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!!