Short Call: Fund managers flash amber signal for small caps; Titan, MCX, Bajaj Auto in focus

Fund managers are right in being cautious, history has shown that corrections in small and midcap stocks are quite painful.

― Hendrith Vanlon Smith Jr

If you are wondering how much longer the rally in small and micro cap stocks can go on for, look at cues from fund managers managing small cap and other similar kind of funds. Nippon India Mutual Fund on Thursday said it was restricting lumpsum investments into its small cap fund. Over the last couple of weeks, Tata Small Cap Fund and HDFC Defence Fund too announced similar curbs. These developments highlight two things: a) the craze for small cap funds among retail investors and b) the difficulty fund managers are finding credible investment ideas.

This is a phase of the market when every story appears promising, and the market is ignoring potential risks that could arise from multiple factors—disruption, more competition, sudden fall in demand, change in regulations. Fund managers are right in being cautious, history has shown that corrections in small and midcap stocks are quite painful. Lumpsum investments typically come from investors chasing momentum. When the market corrects, as it will at some point, these investors will be the first to ask for their money back. And that poses a problem for fund managers. By their very definition, small caps are not very liquid, meaning the stocks are not easy to buy and sell in large quantities. When faced with huge redemptions, fund managers will have to sell the best stocks in their portfolio because only those will take finders in a falling market. So it is a double whammy where you sell your good stocks, and are left with the not-so-good ones. This could affect the performance of the portfolio, causing the remaining investors in the fund to have second thoughts, and more redemptions could follow. This trend has been seen in 2001, 2008 and more recently 2018.

And it is not just fund managers who are having a problem. High networth value investors too are in a predicament. That is because most of them, research a stock for a few months before deciding to buy it. In this market, there is a good chance that valuations would have become expensive by the time the investor is done with the research.

Retail investors who never invested in mutual funds before and are now struggling with a feeling of FOMO (fear of missing out) or even FONO for that matter (Frustration Over Neighbour’s Opulence) could do well to remember one thing: Returns of many mutual fund categories over the last ten years look impressive, but to earn those returns, you need to be invested for ten years. In the interim, there will be three or four years where your portfolio returns may be sharply negative, making you regret the decision to invest. Many of the investors who got in around the peak of the 2007-08 bull run jumped out as soon as their portfolios reached break even levels some 6 years later. Likewise, investors who got in during the frenzy of 2017 mid cap bull run were shattered twice--first by the meltdown in 2018 and later when COVID hit in 2020. Many of them took their money and fled when their investments reached break even levels in 2021, unsure whether the rally would sustain. As well-known investors never tire of pointing out: it is not so much about what you buy, as much as it is about the price at which you buy. Jump in if you want to, because long term SIP returns have been rewarding in majority of the case.

For nearly two years, the question was whether Titan’s premium valuations could sustain. Now that the overall market sentiment has turned bullish, Titan too is riding the wave. A robust business update for Q1 is helping, but then the June quarter has traditionally been a strong one because of the wedding season. Investors looking to hop on to the bandwagon should bear two things in mind: either play for momentum or for the long haul, no halfway measures. The stock may not see the kind of volatility associated with mid and small caps, but when the tide turns, a combination of rich valuations and wide ownership by institutional investors can result in a prolonged period of underperformance.

The stock just saw a rerating of its price earning multiple, going by the 7 percent rally on Thursday. The enthusiasm among bulls may seem surprising, considering that a good chunk of the company’s profits for the current year stands to be wiped out because of the extension of the service and license contract with 63 Moons for which it will be paying Rs 250 crore. So what could explain the sudden flare up in the stock price? Most likely it could be a tussle between the bull and bear groups with the bears being forced to cover their positions. Last Friday, there was massive call writing in the 1700 strike even as the stock was hammered below Rs 1500. At that time, it may have looked like easy money for the call writers given the bearish outlook on the stock. Open interest in the 1700 call is quite significant at 381,000 contracts, though it has come off in the last couple of sessions. At this point, the call writers could be staring at huge losses, if the stock continues to rally.

Most analysts are bullish on the stock after the launch of the Triumph Speed 400 and the Triumph Scrambler 400, so we thought of shining light on the less flattering recommendations. Goldman Sachs is neutral on the stock as it awaits more clarity on how well Bajaj can improve its market share, and also at the pace of recovery in the export markets. Likewise, Citi maintains its bearish position on the stock with a sell rating and a price target of Rs 4000 as it feels the recent launches will not move the needle by much for the company, even though it may burnish Bajaj’s image as a premium bike player.