Yet, here we are. The BSE Smallcap Index has not just recouped losses, but surpassed previous peaks to top the 25,000 mark. With 182% gain, it has outperformed Sensex’s 101% gain in the post-Covid rally.
So far so good. But one can’t help thinking about when the next drop is due.
Taking Cues from History
History never repeats, but it does rhyme. And the trends in historical Sensex-to-Smallcap ratio suggest we are not at an inflection point.
The Sensex-to-Smallcap ratio at present stands at 2.1. Over the past two decades, this has averaged at 2.34. In the past, when smallcaps peaked, the ratio had ranged between 1.3 and 1.7. This suggests there is more steam left in the smallcap rally.
ET CONTRIBUTORSRelative valuation hints at further upside in smallcaps
The history of previous crashes and bull run in smallcaps presents another interesting picture.
ET CONTRIBUTORSSmallcap Index: Crash and rebound history
In the past cycles of crashes and rebound over a decade, the gains in the smallcap index have been over 290% in the a decade. So far, the Smallcap Index is up 182%. Smallcaps have indeed rallied fast, but the gains can extend.
Last few years have not been kind to this smallcap space. Events such as GST, demonetisation, IL&FS debacle (and subsequent liquidity crisis), and now Covid, have wreaked havoc with the smaller businesses in both unorganised and organised sectors in the economy.
But something positive has emerged from it.
What doesn’t kill you, makes you stronger… goes the popular saying. The many smallcaps that have survived these disruptions have been no exception.
The tough times have led to a big cleanup in the listed space. This is evident from the improving leverage ratios of smallcap companies. The stronger businesses have consolidated market share amid formalisation of the economy. With megatrends such as digitisation, drive towards self-reliance, China-plus-one push, and infrastructure focus, the opportunity size and the runway for growth have expanded.
Some of the well-run smallcap companies with strong managements and robust business models are well on their way to become future midcaps. This is especially true for niche leaders that seem good candidates for valuation re-rating.
If you tune in to the latest earnings call, some smallcap companies have posted best-ever quarterly and yearly performances. Amid the pandemic and lockdown, the resilience and resurgence of these business models, and their ability to pivot, has been commendable.
And this could just be the beginning. As the economy and GDP numbers improve, even to pre-Covid levels, the biggest beneficiaries are likely to be in the smallcap space.
The Caveat
Most smallcaps – good, bad and ugly –have performed well since the crash last year, thanks to cheap money, rising investor base, and momentum in the markets. When the tide turns down, a lot of these would be found swimming naked. In the meantime, the lure of gains in smallcaps could induce a false sense of skill. This along with fear of missing out could make one bet more recklessly and with no regard to asset allocation.
Even businesses that aren’t downright ugly, are no more available bargain prices. Indeed, the downside risks in some of them could be higher than upside.
So, what’s the best way forward?
Smallcap Opportunity beyond Cyclicality
Timing the market is a skill no one has perfected. And we won’t attempt that. Putting money on speculative bets would not be the best way to make the most of the smallcaps. It’s time to be selective.
And finding the next smallcap multibagger needs a lot more work than running a screener. One must think from a long-term perspective of three to five years, and work backwards to stay invested in companies and sectors that are going through positive structural trends and could be most relevant to the economy. It should be about the business, and not the market cycle.
Vinati Organics, Astral Polytechnic, Tata Elxsi, Aarti Drugs… these are some of the names that have broken the mould of a typical smallcap stock in the last decade. They have rewarded the early investors with generational wealth, irrespective of the swings in the Smallcap Index.
There are many such names in the smallcap space waiting to be discovered and re-rated. Rather than focus on near-term market movements or quick profit opportunities, think of what businesses and managements you would be happy to own and partner with, respectively. Choose stocks accordingly and let the compounding do the magic.
(Richa Agarwal is a Senior Research Analyst at Equitymaster. Views are her own)
