Small caps not at euphoric levels; shakeout will cure F&O craze: Deepak Shenoy

The last year has been weird because the earnings per share have dramatically gone up for many small cap companies. That also explains why a lot more people are interested in small cap stocks.

Again, if you look at mid cap and small cap indexes from a 5-year period, the returns are not all that great. The massive run-up over the last three years has skewed the returns. Short answer: yes a bunch of small cap stocks have done well but it is more of a perception that if you were to pick up any small cap stock at random, you would make a lot of money.

Is earnings growth the big reason for investors chasing small caps? That is always the case whenever there is a big rally going on in the small and midcap space, isn’t it?

The one big difference you are seeing right now is that it is not as though companies have grown by taking on a lot of debt. The average debt-to-equity ratio right now is 1:2 (one portion of debt is to two portions of equity). This level was last seen in 2015 when companies were coming out of a downturn. The fact that balance sheets are in a much better position is giving confidence to investors.

But there are other factors as well, and it is true that there is too much money flowing into small cap funds. Over the last couple of years, small and mid cap funds have given good returns. So, when market sentiment is positive and people want to invest, most will check the schemes that have done well in the last 1-2 years and put money into them.

So small cap fund managers are having a problem. Many of them are restricting inflows into their schemes because there are no good ideas to absorb the money flowing into their schemes. A large cap fund can invest up to 10 percent of their portfolio in a single stock if they are convinced about it. They will be able to buy the stock without disrupting the price, and sell it easily as well should the need arise. Not so with small cap stocks, when a fund will struggle to buy or sell large quantities without moving the price sharply on either side.

So there is a sense of euphoria?

I wouldn’t exactly call it euphoria. What we are seeing in India is not restricted to our market alone. The mood is upbeat across the world. In fact, many other global markets have performed better than India this year (in 2023). I would think that euphoria takes some time to build up. Our market is still not much higher than the peak we saw in October 2021. And what is interesting this time is that promoters are sounding more cautious than they should be, given that growth has been quite strong for many of them. But when they come on business channels to talk about their earnings, some of them almost sound bleak.

Why does that surprise you? Maybe they (promoters) are speaking the truth. Perhaps investors are being more bullish than the promoters, who in fact have a better view of the ground situation.

Maybe. But in all these years I have not seen promoters sounding circumspect at a time when their business is doing well and investors are willing to throw money at them.

So why do you think promoters are being cautious then?

Perhaps they are aware that their stock prices have run up quite a bit. They may be fearful that if they overpromise and fail to deliver, the disappointment will be far more severe. So the companies are trying to ensure that investors have reasonable expectations from them.

Many promoters have been selling their stocks…isn’t that a cause for concern?

True, but the stock has been getting absorbed easily. That shows a good appetite for these companies among large investors. Besides, it is not a given that promoter selling is a sign of the stock being overvalued. I have analysed many companies to see if promoter selling had an impact on the performance of the stock, and could not see any significant co-relation.

But it is still one of the key indicators tracked by the market. So how does one look at promoter selling?

One needs to see it in the context of the overall financial performance of the company. This is particularly true for small cap companies. If the company is doing poorly and the promoters are selling stock, then it is clearly a red flag.

What is your style of investing?

We are pure growth investors. We like to invest in companies that are growing at a fast pace. And there are plenty of opportunities right now. The level of corporate activity, especially in the M&A space, is something that has not been seen in a long time. We try not to be anchored to (stock) prices. For instance, if a stock has doubled because the earnings outlook has improved, then you should be willing to buy at a higher price instead of waiting for the price to go back to where it had started from. If the earnings visibility is good, then the PE ratio will be high. We spread our bets across 40-50 companies, knowing that some of them will turn out to be duds. At the same time, some of them will go on to become massive winners.

What do you think of the huge retail interest in the futures and options (F&O) space, especially among young investors? The regulator has voiced concerns that most investors lose money, as can be seen from brokers being mandated to disclose risks associated while trading in derivatives prominently on their websites. There were reports that SEBI was considering a proposal to link eligibility for trading in F&O with the net worth of the individual, which has now been denied by the regulator.

Any proposal, if at all, to link eligibility with net worth would have been a dumb idea. That’s because many clients can fake their networth proof and it would be difficult for brokers to figure out the true picture. In the US the Securities and Exchange Commission has given brokers the option of checking the credentials of retail clients who want to trade in derivatives. So brokers there tell retail clients that if they have passed a certain securities market test or can show proof of their track record, then the regular margin rules would be applicable to them. If not, there would be limits on how much positions they could take, or in other words, they would need to pay higher margins for the same position.

Do you think the Indian market should try a similar approach?

Why not? Make it mandatory for aspiring F&O traders to clear the NCFM test. That is easier for brokers to check. You can’t stop people from wanting to speculate on something they don’t understand. But you can make it harder for them or force them to make some efforts so that they know what they are getting into. But there are other aspects as well to the whole debate around derivatives trading. For instance, at what point do you put in regulations to stop people from losing money? Despite the risk involved, people still trade in penny stocks.

Also, stock exchanges now have options contracts for almost every day of the week. On one hand, you have the regulator approving these contracts, and then on the other hand, saying it is concerned about retail investors losing money in derivatives trading. That’s contradictory. It is like creating a cricket ground and then putting up a board saying playing cricket is dangerous.

And whom are you trying to protect? The option buyers or the option sellers? It is a fact that both option buyers and sellers lose money from time to time. If only one party keeps winning all the time, it means the market is being manipulated. And you can’t protect one party without that having implications for the entire derivatives segment. If you try to protect (option) buyers by making it difficult for them to trade, then the sellers for those contracts would vanish. The converse is true as well.

So how do you see the situation getting resolved?

It will get resolved, not through regulations but through a market shakeout like it always has happened in the past. Whenever that happens, a lot of players who never should have been trading derivatives in the first place will be forced out of the market for good.

How do you foresee that happening? Especially since margin rules are quite strict, and so automatically limit the maximum amount a client can lose.

Margins and stop losses are effective in a market that behaves normally and within a range. So far what we have been seeing is a normal market. We have not seen an extreme move. When that happens, margins and stop losses can be ineffective. Today a lot of traders sell an option and buy an opposite option, which helps them reduce their margin obligation because then your loss is pre-defined. In theory, what you lose on one contract will be offset by the gains on the other contract. But if the market moves sharply in one direction, it may be difficult to get out of one of the legs as easily as you expect to. You may have thought that your loss will be limited but that is contingent on being able to exit at a certain price. If the price overshoots that level on either side, the losses will be much more severe. We saw that during the Volmaggedon crisis in the US markets when volatility surged to unheard-of levels.