With all the segments of stocks heading northwards these days, the broader market comprising mid and small cap stocks has seen a much swifter run-up in prices compared to their large cap peers.

Small-Cap Stock Picking

Several professional investors generate large wealth by unearthing small and mid-cap stock ideas. In a company’s journey to becoming a large corporation, the investors’ wealth is created. This journey through the value cycle is challenging to say the least. To maximise the odds of discovering such future large caps, an investor must zero in not only a strong business model and management capability but also on the benefits that can accrue from sectoral tailwinds.

The Tailwinds

In the recent past, massive wealth creation has happened for investors in sectors such as chemicals which have been the beneficiary of the China+1 strategy being followed by several countries or companies globally. India’s competitive skills in this arena have led to large scale “value migration” from China to India, causing a number of stocks to give multi bagger returns for their investors. One such name is Deepak Nitrite. Realisation of DASDA (Di-amino Stilbene Disulphate Acid), one of its key intermediary products, trebled in 2019-20 due to the supply chain disruption in China, resulting in significant profitability. In addition, putting up capacities of Acetone and Phenol, both import replacement products aided the top and bottom-line growth. The stock has been a 9 bagger in just the last 3 years.

PE Transition

Another aspect of the stocks that successfully transition from small cap to large cap is a change in their valuation or P/E re-rating along the way. As the client pool of the investors in these stocks shifts from retail to HNI and then domestic institutional investors (DII) and lastly foreign institutions, the return, and growth expectation of each category of investor’s edge downwards. An HNI would settle for nothing less than 20-25 per cent returns given his opportunity as well as capital costs. The DII may be happy with 15-18 per cent while the FIIs who are comparing global opportunities and dirt cheap global interest rates may well be happy with 10 per cent returns. This leads to the buyer being willing to pay higher prices and hence higher PE multiples, pushing the stock valuations up. Astral, a pipe and adhesive manufacturer from Gujarat is one such brilliant name that transitioned from a small cap to a large cap in recent years, multiplying investors’ wealth by 400 times along the way. Its PE went from a 10X earnings at the beginning of the decade to 100X trailing earnings currently. During the same period, FII holding moved up from a measly 1 per cent to 23 per cent.

Stomach for Holding Smaller Companies

Smaller companies tend to be significantly affected by head/tailwinds in the broader economy. A look at the historical picture shows that during the 2008 global financial crisis, Sensex lost over half its value while small cap indices lost as much as 75 per cent of their market cap. When the recovery came, Sensex regained its previous peak by 2015 while small caps took a full three years longer. Such instances of smaller companies losing a chunk of their market cap are numerous as events and the economic impact on the smaller balance sheet and business models more profoundly. The slowdown in sales and earnings leads to a collapse in the PE multiple, creating a double whammy of both the earnings and valuation contraction. What complicates the situation even for seasoned investors is the perceived change in fundamentals of the company or the sector. Investors unable to stomach such loss of capital are forced to dump stocks at throwaway prices.

Thoughts on Rich Valuations

The prevailing scenario of exuberance in the market has led to a situation where many stocks have given healthy returns and appear to be richly valued. From an investor’s perspective, this then begs the question: “How long will the bull run last?” Predicting the exact extent and timing of this run would require nothing short of a crystal ball, and it would be naïve for an investor to act based on such speculation. But a closer look at the facts explains the fundamentals driving these stocks beyond the healthy liquidity flows.

To get a complete picture of what’s propelling these stocks, it is imperative to understand the transformation that the Indian economy underwent. Over the last decade, India has witnessed a period of sluggish growth, owing to both global economic conditions as well as major structural reforms undertaken within the country. Global trade had been growing at a snail’s pace for the majority of the last decade, landing a heavy blow to India’s exports growth. India’s trade to GDP ratio, which peaked at 56 per cent in 2011, has been on a consistent decline since, falling as low as 36 per cent in 2020. Domestically, the implementation of major reforms such as GST and demonetisation led to economic shocks that were exacerbated by an NBFC crisis following the collapse of IL&FS in 2019.

A close look at the economy today indicates that we are now coming out of this period of structural slowdown. The Central Bank’s focus is firmly shifting from inflation to growth and significant foreign inflows are all lending a helping hand. Additionally, multiple governmental initiatives on PLI schemes, $1.5 trillion infrastructure pipeline and resurgence in household capital expenditure numbers are visible in real estate demand. For the first time in many years, we have seen a pickup in private sector capex to the tune of Rs 5.15 lakh crore (trillion) in the last fiscal. All these factors are adding economic muscle to the current bull run.

While news headlines and TV channel commentary stays focused on new highs for Nifty, what often gets missed is the earnings growth- which has come in at close to 18 per cent for 2020-21, after almost a decade of low single digit growth numbers. What is more interesting is the likely growth of Nifty between 2020-21 to 2023-24 at almost 22 per cent CAGR. The broader basket of NSE-500 is likely to do even better at ~32 per cent CAGR during the same period. This indicates why the indices are showing considerable strength.

Another way to measure irrational exuberance in the broader markets is to look at the proportion of the mid/small cap stocks market cap to the total listed market cap. Historically, this ratio has been in the range of 22-37 per cent. At the current level of 33 per cent, though valuations are above their mean, they are not exorbitant about their historical comparison.

Strategy for Small Investors

Any bull run cannot last forever, and in the case of smaller companies, even temporary economic setbacks can lead to greater market turbulence. The question thus becomes – “What should investors in small companies do?”. Regardless of the elbow room in valuations, market corrections would happen to manifest themselves in sharper falls in smaller companies. Therefore, prudence ought to be exercised and some degree of profits should be taken off the table if investors have made healthy returns. Some of the sectors like chemicals, consumer durables, hospitals, and diagnostics are all trading at lofty valuations. Investors who have not participated in the rally so far and do not know when to begin should follow either a buy on dips approach or staggered buying using SIP methodology, which should protect against the impact of volatility.

Those who can combine astute stock picking and strong mental fortitude with a cautious eye on signs of the rally peaking – such as structural economic downtrends, and a global slowdown of liquidity, will ultimately be in the best position to not only make money but also retain it.

The author is Head – Research, Edelweiss Wealth Management