Why this is a good time to buy smaller company stocks
After a steep fall, a number of indicators points to why bottom-fishing may be a good idea for investors
Illustration: Sameer PawarGood news and good prices rarely come together.
The last time mid and small caps were this cheap was in mid-2013. Then the Indian economy seemed to be coming apart for a number of reasons. With the US Federal Reserve withdrawing its Quantitative Easing programme, the threat of an increase in the cost of capital had pushed up interest rates and had resulted in foreign investors dumping Indian equities. India’s crude oil basket stood at $108 a barrel.
Unsurprisingly, the rupee tumbled 13 percent to 68 and the markets sold off—the Sensex fell 8 percent to 18,816. As investors rushed for the exits, smaller companies took it on the chin with some quality franchises losing as much as half their value in August 2013 alone. Stocks quoting at an eight percent dividend yield had no takers. No matter how attractive the valuations were, few were willing to put their money to work in these businesses.
Six years on, it’s clear that that was a great buying opportunity. That September, Narendra Modi’s announcement as the prime ministerial candidate started a rally that saw the Nifty Midcap 100 Index compounding at 22.9 percent a year till August 2018. There were several instances of individual stocks rising 10-fold in that period. Sure, there were other aiding factors that couldn’t have been foreseen then— the collapse in oil prices and food inflation and subsequent lowering of interest rates. But those brave enough to buy smaller companies then have had a profitable ride.
The present year-long market sell-off starting mid-2018 has prompted investors to question whether this could be the right time to enter smaller companies again. While the Midcap Index is down 31.6 percent, there are many instances of companies losing anywhere between 50 and 70 percent of their valuation. Data from Equirus Securities, an investment bank, shows that the BSE Small Cap Index has been declining for the last 84 weeks. It also points to the divergence between the large cap and midcap indices. At over 20 percent, these divergences are the highest they have been this decade.
Kenneth Andrade, chief investment officer, Old Bridge Capital Management, believes that valuations are attractive with several businesses quoting below their replacement values. While there is always a chance of prices falling in the near term, those investing now with a three-year time horizon have a good chance of making money, he says, while cautioning that these stocks can be extremely volatile. The first two weeks of September have seen buying interest returning to mid and small caps with stocks rallying sharply.
This Fall
The spectacular outperformance of mid and small cap stocks was on account of the valuation gap that had built up. At the start of the market rally in September 2013, the Nifty quoted at an earnings multiple of 17 times while the Nifty Midcap 50 quoted at 12 times. With the valuation differential ignored since 2011, it was time for midcaps to close the gap, and how. By January 2018, while the Nifty had moved to 27 times earnings, the Nifty Midcap 50 was trading at 85 times with a large part of the gains coming in December 2017 and January 2018. It was the melt-up moment for the Indian markers.
This valuation boom soon exposed many shortcomings of the rally. First was the lack of liquidity in midcap stocks. Trades of a few thousand shares were enough to have them locked on upper circuits (20 percent or 10 percent depending on the stock) as investors bought into future growth projections. (The same story repeated on the way down as well.) As the cost of capital for smaller companies fell, their balance sheets began to look a lot leaner, which resulted in a valuation rerating.
