Should you heed to the popular narrative on small-caps?

When going is tough, it is “easy” that gets sold. If the story is simple and eloquent, it becomes easy to sell. This is precisely what the investment advisors do in every cycle. In down-cycles, they can make a good story out of “long-on-large” theme as investors seek refuge in safety. As investors perceive small-caps as risky, it is easy to sell the story of large-caps in stressed times. Investment advisors, in their rush to sell the easy ones, unfortunately they end up painting the entire space with the same brush i.e. sensationalize safety in large-caps and trash the small-caps as toxic ones. How should investors respond to such a narrative? Does the risk come from the size or from the balance sheet quality? The other spin the advisors give in their eagerness to sell the easy ones, is that, the large caps will lead the recovery first while the small-cap space will struggle for longer time. Is that true? How did this play out in past cycles? Let us look at these in little more details as follows.

Reality Check1:

As one veteran banker eloquently put, in this pandemic crisis, there is going to be no winners, only survivors. But those who get to survive, can hope to gain from the huge wave of consolidation (market share gains) that will be triggered by weaker hands getting out. While investment advisors, dictated by the large-cap narrative, may try to project “Size” as key to survival, in reality, it is the quality of balance sheet that will determine who survives and who doesn’t. Quality of balance sheet will become the biggest differentiator in this crisis. It will not be limited to only small-caps. It will be across the spectrum including large caps. Large companies with weak balance sheet (high gearing ratio with unsustainably high debt) are likely to be weeded out as much as the weak ones in the smaller end of the weighing scale. So what one needs to worry is not on how large are the companies in one’s portfolio, but how good they are in terms of quality of balance sheet and quality of cash flows. Even some micro-cap minions who are leaders in their own niche market-space with zero debt and positive free-cash flow business (so many names come to mind) will emerge stronger from this crisis. Strong-will-become-stronger will be the over-arching theme across the spectrum which will include the much maligned small-cap space as well, contrary to the ongoing narrative that puts emphasis on safety of large-caps.

Reality Check2:

The next question that springs up spontaneously from advisors is, if quality is the key differentiator, why not stick to large caps, esp. when they are likely to lead the recovery? Here is where pattern of past cycles can help us understand the nuances of recovery. Both, in 2008 and 2013 down-cycles, while small-caps lagged the large-caps by few weeks (weeks, not months), the quantum of recovery in small-caps was substantially higher than that of large-caps in both these cycles. Looking at the data-points, in 2009, within 3 weeks of large-cap rally, small-caps turned and followed. The surprise is where both ended in Dec’09. Sensex delivered 81% that year while Small-cap index surged by whopping 124%. No one can deny that the trade-off of 3 weeks is a small price to pay for the additional 43% returns. Similarly in 2014, with a few weeks of lag, small-cap index delivered a stunning 106%+ returns while the much touted larger one delivered less than one-third of small-cap index returns (Sensex delivered 30% in 2014).

It doesn’t stop here. Even the 2020 short-term data is not siding with the ardent advisors, however much they try to de-sell small-caps, as can be seen from below chart (Small-cap index up by about 25% against 18% rise in Sensex in this quarter from Ist April to 15th June 2020).

Sensex Vs Smallcap New

Hard-sell: A Better Bargain:

In investment business unlike other businesses, what is difficult to sell makes more money for investors in the longer term. Money works harder in hard-sell products. Easy ones, of course, appeals in the short-term, but hardly a bargain in the longer run. Next time, when investment advisors push you to switch from small-cap schemes to large-cap ones, esp. in a down-cycle, you know what to say. Of course, in small-caps, one has to digest higher volatility. That doesn’t mean higher risk (permanent loss) as long as one stays put thro’ the crisis.

Happy Value Investing!!!

Market View: Push & Pull?

Globally, there are now two camps when it comes to market direction. One camp believes that the pandemic cycle will play out very similar to past down-cycles. As per them, the economic and fundamental news-flow will be so negative in the coming months that the market cannot escape from testing March lows. This camp believes that the current global rally will fizzle out at some point of time. The other camp believes that unlike past cycles, this cycle will play out differently because of Fed’s unlimited back-stop. The reason markets retested lows in the previous cycles is much to do with credit events (blow-out of funds, corporate defaults and bankruptcies etc.) than economic or fundamental news-flow. With Fed ready to even buy non-investment grade junk bonds (unheard of in past cycles), where are the chances of credit events in this cycle? Fair question. Boeing’s ability to raise 25Bn from markets during this unprecedented crisis without any bailout from US Govt. is a case in point. As per the second camp, given the remote chances of credit events, upward bias may continue, thus ruling out the possibility of markets testing March lows.

As always, the reality must be somewhere in between. This means, markets will be pushed and pulled by these two opposing forces without breaking out on either direction until the world comes out of this crisis. In other words, volatility is likely to continue with downward bias, but with remote probability of retesting March lows, though one can’t rule that out given the unprecedented nature of the current crisis (notwithstanding the current rally in the global markets). The story for emerging markets like India, is unlikely to be any different, given their penchant for following the footsteps of US markets. Having said that, EM specific credit events if any (Fed backstop doesn’t come to the rescue in such cases) can still rattle the markets, thus the overall caution for EMs. Investors should use this volatile period to re-balance their portfolios, increase allocations on stronger ideas in a gradual manner so as to benefit from the eventual turn.