BSE 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 BSE small caps. 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 procure. 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 BSE small caps 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.

BSE Small caps 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.

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.