Falling Small Caps: Cause, Effect and What to do?

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Arguably, it is a tough year for small caps. Nifty small cap index has fallen by -17% from 1st Jan 2018 till date. At individual stock level, it has been more severe. While there is a lot of discussion of this correction, there are limited articles which explains this fall and advice investors. In this article we are trying to bridge that gap by explaining the real reasons of this fall and what should be the best coarse of action for investors.

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Primary Reasons of Correction

Let’s first understand various reasons behind this correction in small caps and then we will discuss on what do in such a case.

  • Rising US Dollar Interest Rates: Interest rates are rising worldwide and american dollar is appreciating. Historically, it has negative correlation with emerging stock markets like India. In the era of cheap money which started post 2008 financial crisis, foreign investors were looking towards emerging markets to deploy excess cash that they were able to source at zero interest rates. Now, things have changed and interest rates are escalating, causing foreign money to flee emerging markets like India. While domestic inflow are getting stronger day by day, sudden outflow of foreign money is just too much to be compensated by domestic inflows. Small caps became popular in late 2016 and many foreign investment bodies have invested money into relatively bigger small caps via Mauritius or Singapore routes. This may not be big for them but for small cap stocks, their investment is sizable as compared to stock’s market capital. Resulting in free fall of stock prices.
  • SEBI mandate for Mutual Funds: SEBI has mandated mutual funds to align their portfolio according to their stated objective under broad categories like Large-Cap, Mid Cap, Small Cap or Balanced and so on. Over the last few years, due to good performance of small caps, many large cap or balanced funds also had exposure to small cap stocks which is contrary to their stated scheme objectives. In order to comply with SEBI guidelines, they have started frantic selling to get rid of small caps from their portfolio. The problem is number of funds & AUM under large cap or balance funds is way too much as compared to small caps. To balance out, there are hardly a few pure small cap oriented mutual funds. This has resulted in demand-supply imbalance where there are more sellers than buyers of small cap stocks.
  • Domino Effect: With institutional investors leaving small caps, there are mostly ordinary investors left into small caps who are prone to panic selling. Fear is a very powerful force and this is forcing public to sell small cap stocks due to panic. It has become a domino effect. In such a scenario, even slightest of bad news can create ripples and crash stocks. This is the third leg and possibly final but longer leg of selling which is happening now-a-days. Earlier, foreign investors left in Feb-March while Mutual Funds left May onwards. Die-hard small cap investors will be the last  one to sell as they tend to have more patience. However, such is pressure of loss that sooner or later, some of them will also sell their holdings (worst mistake) after which this correction should stop.

What to do?

Small cap investment is prone to such panic selling and hysterical buy. Anyone who has seen 2013 or 2008 can vouch for this. Such times will separate men from boys. You should ask yourself why you ventured into stocks? If it was for easy money, then that time has gone. If you ventured into small caps for long term wealth creation then this is the best time to read about stocks that you hold. Re-validate your investment theory & average down stocks which have good earning visibility in future. Selling junks or stocks with deteriorating investment theory is totally acceptable. It will do more good than harm in long term.

Remember famous quote that “You should buy stocks when there is panic on the street”. Well, undoubtedly there is panic on dalal street so you know what to do!!

Few pointers to keep in mind while you re-assess your investment theory about a stock:

  • With rising interest cycle, banks and NBFCs will have hard time in raising fresh funds thereby slowing their revenue growth.
  • Avoid companies with significant debt (Debt/Equity more than 1), Best is to stick with stocks having low or no debt. As interest rates rises, loan cost will increase and their profit margin will shrink sending them into downward spiral.
  • Look out for companies having healthy order book at hand. This provides revenue visibility.
  • Stock with companies having lower capacity utilization or companies that are almost finishing their capacity expansion. Scrutinize companies which are announcing fresh capacity expansion at this stage.
  • Export oriented business shall do well in this year, so watch out for export vs domestic revenue mix.
  • Turnaround companies will find it tough to sustain so don’t jump into turnaround stories till they really turn around and start posting good results consistently. You may miss out on initial gains but it’s worth compared to risks turnaround companies carries.
  • Look out for stock where financial performance is good but rumors have beaten down the stock price. Do not blindly believe in investor forums (moneycontrol) or whatsapp groups. Such stock will come out of trouble if they keep on posting good results.
  • Don’t sell good small cap stocks due to panic, this is worst mistake. Instead, think of 2018 as a building block for 2020. All people who made multibagger returns in 2017, bought these stocks when they were trading in single or double digits in 2013-14.
  • Last but not the least, stop overestimating. In mirror, we are all kings. But this does not work in stock market. It is practically impossible to match the efforts of equity researchers as they have more sophisticated tools and far more time to devote. Buy a subscription plan from a trusted advisor. This will give you already validated & structured stock ideas. Not to mention, the much needed confidence to stay on course of long term wealth creation. You can always apply your own logic to enhance returns but having a baseline or platform is crucial.