How to (and not to) play the small cap opportunity

SEBI’s new circular dictating a minimum mid-cap and small-cap stock allocation has left investors in multicap funds scratching their heads. (We have covered the impact of this for multi-cap mutual fund investors) But there’s another set of investors who are thrilled with this move. These are the folks who are already invested in smallcap stocks in their direct equity portfolios or owning smallcap equity funds.

They have good reason for their excitement. The smallcap segment of the Indian market is notorious for its poor liquidity and depth. Therefore, even limited new money flowing into this universe can cause stock prices to spiral out of control. If SEBI’s new diktat is implemented by the mutual fund industry without any Jugaad solutions (more on this later), we’re talking of some big money flows into smallcaps.  

Based on ballpark estimates based on July assets, MFs would need to move about Rs 29,000 crore of their existing largecap holdings in their multicap funds into small-cap stocks and over Rs 11,500 crore into mid-caps. That’s a big incremental flow into smallcaps. Today all small-cap equity funds put together manage assets of just Rs 52,119 crore (AMFI data).

Given that SEBI has granted them a timeline until end-January 2021 to comply, fund managers presently have the next five months to reshuffle their holdings. But the price action in smallcaps may pick up much before that as short-term traders, portfolio managers, HNIs and other savvy folk try to position themselves in smallcaps ahead of MFs, in the hope of making quick gains from the coming flood of liquidity.

It’s a risky trade

So, should you attempt to make a quick buck from this smallcap party too? What are some smallcap stocks you can immediately buy? While we’re getting a lot of such questions (which we’ll answer here), we believe that we should warn you of the pitfalls of betting your hard-earned money on this tactical gamble first.

While a higher MF allocation to smallcaps can lift the long-term returns and liquidity in this market cap segment in the long run, indiscriminately piling on to smallcaps at this juncture can be injurious to your wealth, for three reasons.  

# 1 Smallcaps can decimate wealth as quickly as they create it. Therefore, the best time to buy smallcaps is when broad markets are in the doldrums and smallcaps are entirely out of favour. Today, we are quite far from this situation. Any investor buying into smallcaps now would be buying into a frothy segment of the market where there’s a mad scramble for the next big multi-bagger stock. Unfortunately for retail folks, the SEBI circular has come at a time when a bull market in smallcaps was already in full swing, with the BSE Smallcap Index gaining 60% between end-March 2020 and now.

The following table shows how broad-based this smallcap rally has been, with over 100 stocks registering 50% plus gains and 43 more than doubling in price in a year’s time.

# 2 The best time to buy small-caps is when they’re trading at steep discounts to large-caps and the market at large. But after the recent rally, most smallcaps with decent investment credentials are trading at stiff valuation premiums.

Of the 700 stocks in the BSE Smallcap index, only 537 have a meaningful PE (price earnings ratio).  Nearly half of these stocks trade at a PE of 25 times or more, while over 90 trade at PEs of a steep 50 plus.

Avoiding the highly valued quality stocks and betting on second rung or third rung smallcaps in the fancied sectors in the hope of a catch-up rally, is extremely risky. Should the markets melt down, such stocks can see debilitating price falls accompanied by vanishing liquidity.

# 3 The small-cap segment of the market is the favourite playground for scamsters and pump-and-dump operators who are ever keen to offload dud stocks to unsuspecting retail investors. These scamsters circulate exciting stories about small businesses and help drum up buying from retail investors, preparing the ground for operators and promoters to offload their holdings at steep prices. Such activity has been on an overdrive in recent months, with Whatsapp forwards and SMS tips circulating about a wide variety of dubious smallcap names.

# 4 Initial reactions from the MF industry suggest that multicap fund managers are highly aware of the above risks and are therefore quite wary of adding sizeable smallcap exposures at this juncture based solely on SEBI’s diktat. AMCs have indicated that they will lobby with SEBI to rethink its proposals. They may prevail upon SEBI to either delay the implementation of this proposal or dilute it, say by matching the smallcap weight in their multicap funds to the index weight of 6-7%. They will also examine Jugaad solutions like creating a new ‘flexicap’ category, merging their multicap funds with their large-midcap funds, or relabelling them as large-midcap, focussed, value or thematic funds. If these ploys succeed, incremental flows into smallcaps may be much lower than what the market is now budgeting for, swiftly killing the excitement building up over this move. 

Given all the above factors, it is extremely important for retail investors looking to play the small cap opportunity now to take a cautious approach to their stock selection. Staying off dubious and operated stocks which can destroy your wealth in a blink, is far more important than unearthing quick multi-baggers.  

If you’re still determined to add smallcaps now, be sure to allocate only a fixed proportion of your portfolio (say 5-10%) to them. Ensure that the stocks you choose aren’t based on tips or fads but make the cut on fundamental and business filters.

In this context, it may help to be aware of the filters that MF managers apply while choosing smallcap stocks for their portfolio from the hundreds of listed names.  

Filters they use

#1 Reasonable market cap

The bulk of MF equity assets are in open ended funds. Therefore, MF managers looking to add smallcaps, usually look to own stocks that are easy to build and liquidate positions in, without causing big price upheavals. They are likely to favour stocks with higher market capitalisation within the smallcap universe, while staying off the tiny-caps.

MF managers need to make their choices from a SEBI-approved list of stocks classified as large, mid and small-caps published by AMFI. As of June 30 2020, AMFI’s small-cap universe consisted of 4728 stocks ranging from sub-Rs 1 crore market cap all the way to Rs 6938 crore (Sheela Foam being the largest).

If we filter this list for stocks that meet a reasonable market cap threshold of Rs 1000 crore, only 370 small-cap stocks make the cut. You can find the list here. If you’re choosing smallcaps for your portfolio, it would be safe not to venture beyond these names.   

#2 Existing investment universe

When looking to add new stocks to their portfolio, MF managers seldom pick a stock that they’ve never tracked before. MF research teams maintain a coverage universe of 250-300 stocks that they regularly track, from which fund managers usually make their choices. New stocks that appear attractive from a business perspective first enter this investment universe of the research team, before they are added to fund portfolios.

Before adding any stock, research teams ensure that the company they’re choosing meets basic internal filters on business, management, profitability, governance and market liquidity.

This suggests that managers of multicap funds looking to now add more small-cap stocks would first shop within the approved list of stocks that they already own in their other schemes- whether they’re smallcap, hybrid or other equity schemes.

So which are the smallcap stocks that already figure in existing equity MF portfolios? PrimeInvestor ran a screener on the latest portfolios of all equity and equity-oriented hybrid schemes, to put together this list of the smallcap stocks already held by them. This shortlist of 378 smallcaps also captures the total value of shares held by MFs in each company, their latest Market Capitalisation and Free Float Market Capitalisation (market value not held by promoters).

#3 Fundamental filters

While buying smallcap stocks, MF managers also strive to unearth companies with strong growth potential that are likely to transition into midcap or large-cap names over time. These are some filters they’re likely to use.

• Return on Equity (ROE) of over 15%
• Profit growth of 10% plus over the last three years
• To reduce impact costs, MFs prefer more liquid stocks with higher free float market cap (say, over Rs 500 crore) and reasonable daily trading volumes. The excel sheet mentioned above can help you with the numbers.  

#4 Qualitative factors

While hunting for promising smallcaps, there are qualitative aspects fund managers look for too. Here are some of them.

• Small cap companies that are leaders or strong challengers in their respective sectors, avoid me-too names
• Capable of delivering steady rather than cyclical sales and profit growth
• Avoid companies with unknown auditors or a history of run-ins with the regulator
• Focus on growth stocks and avoid deep value/cigar butts. Paying huge valuation premiums to the Nifty for a smallcap stock can expose one to the risk of sharp de-rating if the company’s performance disappoints. But ultra-low PEs in the smallcap space are even more dangerous. Single digit PEs for smallcap stocks, especially in a bull market, are often a sign of the market disbelieving the company’s numbers, disliking the company’s promoters or being doubtful about its governance standards.

If you feel all this is too much due diligence to put in for adding a few stocks to your portfolio, stay off direct investments in the segment for now. Better to be safe than sorry.

Read our earlier note on the SEBI circular about multi-cap allocations here – https://www.primeinvestor.in/sebi-multicap-rule-funds-what-it-means-for-you/