Exit small-caps with high valuations and poor basics, say analysts

MF investors must limit allocation to 10% and have five-seven-year horizon

The BSE SmallCap Index has declined 10.1 per cent over the past month, far more than the Sensex, which is down 3.1 per cent. It has fallen 13.9 per cent from its 52-week peak (vis-à-vis 8.1 for the Sensex). In the market run-up over the past few years, small-cap stocks had outperformed mid- and large-cap stocks. But the tide has changed now.

“The law of averages is catching up with small-cap stocks, which is why they are falling at a faster pace than large-caps,” says Samir Rachh, fund manager, Nippon India Mutual Fund (MF).

Sharper rise, steeper fall

When market sentiment turns bearish after a good run-up, small-caps tend to take a bigger hit.

Harish Bihani, fund manager, ICICI Prudential Smallcap Fund, says, “The small-cap index has outperformed the large-cap index significantly over the past two years. Some part of this sharp outperformance wasn’t sustainable. That got corrected over the past few weeks.”

Small-cap stocks tend to have lower liquidity. A relatively smaller amount of money entering or exiting these stocks causes bigger price swings in them.

Roop Bhootra, chief executive officer (CEO), investment services, Anand Rathi Share and Stock Brokers, says, “These stocks have a relatively higher impact cost, beta, and value at risk.”

As they have higher beta, they tend to rise more in a bull market, and also fall more in a bear market, than large caps. From the start of 2018 to the end of 2019, the BSE SmallCap Index was down -15.6 per cent (Sensex was up 10 per cent). From the start of 2020 to the end of 2021, it was up 46.6 per cent (Sensex was up 29.1 per cent).

The correction in the small-cap cap segment is likely to continue for some time.

Tarun Birani, founder and CEO, TBNG Capital Advisors, says, “Owing to headwinds like high inflation and geopolitical risks, there could be more volatility in small- and mid-caps.”

Bhootra adds, “Owing to heightened uncertainty in the near term, arising from the Russia-Ukraine crisis, short-term fund flows could move into safer havens.”

Focus on fundamentals

Direct stock investors, especially those who have entered the markets in the past couple of years, must hold their nerve.

Rachh says, “Times like these test investors’ patience. At the same time, they create opportunities to pick up long-term winners.”

Investors should avoid undue pessimism.

Bhootra says, “Domestic companies’ long-term growth prospects remain intact and should help them tide over short-term volatility.”

Focus on companies with strong earnings growth prospects and low debt. Also, stick to companies with competent management and strong corporate governance practices.

Exit those whose valuations have run up but whose fundamentals are weak. Avoid investing based on unsolicited tips, or placing speculative bets.

 Bihani insists investors do their homework before investing directly. Those who can’t assess the fundamentals of stocks, their growth prospects, and their valuations should avoid the direct route and instead invest via MFs.

Limited exposure, long horizon 

To limit risk, follow an asset allocation strategy. Conservative investors need not have any allocation to the small-cap segment. Those who have the requisite risk appetite may take a 10-15 per cent exposure.

Birani says, “Have at least a five-seven-year horizon while investing in the small-cap category.”