Small-cap Stocks

In­vest­ing in small-cap stocks is in vogue glob­ally as small-cap stocks are con­sid­ered long-term in­vestors' best friends. Yo­gesh Su­pekar and Tanay Loya hunt for the best small-cap stocks avail­able for in­vest­ment at the cur­rent junc­ture and rec­om­mend stayin

Dalal Street Investment Journal - - COVER STORY -

Sen­sex is up by nearly 14 per cent over the past one year and is trad­ing at 18.6 times its pro­jected earn­ings. Nifty has moved from 20.95 P/E mul­ti­ple to 25.89 over the past three years. With cor­po­rate earn­ings yet to see signs of re­vival, ma­jor­ity of an­a­lysts be­lieve val­u­a­tions are on the higher side. While val­u­a­tion con­cerns and global geopo­lit­i­cal ten­sions are af­fect­ing the mar­ket moods, small-cap stocks con­tinue to im­press in­vestors with their per­for­mance.

Small-cap in­vest­ing is again the talk of the town as the cat­e­gory con­tin­ues to out­per­form its peers on the In­dian bourses. Well, we ob­serve that the trend is global and not re­stricted to In­dia. The small-cap eq­uity as an as­set class has out­shined all the other as­set classes on mul­ti­ple year ba­sis.

Pop­u­lar­ity of mu­tual fund in­vest­ing has a lot to do with the liq­uid­ity in the mar­kets to­day. Lack of in­vest­ment choices are driv­ing many in­vestors to­wards mu­tual funds in In­dia. Bal­anced funds, small-cap funds and mid-cap funds are amongst the most popular cat­e­gories of mu­tual funds with in­vestors in re­cent times.

The re­bal­anc­ing of as­set al­lo­ca­tion of In­dian in­vestors is in progress and mu­tual funds are its big­gest ben­e­fi­cia­ries. With mu­tual funds be­ing one of the big­gest ben­e­fi­cia­ries, small-cap stocks be­come a nat­u­ral ben­e­fi­ciary indirectly as the fund man­agers de­ploy the new funds in high growth small-cap and mid-cap stocks. We can say that re­tail

in­vestors' con­tin­u­ous buy­ing of eq­uity via mu­tual funds has pushed the eq­uity val­u­a­tions higher.

The mil­lion dol­lar ques­tion is: Will the small-cap out­per­for­mance con­tinue in the com­ing years and whether in­vestors should al­lo­cate more of their funds to the cat­e­gory. The an­swer def­i­nitely is not as easy at it may seem, be­cause his­tor­i­cally, we have seen that when mar­kets are in con­sol­i­da­tion phase, the small-caps have a ten­dency to crack more than their large-cap peers. Hav­ing said that, any correction due to the global geopo­lit­i­cal fac­tors or high val­u­a­tions should present in­vestors an op­por­tu­nity to en­ter the mar­kets.

Ow­ing to some ex­tra­or­di­nary per­for­mance by the small-cap cat­e­gory over the last 5 years, re­tail in­vestors are in­creas­ingly show­ing in­ter­est in park­ing their funds in the small-cap stocks.

While there may be lit­tle doubt that small-caps can be more volatile than their large-cap peers, re­tail in­vestors have a pref­er­ence for the cat­e­gory look­ing at the re­turn po­ten­tial. Says Su­raj Agar­wal, who is an HNI and has been in­vest­ing in stock mar­ket for more than 16 years now, “Small-caps, if cho­sen care­fully, give ex­cel­lent re­turns across all mar­ket con­di­tions.”


Even as the fu­ture of a small com­pany may seem un­pre­dictable, they are quick to re­bound faster in the de­vel­op­ing economies as com­pared to the larger com­pa­nies. The growth mo­men­tum of th­ese com­pa­nies do not di­rectly rely upon the macro fac­tors of the econ­omy such as in­ter­est rates, un­like larger com­pa­nies.

The small com­pa­nies typ­i­cally rely on in­vestors rather than bor­row­ing funds to raise cap­i­tal, un­like large com­pa­nies whose vast needs of funds are mostly met with high amount of bor­row­ing. This makes the small-cap com­pa­nies im­mune to any changes in in­ter­est rates, be­sides keep­ing the likely bur­den of sur­mount­ing in­ter­est cost at bay.

Small-cap com­pa­nies (and most growth-ori­ented stocks across all mar­ket caps) typ­i­cally raise most of their cap­i­tal from in­vestors (by sell­ing shares of stock), as op­posed to bor­row­ing money (by is­su­ing bonds) like larger com­pa­nies. There­fore, higher in­ter­est rates have less neg­a­tive im­pact on the abil­ity of small com­pa­nies to grow, be­cause they do not rely heav­ily on loans (bonds) to ex­pand oper­a­tions and fund projects.

Small com­pa­nies are able to take more rapid de­ci­sions about prod­ucts, ser­vices and oper­a­tions with lower in­stances of red-tapism and bu­reau­cratic im­ped­i­ments, un­like large en­ter­prises.

Thus, small-cap stocks make for an in­vest­ment haven, es­pe­cially at a time when the econ­omy is re­cov­er­ing from a slump or a re­ces­sion. In an en­vi­ron­ment con­ducive to growth, the small-cap stocks re­spond more quickly and po­ten­tially grow at a faster pace as com­pared to the large-cap stocks who have much higher stakes.


Stock mar­ket for­tunes are lin­early re­lated

to the eco­nomic growth of the coun­try in the long run. Re­cent eco­nomic data sug­gest there is a vis­i­ble slow­down in the In­dian GDP growth. On the neg­a­tive side, the GDP growth has slowed down and the In­dex of In­dus­trial Pro­duc­tion (IIP) con­tracted 0.1 per cent YOY in June 2017, as against 8 per cent growth in June 2016. In­dia's gross do­mes­tic prod­uct rose 5.7 per cent in April-june from a year

ear­lier, miss­ing the econ­o­mists' es­ti­mates. The gap be­tween the in­dex P/E mul­ti­ple growth and GDP growth is also at mul­ti­ple-year highs.

On the pos­i­tive side, di­rect tax col­lec­tions jumped 19 per cent in the four months of the cur­rent fis­cal, as de­mon­eti­sa­tion of higher de­nom­i­na­tion cur­rency bought in more num­ber of in­di­vid­u­als into the tax net.

Says San­jeev Prasad, Co – Head and Man­ag­ing Di­rec­tor, Ko­tak In­sti­tu­tional Eq­ui­ties , “We be­lieve mar­ket par­tic­i­pants may be ig­nor­ing the struc­tural chal­lenges to In­dia’s GDP growth by overly fo­cus­ing on the cycli­cal fac­tors of de­mon­eti­sa­tion and GST. In our view, weak in­vest­ment de­mand (30% of GDP) is a far big­ger ‘struc­tural’ chal­lenge for the econ­omy. We are not sure how this will change in the short term. We note that con­tin­ued weak in­vest­ment will af­fect con­sump­tion even­tu­ally, high gov­ern­ment ex­pen­di­ture not­with­stand­ing.”

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