Investing: Hold on to good mid- and small-cap stocks

A market correction is a good time to reassess the quality of your portfolio and purge the poor quality names from it

Year-to-date the S&P BSE Midcap Index is down 11.53 per cent, the Smallcap Index is down 14.05 per cent, while the Sensex is up 4.04 per cent. The rout in mid- and small-cap stocks has led to panicky calls from investors to the offices of fund management, wealth management, and brokerage firms. This is in sharp contrast to the mood some time ago when equity prices, soaring on the back of a surge in domestic liquidity, were making investors confident, even cocky. The tables have now turned completely. More time is being spent now on investor management rather than on investment management.

Investors who had entered the  markets for the first time during the recent bull run are realising how brutal a market downturn can be, and how deeply it can erode portfolio values, more so in the case of investors who had bet on low-quality stocks having dubious fundamentals. While all things that go up must come down, in the case of low-quality stocks the fall tends to be steeper. This time the  pain to investors is likely to be greater because inflows into mid- and small-cap stocks have been much higher than in earlier cycles.

Build-up towards the perfect storm

Let’s turn the clock back by about 18 months. Till then the markets had enjoyed a smooth one-way ride up, thanks to increasing liquidity, benign interest rates, poor or negative returns from other asset classes, and extremely low volatility not witnessed in years. At that point, FOMO, or the  fear of missing out, was the  predominant sentiment among investors in the mid- and small-cap space. They brushed aside concerns about the  fundamentals of these stocks and were instead seduced by the daily rise in their stock prices. Market gurus added fuel to fire with their pronouncements on television on which stocks would be the next multi-baggers. 

In this period, most investors indulged in rear-view investing. They were swayed by the returns earned by these stocks in the recent past. They conveniently forgot the  law of reversion to mean: Over the  long term, returns tend to converge to a mean. This implies that an asset class that has yielded high returns in the recent past has a higher probability of disappointing investors over the next few years.

The slow pace of improvement in earnings should have worried investors. If one were to examine the  break-up in the  price rise, more than 70 per cent of the gains can be attributed to P/E (price-to-earnings) ratio re-rating. In the small pockets of the  market where earnings were growing briskly, valuations had turned prohibitively expensive, with three-five years of forward earnings getting discounted. Moreover, mid- and small-cap stocks were trading at much higher valuations than those of the frontline indices. That the gap would narrow was inevitable. These premium valuations could only have been justified if the economy were on a roll. But the recovery in earnings growth was patchy at best. Ultimately, it is free cash flows and quality of earnings that sustain stock prices. 

Another signal that the market had turned frothy was fund managers and asset management companies stopping lump sum investments in their mid- and small-cap funds, citing valuation concerns. This admission by seasoned fund managers that they were having trouble finding sound investment opportunities should have sounded a  warning bell. But instead of booking profits and exiting the markets, investors merely shifted to portfolio management schemes (PMS) and alternative investment funds (AIFs), where the revelry continued.

Thus, the mood had turned extremely buoyant and investors felt nothing could go wrong. The sage voices that advised caution were ignored. As we know, there are no free lunches in the markets. The moment of reckoning was close by.  

Panic as the tide turned

Come 2018 and a number of the tailwinds of the previous year turned into headwinds. Today all talk of gains have evaporated and the  mood in the markets has turned decidedly gloomy. Investors are now only focusing on the risks: rising crude and commodity prices, a depreciating currency, rising inflation, and so on. Rate hikes by the US Fed and its potential to drive domestic interest rates up are spooking equity investors. The Q4FY18 earnings scorecard showed that margins are coming under pressure on account of rising input and funding costs.

Investors are now ignoring the positives that still remain - the  ongoing turnaround in the economy, rise in credit growth, expectation of a normal monsoon, and revival in rural consumption. 

Liquidity risk, too, has contributed to the panic. When markets fall sharply, trading volumes tend to dry up, and sales in even small quantities result in large price drops. Second, leverage had made a comeback. Now margin calls from brokers are causing big price corrections in several well known small-cap names. Thirdly, humongous amounts were raised by PMS schemes and AIFs. They too are being forced to sell to meet redemption pressures. Hence, in this phase even quality mid- and small-cap stocks are being sold off. 

In extremely bullish and bearish times, investors should keep an eye on the 52-week high/low chart. In panicky markets, whenever the number of stocks hitting yearly lows versus stocks hitting yearly highs is close to 40 or 50:1, price correction abates, markets tend to bottom out, and the recovery in good stocks begins. Inversely, markets tend to top out if the 52-week high/low are in the same ratio in favour of the gainers.

What should you do? Firstly, do not panic. Assess your portfolio. Make sure your allocation to mid- and small-caps is within your comfort zone and not excessive. While these stocks can deliver higher returns, the risk and volatility in these stocks can be unnerving. If you are in good quality stocks or your portfolio is being managed by a professional fund manager, then you have nothing to worry about. The markets will eventually settle down. In tough times like these, all stocks, irrespective of quality, tend to fall simultaneously. When sentiment revives, however, the pace of recovery in good quality stocks will surprise you positively. 

Being patient in such times and sticking to quality stocks is of paramount importance    as markets can deviate from rationality for prolonged periods of time. If you are worried, there is no point in catching a falling knife by adding more positions just because prices have fallen. More importantly, if you are in low-quality stocks, do not fall prey to the concept of averaging as it will amount to throwing good money after bad. This is as good a time as any to cut your losses and reallocate. The best time to allocate to small caps will be when no one wants to be in them. Take the losses in your stride and get back to the basics. In fact, this is a good time to revisit the assumptions behind investing in each of the  stocks in your portfolio. If the investment rationale is intact, be patient and ride out this phase. 

The  writer is co-founder and director, Entrust Family Office Investment Advisors