TrailBlazing Small Caps!

June 16, 2021 | Industry Insights

Small caps have been on fire recently. They have been such great out-performers and have been the talk of the town within the Indian Financial markets. People just can't stop talking about them. With a long period of muted performance, the smallcap stocks have now performed exceptionally well in the last one year. To make more sense of this phenomena, Smallcase and Niveshaay sat down to have a talk on the Trailblazing Performance of smallcap stocks.

1. Small caps have been on the rise and they've been skyrocketing! What could be the reason for smallcaps to rise at a time like this?

2020 was an eventful year for equities. The markets were at all-time high in Feb, 2020 and then entered bear territory in no time and hit the low in March-2020. It did make a comeback very quickly. Amidst these, mid-and small cap companies emerged as market favourites in 2020. The primary reasons were:

i. Performance Attribution

Sector Representation: Constituents in the indices play an important role in determining performance

The NIFTY 50 gives a weightage of 37.82% to financial services which is quite high as compared to 14.58% in NIFTY SMLCAP 250.

The weightage of the Chemical and Pharmaceuticals sector is around 14% in the NIFTY SMLCAP 250 as compared to 3% in NIFTY 50.

If we analyse the past year’s performance, one can infer the out-performance of the Chemical and Pharmaceutical Sectors vis-à-vis the Financial Sector. This precisely explains why small caps have been on the rise during the last year.

Now, if we dig one step further and analyse the top constituents of the NIFTY SMLCAP 250, we can deduce that the high growth technology platform companies like IEX, CDSL and Tanla Platforms Ltd. have also performed well in the past year. This also explains the rise in small-cap indices.

Top constituents by weightage in Nifty Smallcap 100 -

ii. A Historical Perspective- It’s interesting but things change beyond our expectations at times

Cyclicity is the fundamental nature of equity markets: Small and Mid-cap had a tough ride before

If we look at the charts of small and midcap companies, they were all beaten down from their peaks of 2018. This paved the way for good upside potential.

Similar scenario was observed from April 2012-2014 when the small and mid-cap indices under-performed the large cap index. This was followed by a good rally from May-2014 to Jan-2018 in small and mid-cap generating 33% CAGR returns.

iii. Multi-fold increase in market participants

Active retail and HNI participation also explains the rally in small and mid-caps. The number of demat accounts at CDSL stood at 2 crores in Jan-2020. The number grew to 3.34 crores in March-2021.  Around 98.4% of the total new accounts opened comes from retail investors.

This resulted in inflow of liquidity into smaller stocks. In a rising market, small-cap tends to grow faster than large cap which is generally preferred by institutional investors.

2. Small caps have been giving some exceptional returns after a period of muted performance. What could be the reason for this?

Liquidity, low interest rate and currency stability in the past year explains a good rally in small and mid-cap index after a muted performance.

Small sized companies rely on external capital for their growth as compared to large companies. Higher interest rates means higher cost of capital. This results in growth becoming more expensive.  If the interest rate is lower, that means the denominator while estimating the valuation is lower resulting in higher estimated valuations for small companies.

Also, low interest rates create liquidity. This resulted in more money coming into equity markets.

Small and Mid-Cap trading at attractive valuations

The small and mid-cap indices are far more volatile than large cap. During the March lows, many good quality small cap companies were trading at attractive valuations. Ample liquidity in the market combined with government's effort to revive the economy, positive FPI inflows boosted the investor sentiments and took markets to higher levels including the small and mid-cap stocks.

Last One Year Performance Chart of NIFTY 50, NIFTY SML 100 & NIFTY Midcap 100

3. What are the risk factors that need to be taken into account before investing in smallcaps?

Investment Horizon: The time horizon should be around 3-5 years to generate meaningful returns.

Volatile and Illiquid Nature: Small cap stocks are more prone to market fluctuations and take time to recover from market recessions making them volatile in nature. Also, it offers less liquidity to investors. Sometimes, it becomes difficult to sell.

Change in macro factors and market fluctuations: An increase in interest rate can change the sentiment of investors. Any reversal in bond yields could lead to a sharp correction in the global equity markets. Small caps correct faster than the large indices. Growth stocks valuations are more sensitive to change in interest rates. The lower growth rate in GDP than expectations also can hurt small caps.

One should do thorough research in these stocks before considering them as an investment avenue.

4. What does the trend for smallcaps look like moving forward and how long can this last?

Recovery in the earning cycle – Generally, a favourable cycle for small caps sustains for 3-5 years. It is necessary to move down one level to find out which sectors in particular can do well in the coming years. Sectors such as pharma, chemicals and capital goods continue to perform well. Companies should have good earnings visibility, exhibit demand recovery after the unlocking of the economy.

Corporate profit to GDP ratio hits a 10-year high of 2.63% in FY21 – The combined net profit of the listed companies was up 57% to 5.31 trillion in FY 21. Improvement in operating margins and lower cost of capital boosted companies’ profits to a decade high. The corporate profit share in India’s GDP hit a 10 year high of 2.63% in FY 21, it was at a record low of 1.6% in FY 20.

Large blue-chip companies were already earning well and were not much impacted in previous years. Major growth in FY 21 ratio came from cyclical, mid and small-size companies.

Nifty 50 vs Nifty 500 EPS Growth in the last 1 year

The increase in earnings ratio signals that the unlisted or unorganized players were affected the most during the lockdown.

The shift from unorganized to organized sector– In 2017, after demonetization and GST, many small and mid-cap companies increased in the hope of the shift from unorganized to organized sector, but the shift was not meaningful at that time.

Sectors such as apparel, tiles and sanitaryware, plywood, textile, footwear, logistics, electrical equipment, and plastics form a higher composition in the unorganised sector. After unlocking the lockdown, this shift seems clearer and also visible in earnings of the last few quarters. Some of them may see erosion in profits while the others might fail to survive. This will help listed mid and small companies to gain market share in the sector.

Government Policies – Large companies have a strong product portfolio and a competitive advantage over the peers. These companies are generally less dependent on government policies and competition from outside India. The focus of the government on Make in India, PLI Scheme and the imposition of duties on import of products and other initiatives to support domestic business will help mid and small-cap companies in expansion, improving competitiveness and margins.

Higher GDP growth expectation on a low base – The RBI has projected FY'22 GDP growth at 10.5 percent, while IMF puts it at 12.5 percent. The World Bank sees 2021-22 growth at 10.1 percent. Higher growth expectation scenarios help more mid and small-cap companies.

5. What could be the easiest way for investors to have a share of the pie with heavy returns?

Niveshaay is a SEBI Registered Investment Advisory Firm with a Dedicated Research Team specializing in unearthing high quality undervalued stocks. We are focused on mid and small cap companies.

At Niveshaay, we have continuously invested in stocks that are available reasonably and have huge earning potential upside.

We have designed ‘Mid and Small Cap Focused Portfolio’ on smallcase

It is a portfolio which constitutes more than 70-80% allocation in quality small-cap stocks.

Our portfolio is perfectly suitable for an investor with a time horizon of 3-5 years, and strongly looking for long-term investments.

We have been live on the smallcase platform since Sep 2019. The unprecedented COVID crisis was the most stringent stress test that one could have applied on their portfolio companies. We have proved our strategy on the platform by outperforming the index returns with good margins.

Live Performance of Niveshaay’s Smallcase Vs Equity Small Cap Index

Live Performance of Niveshaay’s Smallcase Vs NIFTY Index

You can checkout Niveshaay’s very own mid and smallcap smallcase here - https://niveshaay.smallcase.com/smallcase/NIVMO_0001