While Nifty is at lifetime high, the average fall across 3,000 traded stocks is still 40-50% from their 2018 highs. Smaller the market capitalization bigger has been the bashing its stock has taken.
While Nifty is at lifetime high, the average fall across 3,000 traded stocks is still 40-50% from their 2018 highs. Smaller the market capitalization bigger has been the bashing its stock has taken. Though there is nothing unusual about it – small companies swing wildly in both directions depending upon market sentiment; after all they are thinly traded with low free-float (non-promoter holding, available for trade) so rise in volumes can lead to high impact.
The onlookers and investors who entered markets recently might have concluded by now that it is so safe to invest in large caps which not only did not fall much in correction but now when markets are improving they are also participating on the up move. While purely on the basis of this divergence seen between select large caps and broader markets during 2018, the observation cannot be dismissed. However, it is nothing but an outcome of recency bias.
Most of these so-called high-quality large caps are trading at ridiculous valuations from which it is very unlikely for investors to make reasonable returns even over next 3-5 years. The real opportunity lies in broader markets and emerging companies, where once again valuations have turned reasonable (if not cheap like 2013) and one could at least expect those stocks to mimic earnings growth without the risk of any meaningful de-rating.
In previous occasions when we had such a steep fall in small caps in such a short period of time, the reversal too had been swift. Also, the returns over following one and three year periods have been above average.
Happy hunting ground
A good starting point could be to look for companies where insiders are buying – could be promoters, directors or employees. They understand the business way better than us and, though not always, it is a good screen for idea generation which can then be rigorously analyzed for business quality, management quality and valuation parameters.
Look for quality
A small cap company may not mean small business. Many small and mid sized companies are actually market leaders in their respective segments. Further, prefer companies which are owner-operated (run by promoter himself) having skin-in-the-game (high stake in the company) with no doubtful related party transactions.
Avoid these ponds while fishing
Anchoring to 52-week or 2018 highs
Many investors tend to confuse price with value. They think the stock has fallen 70% from its highs, how much more can it fall? The honest answer is another 100% from there. Avoid this folly. Focus on value, derive it yourself using conservative estimates of growth and valuation, and then compare if current price is attractive. Don’t start with market price, markets are often wrong in short term.
Leveraged Balance Sheet
Avoid companies having too much debt. Anything beyond debt-equity ratio of one and interest coverage ratio below five times could be problematic. Why take balance sheet and solvency risk? There are plenty of listed companies with strong balance sheets.
If you can’t trust the reported numbers, it makes just no sense to even waste time on analyzing that business. Any indulgence in this bucket is purely speculative and should not be confused with value investing. Don’t rationalize by thinking you are getting a dollar bill for 25 cents, the dollar bill could be fake for all you know. As Richard P. Feynman puts ‘The first principle is that you must not fool yourself and you are the easiest person to fool’.
Circle of Competence
Don’t get into businesses which you don’t understand. For instance, if you don’t know much about biotech, IT or cyclical commodities, no matter what sector experts say, you should avoid it like plague. They will shout from the rooftop when it’s a good time to enter a particular sector, but how would you know when to exit? Stay within your circle of competence and invest in what you understand. There are various ways to become poor and eagerness to get wealthy fast would top that list.
(This article has been authored by Jatin Khemani, CFA. He is the founder & CEO of Stalwart Advisors a SEBI registered investment advisor, which assists individual investors to deploy capital for long- term via its subscription based model portfolio offering. Views expressed in the article are author’s own. Please consult your financial advisor before making any investment related decisions.)