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03 Sep 2020 by Pradeep U
Small Caps on The Rise: A Bubble That Is Soon Going To Burst? Part II - Research & Ranking

In our previous article we told you about the problem with many small-cap stocks which are growing by more than 100%, irrespective of weak fundamentals. Read the complete story here.

I told you this is catch-22 situation, and let me tell you why I say so.

Small caps stocks have high risk. Investing in bad stocks increases the risk by several times.

Risk of investing in bad stocks

Problem #1: As per the data released by Economic Times, about 12 lakh new investors opened demat accounts with the Central Depository Services (CSDL) in March and April alone. So, while the large-caps led the rally initially, small-caps grabbed attention as most of these new investors entered the small-cap stocks with the greed of making quick money. These investors started investing in small-cap stocks just by going by the stock price, without much knowledge of the underlying fundamentals.

Problem #2: Talking about knowledge, there's another problem here. The information about such stocks is very limited. So, anyways, you will never understand the real health of such companies. But still, new investors were investing in such stocks for a singular reason - earn quick money. This drove the stock market prices of bad quality stocks up.

Problem #3: This means whenever there are any withdrawals from the traders/investors from these weak companies, the contagion effect would be seen on the broader markets, thus hurting the market sentiments.

Problem #4: Again if history has to go by, going by the recent crisis, even though the small-caps delivered better alpha than the broader market, this euphoria did not sustain for long. During the period Dec'10 - Aug'13, small-cap index got battered by approx. 52%, much higher than the Sensex plunge of 11%. This happens when the fundamentals of the stocks are not aligned with the market rally.

Index

High in Dec'07

Fall in Mar'09

Recoup in Nov'10

Aug'13

Levels

%

Levels

%

Levels

%

S&P BSE Small Cap

12,901

2,911

-77%

11,044

279%

5,247

-52%

S&P BSE Mid Cap

9,574

2,586

-73%

8,678

236%

5,429

-37%

S&P BSE Large Cap

2,412

1,021

-58%

2,391

134%

2,152

-10%

S&P BSE

20,206

8,325

-59%

21,000

152%

18,598

-11%

 

The point here to note is that, not all companies will get battered. Only companies that display weak fundamentals will not sustain the recent rally in the past.

 

When the markets correct, these companies would be the first ones to fall and wipe out the gains. Investors should remain vigilant and choose their investments sagaciously.

 

So, what should you do as an investor and how you can stay away from bad investments? Don't worry, as our research experts have put together 5 best investing practices to avoid such investments and rather identify stocks that have the potential to not just survive, but also flourish to deliver impressive results for you.

Investing strategy for the current times

1. Don't chase weak / penny Stocks

Considering the markets running ahead of fundamentals, it is crucial for investors to chase quality stocks rather than running behind penny stocks. This rally in small-cap stocks can be speculative and can trap naïve investors. As we saw on 31st August, when the broader markets fall, small-cap stocks are the first ones to bear the brunt. Hence, investors should remain wary of such weak stocks,

2. Don't ignore the role of stock allocation

Looking at the market situation, it is recommended to stay invested in large-cap and mid-cap stocks, with 67% exposure to large-cap and 33% exposure to mid-cap. An investor can increase exposure to small-cap and mid-cap stocks once the risk-on mode is back, but remains below 50%.

3. Have a long-term horizon

One has to invest selectively. Scout companies that are well-managed and boasts of decent fundamentals while trading at fair valuations. Be prepared to accept the downsides on the way. Have a long-term horizon while investing; otherwise the chances of losing money are high.

4. Fundamentals were, is and shall always remain the king

Even while investing in small-caps, look for credible promoters, look for quality products, look for competitive advantage, look for dominant franchisees with significant market share. If you invest in such companies, there are very high chances that you'll make steady return in the next 2-3 years.

5. Short term gain should not lead to long term pain

If you invest without understanding fundamentals, chances are high that you'll experience one year of good returns followed by two to three of negative returns, similarly to what happened after 2008 crisis.

To conclude, while investing in any company, be it large-cap, small-cap or mid-cap, look out for three hygiene factors:

  • Market leader with significant market share
  • Strong competitive moat
  • Healthy balance sheet

Doesn't matter if it's a bull or bear run; it is important to stay away from weak companies. In the long run, only companies with strong fundamentals win the race.

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