The narrative has changed for smallcaps, from being one of the gold mines to the minefield of grenades in a short span of time. How should investors deal with this change in the narrative?
From hidden gems to hidden worms, smallcap investing has come a full circle now. In 2017, if you were not investing in smallcaps, you were missing out.
Now, if you are in smallcaps, you stand scrutinised and slammed. With tide changing from recklessness to risk-averse, it is quite astonishing how smallcaps 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 an opportunity for value investors?
Let us go back to past and examine how such corrections in small and midcaps played out eventually. Well, vicious corrections within a structural bull market are not something new.
Let us take the previous bull cycle of 2004-08. In that period, small cap index corrected by over 10 percent at least 3 times and in two of them, the smallcap index slumped by over 20 percent in 2005 and by over 40 percent in 2006. Of course, for individual stocks, there was no hiding place. Much of the stocks in the smallcap space were slaughtered by over 50 to 60 percent in this period.
Well, not much is different in the current bull cycle which started in late 2013. Savage fall in smallcaps occurred in 2 of the last 3 declines. We saw one in February on fears of hardening interest rates in the US and impact of demonetisation in November 2016.
As can be inferred from the below chart, what is interesting is that the recovery was quick within few months and the bounce was far greater than the bump.
In each of this fall, the narrative turned negative on smallcaps, only to return back with vengeance on a 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 investors into inaction. This is not 1 or 2-year phenomenon. Over a 14-year period, this has happened consistently over and over again without exception, as can be seen in the chart.
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 of 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 the economy getting closer to the pay-off time from structural changes like the Goods & Service Tax, Subsidy reforms through Direct Benefit Transfer, Real Estate Regulatory Authority, and formalisation/ financialisation initiatives through increased tax compliance.
With the long-awaited recovery in investment demand showing signs of revival, growth in the broader economy is coming back with a vengeance giving a fillip to the corporate earning cycle.
It is funny that market with its eyes fixated on global cues is ignoring local positive developments on the ground. It is no surprise.
That’s what bear cycle does. It makes the investors ignore the good news and makes them 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 the economy is likely to take off.
With huge price crack, small and midcaps offer the best opportunity to capitalise on this upswing. High quality small and midcaps with superior margin profile, high return ratios and free cash flow are available at very attractive valuation across sectors (barring, IT) after this correction.
Investors can look at these from the bottom-up and stock-specific basis. Though it is tempting to move away from the small and midcaps because of an ongoing narrative, one needs to take an objective approach taking evidence from past cycles.
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!!Disclaimer: The author is Founder CEO & Fund Manager, TrustLine Holdings Pvt Ltd. The views and investment tips expressed by investment expert on moneycontrol.com are his own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.