Dollar story of small-cap index!

Is the savage correction in small-cap index scripted by domestic setbacks or by scarcity of dollars?

When the going is good, small cap space does wonder. It is the most seductive space with spicy returns, in such times. It turns sleazy when sentiments sour. Overall, it is not an easy space to be in, as one will see gut-wrenching volatility now and then. But they pay rich long-term rewards, if one has the right temperament to stay put, of course on the right stocks. Times like this, when they nosedive and undershoot, no dearth of experts to write obituary with some even calling not to touch this space till elections cycle gets over.  This in our view, is a misguided one and is based on misunderstanding about the ongoing correction.

Is there a way to put this correction in a context that can cut out the noise and give us a unique perspective that can help investors to make an informed decision? Here is an interesting chart that can help in this objective. This chart is a simple plotting of small cap index for last 15 years along-with the level of dollar index at critical points.


From this chart, one can decipher two distinct patterns…

  • Every time when the dollar index rallied, there was a big crash in small cap index, be it 2008, 2011, 2013 or now 2018. All big fall in small cap index has been accompanied by spike in dollar index.
  • More importantly, every time when small-cap index fell by a certain level, the subsequent bounce in the next immediate year has been stronger (by 1.5 times) irrespective of the narrative at that point in time. This is not a one year wonder, but a consistent repeating theme year after year for 15 years, without any exception. Going by this, given the fall of small cap index by over 25% this year, it is no brainer that the index will bounce by at-least 40%+ in the coming year.

Why then people are not jumping in to invest?

When this question is put across to investors, the response is weird. Investors give more weightage to the impending election cycle than to the data thrown by the chart. This clearly misses the point.

To put this correction in perspective, it is not anything India specific. It has nothing to do with domestic issues, though some domestic challenges like ILFS have aggravated the crack.  It is more to do the cycle of dollar strengthening and Fed tightening. As in the past, every time when dollar index made a strong rally, emerging markets like Asia (ex-Japan), Brazil, Russia etc. take a huge knock in their stocks, currencies and in their yields when money moves out of emerging markets. India is no exception to this. This is because of huge unwinding of EM carry trade on dollar strengthening. This explains why there is such a strong negative correlation in the chart between the small cap index and dollar index.

As happened in the past cycles, this is not a one-way traffic. EM carry trade does resume after a while. One can’t predict when this turns, but going by earlier cycles, it is reasonable to assume that it can’t take longer than 10 to 12 months, as even in the worst financial crisis of 2008, it didn’t take more than 14 months. When the trade resumes, money starts coming into EMs. That time again, it is not going to be India specific. When FIIs come back, they are going to allocate across EMs as a basket, based on some benchmarks like MSCI etc. India is unlikely to get left out just because of election risks. What will trigger the resumption of carry trade is a million dollar question. We don’t know.  It could be simply because of overselling or EM equities becoming more attractive in valuation because of beaten down currencies etc.

There are two critical observations here …

  • When carry trade resumes, markets may see a strong bounce irrespective of election risks as happened in the past cycles, and
  • Election risks unlikely to play a major role except for increased volatility closer to the election. The best way to deal with such risks, is to be stock specific and bottom up and keep buying whenever one gets the target price.

Already one can see the early signs. FII flows have turned net positive in the month of November after very long time. Ten year yield has come off from the high of 8.15% to 7.75 odd.  Rupee has come off from the low of 74 and the next in line could be dollar index. When it cracks, it will be EM times again. Watch out for interesting times.

Happy Value Investing!!


Should one invest in the fall or wait for the prices to stabilize? There are no easy answers.

These are interesting times. When it comes to investing, incentive for action seems to have got inverted these days. There is hardly any incentive for quick actions. Go getter attitude may take one places in the corporate world, but in investing, in the current market backdrop, aggressive action puts one in poor light. On the other hand, procrastination has become a virtue that pays handsomely. It may look confusing, but that is a reality now with the market punishing anyone who rushes to buy (go getters) and rewarding anyone who sits on it and waits, by proving them right with persistent fall in stock prices. But, getting proved right in the short-term could be worst trap they could be falling into as they would lose an opportunity to get proved right in the long-term.

There is this typical dilemma the investors go through now. Should one invest in the fall or wait for the prices to stabilize? There are no easy answers. To understand this more, let us take a scenario in which we have a stock  that has the potential to give you 2X returns in one to two years, but could go down by 10 or 20% in the immediate short-term. But the catch in this scenario is, if one decides to wait to time the bottom (to catch the last 10 to 20% fall), one could miss the entire upside. This catch is real because of presence of following factors:

  • Many false starts (bounces) before the final rally.
  • Final turn could be sudden and swift that investors could misread that as a false bounce and wait eternally for the low prices.
  • In the final turn, prices could quickly move up by 30 to 40% in just few trading sessions (as happened in the past cycles)
  • Prices are best when pessimism is maximum.

From the above, it should be reasonably clear that, for value investing to work, there is no choice but to invest into the fall, however difficult emotionally it could be. But the pain could be made more palatable by pursuing stock-specific bottom-up investing, that too only in high conviction ideas where one would not hesitate to invest more if the prices were to fall sharply from the already low prices. If the down-turn turns deep and one runs out of cash, one could shift from relatively defensive to deep value and thereby continue investing all through the fall. This is time for turning aggressive on deployment, not defensive, though the high decibel media narrative manically mocks aggression. The reason why media does this is not anything obscure. It is fairly straight that they need to appear right in the short-term and hence toeing the line that is trendy than risking their reputation by swimming against the stream.

More importantly, investors need to be also aware of another trap, that is, to get lost in the innumerable problems that always surface in the down-cycles. To think about it, it is an interesting question to ask, why in an upcycle, one never gets to hear any problem? Is it a mere coincidence that India’s inherent structural issues like weak current account and high inflationary pressures (hence high interest rates) pop up only in a bear-cycle? Change in stock prices can do strange things.

Price action in stocks can magically change market’s view on problems. In frenzied times, market is more magnanimous to see the brighter side of the problems while in depressed times, it takes a myopic view to magnify any troubles. It is price action (cycles) that drives the narrative, not the other way. This understanding is key to take appropriate action during cycles without getting lost in the accompanying magnified narrative.

Moreover, current down-cycle has nothing to do with India specific, but has all to do with reversal of EM carry trade (money moving out of emerging markets). At some point (not too far), as in the earlier cycles, this trade will resume and lift all EM boats including India. During that time, now forgotten India’s long-term structural story will come back to dominate the narrative once again. If one waits for those robins, spring (attractive prices) will of course be over!! Investing is at its best when narrative goes negative. “Time to invest is when drums are beating, not when trumpets are blaring.” Follow the cycles (mis-pricing), not the narrative for the superior results in investing.

Happy Value Investing!!

Not a selective slump this time!!

Last few trading sessions have been brutal for the markets, esp. for small and midcaps. Meltdown could be an understatement. If anyone thought it was a perfect storm for small and midcaps in July/early Aug when confluence of negative factors like mutual fund rationalization, ASM, PMS selling, EM outflows, Rupee fall etc. came together, sadly they didn’t know that worse was coming in Sep/Oct.

Rewinding back to July, market, in a similar scare, punished lot of stocks in the broader space leaving few places for hiding for investors. Back then, large caps were spared and the damage was limited to small and midcap space. But in the current one, markets participants couldn’t hope for such a selective slump. Damage has been inflicted across the board barring IT and Pharma. Even high quality financials where people could hide in the earlier fall weren’t left out. NBFCs, the erstwhile haloed sector, took the worst hit.

As if the heart-burns from crude and rupee were not enough, ILFS debacle descended from nowhere to conspire a deadly blow to the markets. RBI’s no to extension to Yes bank CMD couldn’t have been more ill-timed. When credit markets at the short-end froze on some mutual funds attempt to desperately clear short-term papers (CPs) to meet the redemption pressure in their liquid funds (on fears of their  exposure to ill-fated ILFS), hell broke loose and set off a vicious slide in stocks across the board.

Credit markets may look sophisticated. But, at the end of the day, it’s most vital component is also most ephemeral i.e. trust and confidence. When trust erodes, system freezes up. When such things happen, a simple liquidity issues can lead to solvency issues. Fears of such outrageous outcome (driven partly by rumors by vested interests of course) took a ferocious proportion to inflict a serious dent to confidence in the equity markets. Traders with big losses in stock futures and options had to resort to indiscriminate selling in the broader cash markets (even quality names in and beyond small and midcaps) to cover the margin calls.  This led to panic in the small and midcaps with stocks crashing by 30 to 40% in few trading sessions. Normally, such indiscriminate selling happens during last leg in so called “capitulation” phase, post which market usually finds bottom. If what happened this week is not capitulation, one would dread to think what will it be? Assuming this is capitulation, with weaker hands completely out, one can now sigh a relief that we are closer to the bottom, if not bottom itself.

So much has changed in one year. Last year, every small cap was sensationalized as hidden gem irrespective of the underlying quality. In stark reversal now, every small cap is indiscriminately avoided as a hidden worm. Seasoned investors know that this is precisely when the opportunities arise multifold. No better time for selective stock picking and accumulation esp. in the small and midcaps.

Market has moved from “Buy-on-dips”(March Quarter) to “sell-on-rallies”(June Quarter) and then further to “sell-on-dips” now, This is usually the time market capitulates and forms the bottom, going by the wisdom of earlier cycles. Also this phase usually turns out to be a fat-pitch for turning aggressive on deployment/investment.

Happy Value Investing!!

Big gets Bigger?

Small was sleek and smart all through 2017. Now it has turned sleazy and sick with no one wanting to touch even with a barge pole. But for large and big, life has turned a full circle. Not a week has gone by in the last few months without someone (from large-caps of course) hitting headlines for scaling new highs in the market-cap race. First, it was Reliance (RIL) to hit the Rs 8 lakh crore mark. But, TCS which was not too far behind, quickly caught up to make it a dead-heat fight. The race for number 1 is still on, as we write this..

It is well documented that the current market rally has been too narrow. Headline indices hitting life-time highs have hardly brought cheers to investors, as portfolios continue to bleed on broader market’s under-performance. One estimate suggests, that more than 60% of the 15% rise in NIFTY in this calendar year has been on account of just five stocks namely TCS, RIL, HDFC twins and Infy. Small cap index is down by over 10% in the same period. Story can’t be more skewed than this. Of course, this madness may continue, till the excesses of last year get flushed out in small and midcaps by continued selling by HNIs and PMS houses (not to exclude the PMS cloned portfolios) on every small rallies.

But the larger point is, what is happening in large caps is more cyclical than any fundamental or structural shift. Large cap binge will have its shelf-life too and soon should see an end. Seasoned investors know this cyclicality too well. It is counter-cyclicality that creates long-term value, not joining the current flavor of the season, as much of returns come from price one pays. It is not time to chase large cap, but time for selective stock picking in high quality small caps which have corrected because of binge in blue chips. It is time to create RICH portfolios from SMALL gems!!

Indian Markets: Is it all about carry trade?

It is fascinating to fathom that the set of stories that surface in every cycle in India is strikingly similar. In the upcycle, it is all about the structural India story in terms of growth potential, demographic dividend, financialization and formalization (un-organized to organized) etc. In the down-cycle, risks like twin-deficits (current and fiscal), falling currency and rising inflation etc. return to dominate the narrative. It is about shining macro in the upcycle and all about daunting macro risks in the down-cycle. It is not that this pattern has popped up only in this particular cycle. In every cycle in the past, without exception, one would find this striking script shaping the story.

What do investors infer from this? It is the simple fact that India macro is neither daunting (as feared in down-cycle), nor shining as scripted in the upcycle. Understanding what causes the underlying cycles that steer up the stories is far more stimulating for investors. These cycles, esp. in emerging markets, are caused more by the carry trade flows than anything else. These carry trade flows that triggers the big up-move or a sharp fall when they reverse, are dictated more by direction of Fed rates than any country specific chronicles. But what happens on the ground is grossly different. When the carry trade flows change the direction, narrative on the ground changes to suit the local script, thus amplifying the trend.

What we are currently going through’ is one such amplified trend of downturn in the broader markets (though indices are at all time high because of skewed surge in few stocks).  Though what has triggered this fall is a simple cyclical issue of EM (Emerging Market) carry trade reversal, the deficit and currency issues that normally accompany such reversal have come back to make the macro look murky and thus aggravating the fall. Local challenges like political uncertainties, SEBI’s surveillance adventures and untimely mutual fund scheme rationalization etc. couldn’t have come at a worse time to make this otherwise cyclical fall into deeper downturn. What is more important to understand is, this fall has nothing to with India-specific issues and is more triggered by carry trade reversal. All negatives (which are always present) come to the surface as normally happens in any down-cycle. More interestingly, when the carry trade flows come back, it will be time for positives to come to the surface to script the sensuous bounce. Early signs of such a reversal are already visible if one goes by the slow and gradual improvement in FII flows in this month i.e. about $250mn net inflows into equities so far in July. Investors who don’t get lost in the narrative (like murky macro, political risks etc.), but focuses on the underlying cycles, will more likely to use the current fall as a great opportunity for stock picking and portfolio construction for long-term rewards.

Happy Value Investing!!


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.


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!!

May stands for Mayhem?

Rewind back to May’2013. One would find a striking similarity to what we witness now – ferocious fall in small and midcaps triggered by vicious fall in currency, sharp rise in ten year yield, incessant FII selling, rising fears on twin deficits (current account deficit and fiscal deficit). Underlying cause for the mayhem in both May(s) can’t be more similar. Back then, it was taper tantrum i.e. the term used for unwinding of bond buying program from Fed (withdrawal from quantitative easing). Fast forward to now, it is the expected acceleration in Fed rate hikes coupled with some unexpected jitters from crude that have caused the slump in small and midcaps.

But the interesting aspect of 2013 was, within few months, that is, well into taper tantrum, markets recovered with Rupee recouping much of its losses on return of FII buying. It was not so much of “taper” (unwinding) that caused the trouble, but the sheer prospect of such “taper” coming did more damage. In hindsight, going by the sharp rebound in the markets in six to eight months, taper tantrum was a terrific opportunity for anyone who cared to ignore the macro noise and focused on stock picking and portfolio building. Needless to say, current Fed induced fear, is a fantastic opportunity for seasoned stock pickers who have the wisdom not to time the bottom and have the stomach & nerve to digest the notional mark-to-market losses in the interim.

“It is time to invest, not to time the bottom. When it is raining gold (in the context of small and midcaps), it is time to reach for the buckets”

But unfortunately, few learn from history. Even those few who learn, most take comfort in the breathless commentary in business channels that focuses on the short-term gyrations than to switch-off from those endless chatter and take the most important action, that is, portfolio building on the ground. Those exceptional few who brave the volatility to build portfolio, needless to say, will reap rich dividends not too far in the future.

Happy Value Investing!!