Smallcaps : goldmine or landmine?

Narrative has changed for small-caps, from one of gold mines to minefield of grenades in a short span of time. How should investors deal with this change in narrative?

From hidden gems to hidden worms, small cap investing has come a full circle now. In 2017, if you were not investing in small caps, you were missing out. Now if you are in small caps, you stand scrutinized and slammed. With tide changing from recklessness to risk-averse, it is quite astonishing how small caps have slipped from sacred to untouchables in a span of just six months.

Is it something unusual that investors should worry about? Or, is it rather a reoccurring theme that throws up opportunity for value investors? Let us go back to past such corrections in small & midcaps and examine how they played out eventually. Vicious corrections within a structural bull market is not something new. Let us take the previous bull cycle of 2004-08. In that period, small cap index corrected by over 10% at least 3 times and in two of them, the small cap index slumped by over 20%+ in 2005 and by over 40%+ in 2006. Of course, for individual stocks, there was no hiding place. Much of the stocks in the small cap space were slaughtered by over 50 to 60%+ in this period. Not much different in the current bull cycle which started late 2013. Savage fall in small caps occurred in two of the three declines we saw in this cycle i.e one in Feb 2016 on fear of hardening interest rates in US and in Nov’16 on DeMon impact.

As can be inferred from the below chart, what is interesting is that the recovery was quick within few months and more importantly, the bounce was far greater than the bump. In each of these fall, predictably, the narrative turned negative on small caps, only to return back with vengeance on subsequent bounce. It is important to understand that the price-action dictates narrative, not the other way around. Seasoned investors know what to follow and focus on. What is to be followed and focused is the cycles (price action), not the narrative. Unfortunately, noise that comes from amplified narrative numbs the investors into inaction.  This is not one or two year phenomenon. Over a 14 year period, this has happened consistently over and over again without exception, as can be seen in the chart. Yet, most investors do panic and fall into the narrative trap instead of taking actions based on cycles.  Few who learn from history make the most from these reoccurring cycles.

BizNotes_July18

There is a reason why every fall has been followed by a quick and sharper bounce. It comes from India’s strong structural growth story. If anything, this story has only become stronger this year with economy getting closer to the pay-off time from structural changes like GST, Subsidy reforms  thro’ DBT, RERA (real estate reform), Formalization/Financialisation initiatives thro’ increased tax compliance  etc. With long waited recovery in investment demand showing signs of revival, growth in broader economy is coming back with vengeance giving fillip to corporate earning cycle. It is funny that market with its eyes fixated on global cues, is ignoring the local positive developments on the ground. It is no surprise.That’s what bear cycle does. It makes the investors to ignore the good news and makes them to focus on the amplified negatives.

It is interesting that opportunities always come knocking just before the dawn. This is one such time where a sharp correction in small and midcaps couldn’t have come at a more prescient time, just when economy is likely to take off. With huge price crack, small and midcaps offer the best opportunity to capitalize on this upswing. Though it is tempting to move away from the small and midcaps because of ongoing narrative, one needs to take an objective approach taking evidence from past cycles. Having said that, unlike 2017 which was a one-way reckless rally, 2018 will be more a year of consolidation with heightened volatility. Given this, investors need to pursue a bottom-up stock-picking strategy, that too in a phased (nibbling) manner to get the best out of the crack in small and midcaps.

Happy Value Investing!!

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