Large caps had their share of fun, now its the time for some small caps to run

It’s been almost 6 months (20th March ’20) since I last released a note on my market view. Read it here.

That the market bottomed out on 23rd March ’20, exactly 3 days after I wrote my note, is purely coincidental in nature and I don’t make any claims of having timed the bottom 😀

Before sharing my views on the market going forward, lets revisit some of my arguments in that note and see how they have played out in the last 6 months. I had mentioned some of the typical qualitative indicators, as observed by me, that could imply a change in the downtrend (since the market was in a collapsing mode back then):

Argument (March note)Observation 
When a series of earnings upgrades is replaced by frequent earnings downgrades.  The analyst community was forced to downgrade earnings subsequently, for several sectors, not only for Q1F21, but the entire of FY21.                      
When the investor confidence is badly shaken and the number of ‘next Warren Buffet’s’ dwindle.  My twitter feed was conspicuous by the absence of chest thumpers for some time, even while I released my note. Most of them have not even reemerged from their hibernation, till date. 
When you get a reply “bhagwaan ka naam”, instead of a dozen multi-baggers, to your question “kyaa lene ka?”  This was the scene prevalent, even at the time of writing the note. Of course, the recent bull run has changed that scenario with dozens of recommendations circulated on social media platforms. 
When your local paan waala / milkman / security guy go back to their professions, instead of taking stock market lessons and collecting stock tips.  I don’t think this has exactly played out. My interactions with a few such professionals indicate otherwise. Those who were initially contemplating returning to their individual professions, have again re-entered the markets! On the contrary, with the sharp job losses and work-from-home mandate, post CoVID, people from several other professions have taken a plunge in the capital markets (thanks to a sharp rally over the last 3 months).     
When your father’s/relative’s tone changes from “this IPO look good to invest” to “stay away from stock markets, it’s very risky”.  This hasn’t yet played out. But then, there were not too many companies IPOing in this period as well. If you exclude the Rs.150 bn Yes Bank IPO (largely insti subscription), the other primary issuances (4-5 of them) managed to garner a meagre Rs.65 bn.   
When retail investors stop asking for ‘the next multi bagger idea’.  Return of capital assumed the centerstage, over return on capital, indicating the investor mindset in the March-May period. 
When there is a disconnect between the news flow and stock price (or index). This has played out perfectly well. While the real economy is plagued with several problems to tackle with, the bull run in the stock markets portray a completely different picture. 

Look at the news flows in the last 6 months – Indo-China border skirmishes, GDP slump, Increasing CoVID cases, extension of nationwide lockdown, lower GST collections, companies (other than consumer and pharma) reporting dismal numbers, layoffs and job cuts, migrants returning to their hometowns, rising US-China trade tensions and what not. Yet the broader market defied all this and reversed the downtrend, much to everyone’s surprise.

Since the lows of March 23rd, the indices have reversed their downtrend, with the small cap indices now outperforming the broader indices by a reasonably wide margin (refer table below).

Blame this run (in hindsight) on hopes of vaccine launch / accommodative policies by central bankers globally / stimulus packages unveiled by several countries as a response to CoVID / normal and widespread monsoon in the country / the CoVID impact being discounted in the fall etc. But the fact remains that the broader market have rallied, globally, and looks more likely to continue doing so, considering the ample liquidity around and US Fed’s assurance to investors about its extraordinarily accommodative monetary policy not changing for a long time.

Back home, this super run which, in my opinion, many investors failed to fully capitalize on could now get further legs, thanks to SEBIs weekend directive tweaking the asset allocation guidelines for multi cap funds. This could result into some reduction of large cap allocations in favor of micro caps. I would not like to get into the specifics of how much funds could flow into small cap stocks / which are the ones likely to benefit from such flows / when would these get fully deployed by etc. There are plenty of broker reports, released over the weekend, which one can refer to. Irrespective of when or how much funds could get diverted into the small cap space; I believe that the multiplier effect (impact cost) in small cap stocks has the potential to deliver outsized returns in several (deserving) small cap stocks.

I came across some interesting data points, in a newsletter released by SageOne Investments (https://sageoneinvestments.com/2019/06/), which I reproduce here to better explain my point. In a study they conducted on 1500 most actively traded stocks (the Top 100 were the large caps, the next 50 were mid caps and the bottom 1250 companies were small caps), institutional holdings in the small caps dropped from ~Rs. 4.74 lac crs (as of Dec ’17, the time when SEBI regulation mandated a shift from small caps to large caps) to ~Rs. 2.88 lac crs (as of Jun ’19), a drop of more than 40%!  What is more interesting to note is that, of the ~Rs. 1.85 lac crs of reduction in this institutional holding, only ~Rs. 11k crs was on account of actual shareholding change, with the balance (~Rs. 1.75 lac crs) being contributed by the decrease in market value of these stocks!!! This translates to a ~15X impact cost that the actual selling resulted into.

If this pattern was evident while MFs were mandated to reduce small cap holdings (due to SEBI recategorization in 2018), the reverse also has to be true. So while a host of theories are being debated upon; reclassification of multi cap schemes into large cap schemes / merging the multi cap schemes with large cap schemes / SEBI giving some relaxation etc, what remains a fact is that some amount of money would need to be deployed into small caps, over the next 3-4 months. Initial estimates put the quantum of money, that multi cap schemes need to redeploy from the large caps to the small caps, at ~Rs.35k crs. And IF the impact cost (multiplier) effect will repeat (as depicted in the SageOne Investments study), then even a ~Rs.10k crs –15k crs of such shift could result in a huge swing in the capitalization of such small cap stocks.  

Investing this quantum of money, in the small cap space, will prove to be very challenging. Not that investment managers don’t understand the perils of investing in small caps and hence would exercise due caution while putting their money to work. Companies who have a demonstrated history of corporate governance, free cash generation, a lean balance sheet, reasonably high promoter stake, revenue runway, strong return ratios etc would be the ones who could figure in their initial consideration list. Companies who check the maximum boxes could witness serious investor attention, notwithstanding the liquidity concerns in such stocks.

Cheers!!!

Sudhir

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