who come in prime times and glorify investing into gifted names that are quoting at obscene valuations. Their glib talk, of course masks the fact that this is nothing but hiding in safe havens in the name of quality. They are now larger than life heroes for the business media in general and for the investment community in particular. Sun is shining on them now. What will bring down the binge in the so called crowded trade of quality (few handful of names that even the barber in the neighborhood would tell you how they will not lose money for you) is anyone’s guess.

Investors who chase the crowded trade have reasons to smile as they are proved right in the short-term. More so, when the contrarians get crushed month after month. But they fail to understand that the surest way to under-perform in the long-run is to fall into the trap of being seen smart in the short-term. Cycles after cycles show that contrarians have the last laugh, though they will have to survive the onslaught (having the stomach to digest notional losses and having the ability to pick the “quality” stocks from the beaten down space) by not only staying the course, but also by having willingness to look stupid in the short-term. That is not easy for institutional money managers, esp. when they are measured on daily NAVs. They have few options than joining crowded chorus.

Here is the table which explains the degree of insanity in the valuations of those gifted and glorified ones (TTM PE has expanded sharply for these).


Even momentum investors should be worried to touch these stocks at these scary valuations, however tempting it could be to hide. Having said that, it is not that they will stop rising or will correct in a hurry. Sometimes, the party can go on for long, esp. when there is premium for quality in a polarized market. The more they go up from here, riskier they will become and harder the correction that will ensue in this segment. While price correction may not be substantial, extended time correction can’t be ruled out in this space when optimism returns to the broader space.

It may not be out of place to end this note with this quote from Howard Marks.

“When everyone believes something is risky, their
unwillingness to buy usually reduces the price to the point
where it’s not risky. When everyone believes something
embodies no risk, they usually bid it up to the point where it’s
enormously risky.”

Happy Value Investing!!