What should you do with your mid and small-cap holdings amid heightened volatility? Experts weigh in

What to do with your smallcap holdings

Relentless selling across the broader market has left many investors reeling, sparking concerns about the sustainability of the spectacular gains witnessed over the past year. The small-cap segment, in particular, bore the brunt of the selloff, shedding nearly 13 percent from its peak in just over a month. Investors are now grappling with the question of whether this is merely a correction or the precursor to a more significant and sinister downturn, especially in light of the cautionary words from Securities and Exchange Board of India (SEBI) chief Madhabi Puri Buch.

On March 13, a staggering Rs 14 lakh crore in market capitalisation was wiped out from the broader market. With portfolios deep in the red, investors found themselves at a crossroads, torn between holding on or cutting their losses and exiting. With the SEBI chairperson warning of froth and a "bubble" in the mid- and small-cap segments, investors were at their wits’ end. While stress test results from mutual funds like Quant and Edelweiss may have allayed some fears, the pressing question remains—after an extraordinary rally over the past year, are small-caps vulnerable to a deeper selloff? And is it time to rotate out of mid- and small-caps into large-cap stocks?

Think long-term, be vigilant

Market expert Ajay Bagga views the recent selloff as a healthy correction rather than a sign of a looming bubble. He advises investors to maintain a long-term perspective while remaining vigilant about market fluctuations. “First, not more than 20 percent of your portfolio should be in mid-caps and not more than 10 percent of your portfolio should be in small-caps. These give higher returns over time but are also hugely volatile, have more failures of businesses and are subject to greater drawdowns than large-caps which can weather challenges for far longer and with lesser impact,” he explained.

Also Read: Mutual funds cut stakes in frothy PSUs as large undervaluation vanishes

“Don’t be in a hurry to buy in times of volatility,” cautioned Dipan Mehta, director, Elixir Equities. “For now, the correction is just a blip, not to say that it can’t deepen. So don’t draw up a buy list when the view is negative, wait for things to unfold before jumping in. Quality of business and management are the two most important criteria for investments in the mid- and  small-cap space. Consider these factors before investing.”

In times of uncertainty and elevated market volatility, the importance of risk management, portfolio diversification and a focus on higher-quality investments cannot be undermined. Therefore, investing in mutual funds is the best bet. “The fund managers choose 40-60 small- or mid-cap stocks for you, giving diversification, active stock picking, liquidity at a small charge of under 1 percent,” pointed out Bagga.

Time to be selective? 

Hemang Jani advocated for a meticulous evaluation of stocks, considering factors such as the extent of correction from peak levels, company performance and valuation comfort. “One of the most simple things one can do is to really make a list of 30-40 stocks. See how much they have corrected from the top, which companies have done better in terms of earnings and whether there is a valuation comfort. Some like APL Apollo, Lemon Tree, healthcare names like Max Health are just some of the companies which have corrected substantially from their 52-week highs. Their quarterly performance was also slightly better,” said the independent market expert. However, he stressed on the importance of thorough research and due diligence in identifying promising investment prospects.

Bagga echoed the sentiment, “If you want to pick mid- and small-caps on your own, look for companies that have strong growth in revenues and cash flows over the last three years, generate high RoE (return on equity), enjoy strong margins in the business, have low debt levels, don’t have continuous capital requirements to generate future cash flows and the most difficult to assess, superior management that is fair to minority shareholders. Avoid promoters who have not been fair in the past , they will not change,” he said. Bagga lists consumption, financialisation and premiumisation as the  mega decadal trends in India that will outperform, irrespective of short-term market fluctuations.

Also Read: MF Stress Test: Why it matters and should investors be worried?

Pockets of exuberance

Some stocks of public sector undertakings (PSUs) have come down substantially from their peaks. After the crazy rally and subsequent correction, must one continue to be overweight? Jani advised against overexposure, urging investors to differentiate between sectors with genuine earnings-driven re-rating potential and those driven merely by narrative. “While certain PSUs like GAIL and IOC (Indian Oil Corporation) present favourable earnings trajectories and valuation comfort, others, particularly in the railways sector, may not justify their current valuations based solely on narratives,” said Jani.

Bagga too warned against excessive exposure to smaller public sector banks. “If you consider a 15-year, 12-year or even a 10-year perspective, these are value destroyers. It's only in the last two years that the cleanup process has finally caught up with them. Subsequently, over the past one and a half years, we've witnessed some positive performance," he underlined. According to Bagga, the PSU story has been overdone, overhyped and oversold. He suggested treading with caution, especially in stocks where institutional investors are making an exit. “If you have a choice between a PSU and a private player in the same sector (the valuation of the private player is typically higher due to their inherent flexibility and operational excellence), opting for the private player will be more rewarding," he said,

Also Read: 7 stocks to bet on as investors turn to large-caps for safe haven from headwinds 

Pockets to sell

Mehta believes one should avoid small-cap stocks where the price-earnings ratios have surpassed the valuations of even some of the large-cap names like Bajaj Finance and HDFC Bank. “These are the ones that should be on your sell list. Railways, defence stocks and even industrials and consumption are some pockets that are expensive,” said Mehta. In a nutshell, stocks with a PE of 50 or higher should be on your sell list.

Disclaimer: The views and investment tips expressed by investment experts on Moneycontrol.com are their own and not those of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.