Investing in small-caps? Direct investors should beware of valuation risks

Direct investors in small-cap stocks should book profits and wait for corrections, while those taking the fund route should invest with at least a 7-10 year horizon

Last week the BSE Small-cap Index touched a new high, crossing the 20,000 mark. Over the past year, small-cap stocks have rallied strongly, with this index giving a return of 53.22 per cent. However, valuations within this space have now risen to exorbitant levels. The Nifty Free Float Small-cap 100 Index is currently trading at a 12-month trailing price-to-earnings (P/E) ratio of  199.1, according to Bloomberg — almost four times the 10-year average P/E of 51.8. For investors investing either directly or via mutual funds, it is clearly time to take steps to safeguard themselves against a possible correction in these stocks. 

Mutual fund flows driving rally: The key factors responsible for the small-cap rally are performance and liquidity flows. Says Vinit Sambre, senior vice president and fund manager, DSP BlackRock Investment Managers: “One of the fundamental reasons for the rally in small-caps is growth in earnings, which has been higher compared to large caps. 

The other reason is the inflow of money. We saw significant inflow of money as investors chased good performance.”

Domestic mutual funds have enjoyed high inflows, which in turn has got deployed in stocks within this segment. Mutual funds invested Rs 1.16 trillion in equities in 2017. A considerable portion of this money went into the mid- and small-cap segments for which Indian retail investors have high affinity (foreign institutional investors tend to stick to large-caps). Since the free-float market cap of small-cap stocks is smaller, a smaller amount of inflows suffices to drive stocks in this segment up by a high percentage. High returns then attract more flows, creating a positive loop. 

Rising risks: The foremost risk in this segment currently arises from high valuations. The Nifty Free Float Small-cap 100 is trading at a premium to the Nifty 50 (P/E 24.1). “The small-cap index is trading at a massive premium to the large-cap index, as are many stocks outside the index. I don’t think this is a sustainable situation,” says Rakesh Tarway, head of research, Reliance Securities. 

Experts point to the tech boom of 1999-2000 to highlight the risks of investing at such  high valuations. Says Jatin Khemani, founder and chief executive officer, Stalwart Advisors, a SEBI-registered independent equity research firm: “Even if companies continue to deliver earnings growth, an investor who enters at a high valuation may not make any money. This is what happened to those who had invested in Infosys or Wipro in 2000. While those companies continued to deliver sustained earnings growth, investors in Infosys had to wait for six years and three months for it to achieve its peak price again, while Wipro’s stock is yet to do so.”

Investors also face execution risk in this space. “The market is giving very high valuations to these stocks, believing the companies behind them will be able to execute their plans over the next two-three years. But the probability of small-cap companies failing to do so tends to be fairly high,” says Tarway. Such failure could lead to a sharp price correction.   

Experts say that this is not a prudent time to put money into small-caps, and they should wait for a correction. According to Khemani, “While the last five years have been extraordinary for bottom-up stock pickers betting on emerging companies, and not on large-caps, investors should take some money off the table. Market frenzy may continue and prices may continue to rise, but I feel it is important to preserve some of these gains.” Bottom-up stock pickers need to focus more on downside risk rather than just the return potential, he adds.

Take the mutual fund route: The small-cap fund category has given an average return of 34.73 per cent over the past one year. For a variety of reasons, retail investors should take the mutual fund route to invest in the small-cap segment. The first is paucity of information. “Large-cap companies are widely tracked, hence a lot of information about them is easily available. This doesn’t hold true for the small-cap segment. Hence, research becomes crucial in this space. It is also harder to do in this segment,” says Kaustubh Belapurkar, director-manager research, Morningstar Investment Adviser India. Not much information is available about the quality of the promoter, the company’s corporate governance standards, its business plans, and so on. “Fund managers may benefit from better access to management of companies, which may not be available to individual investors,” says Sambre. Given the elaborate research resources at their disposal, fund managers are better placed to dig up all the required information and take the right calls. 

The higher volatility of small-cap stocks also makes it incumbent on investors to be adequately diversified. Fund managers are in a position to create a well-diversified portfolio with their larger corpus. Individual investors may not be able to do so due to the limited money they have.  

Liquidity is another key issue in this space. Right now there are many buyers for small-cap stocks, so there is a lot of liquidity. But in case of a major correction, liquidity tends to dry up fast in this segment. An investor who has large holdings could then face considerable impact cost (selling drives prices lower owing to which the average price of exit tends to fall). On the other hand, if you sell your units back to a fund house, there is no impact cost as the fund house is bound to give you the day’s NAV. 

In view of the high volatility of small-caps (the S&P BSE Smallcap fell -73 per cent in 2008 and -43.6 per cent in 2011), new investors should not allocate more than 5-15 per cent of their equity portfolio to these funds, depending on their risk profile. They should also invest only via SIPs and with a horizon of 7-10 years. 

When selecting a fund in this category, don’t go just by the past year’s performance. Look at the fund’s long-term track record. Also, opt for a fund house that has a proper research setup.  

After the recent run up, older investors should rebalance their small-cap allocation to reduce portfolio risk.