Small Caps on The Rise: A Bubble That Is Soon Going To Burst?

As I’m writing to you, Sensex is up by ~50% since its March lows (yes, after considering the recent fall). Barring the recent incident, this resurgence in Indian stock market paved way to a big rally in the small-cap stocks. This reminds me to update you on the recent performance of small-cap stocks. The S&P BSE Small-Cap index dropped by approx. 4.3% on 31st Aug 2020, while Sensex plummeted by 2.1%.

But before I talk about the saga of small-caps in 2020, here’s two cents on what they are.

As per SEBI classification, small-cap stocks are stocks that are ranked below 250 in terms of market capitalization. Now, there’s a reason why they are called small-cap stocks:

1. Number one problem is their sheer size, which makes them riskier as compared to large-cap and mid-cap stocks. They are more likely to swing on extremes as compared to large-cap and mid-cap stocks. Means, if there is a turmoil, they would be the first ones to fall. On the other hand, if the economic engine is firing well, they have higher chances of giving better returns.

2. Small-cap stocks, unlike large-cap, exhibit greater earnings volatility. This makes them highly risky bets.

3. Information about these companies is difficult to get. Hence, it is difficult for an investor to make informed decisions about such companies.

Now, let's take a quick dive into the subject now.

The Background

In the last one year, small-caps have been underperforming the broader market due to economic slowdown affecting small-cap companies the most. While Sensex dived by 23%, S&P BSE Small-cap Index plummeted by 37%.

This was till now...But what about this year?

This year, many small-cap stocks have delivered multibagger returns from year to date. Where the Sensex is down by 6% on Year To Date (YTD) basis, and up by 49% from its March lows; S&P BSE Small-cap Index has outpaced Sensex and is up by 5% YTD and up by 62% from its March lows.

Table 1: Returns delivered by various indices in 2020

But this is not the problem as the broad rally is welcome, given that the Indian indices Sensex and Nifty were driven by just a select few rally in the recent times.

The problem is:

        1. Low quality

        2. Frenzied buying without research

Let me explain to you what I mean in a bit.

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. Goes without saying, without understanding the underlying fundamentals of a company.

The retail investor’s excitement over small-cap stocks in India has reached to a level, where many are buying stocks without proper research or understanding the fundamentals such as sales, profits, return on capital employed, or other quantitative parameters.

But why this is a problem? This frenzy (I would say blind buying) is leading to surging stock prices of companies that have posted zero revenue. These companies do not have a strong balance sheet, neither enough cash buffer. Let’s take a few examples of such stocks.

Source: Screener.in

In fact, from the above list, four companies i.e. Tirupati Tyres, Integra Garments, Jain Studios and GBL Industries reported negative profits on zero revenue in the last quarter.

So as I said before to you, the problem is:

• Investors investing without understanding the fundamentals of a company, and

• Investors investing basis the stock price

And trust me, this is a catch-22 situation for many investors, including me and you. In the second part of this article, I will throw more light on the potential risks of frenzy investing in small-cap stocks. But there’s the good part as well, because I will tell you how you can avoid being a victim of this trap, avoid bad investments and stick to quality stocks.