Showing posts with label Midcap. Show all posts

Wednesday, January 6, 2021

Past performance not a guide to the future

Famous Spanish-American philosopher George Santayana famously said, “Those who do not remember the past are condemned to repeat it”. One of his less famous saying however was, “And those who do study the past are just as likely to make the same stupid mistake as those who do not”. The latter thought applies to the stock market participants more than the first;

Even though the standard guidance to the market participants is that historical performance is no guarantee to the future performance; most of the analysis and behavior is usually based on extrapolation of the past trends.

Analyzing the present consensus view of the analysts, strategists, investment managers and traders about the likely performance of Indian equities in short term (mostly next twelve months), I find that there is an unusually overwhelming consensus on the following trends:

(a) The small and midcap stocks may do significantly better than their large cap peers largely due to sharper earnings upgrade.

(b) Cyclicals businesses (commodities, auto, industrials and financials etc.) may do better than the secular businesses (FMCG, Pharma, Technology etc.) as the economic recovery gathers steam.

(c) Growth stocks (businesses which have direct correlation with the economic growth like cement, steel, capital goods, oil & gas, financials, transport etc.) shall do better than the value stocks (stocks mainly bought for dividend yield, wealth preservation and secular growth, e.g., large FMCG, MNC Pharma, etc.) on relative cheap valuation.

However, a deeper peep into their analysis, gives an impression that most of them are relying heavily on the past underperformance of value, cyclical, mid and small cap etc.

In past 3 years (2018, 2019, 2020) The benchmark Nifty has gained ~34%. Only IT, financial services and services sectors have done better than the benchmark Nifty over this period. PSU Bank (-52%); Media (-52%); Auto (-23%) and Metals (-23%) have been major laggards. Small cap (-22%) and Midcap (-1%) have also lagged significantly.

This underperformance might to be the key driving force behind the present consensus view. I have absolutely no view on the correctness or otherwise of the consensus view, as it has no influence on my personal investment strategy. Nonetheless, I would like to share the following observations with the readers:

· The small and midcap basket usually includes the following five categories of stocks:

(i) Companies which are relatively new in the business. These companies may be growing fast and have the potential to become large; or they may not have potential to grow materially.

(ii) Companies which were much larger in past but lost the advantage or made strategic mistakes on leverage, expansion, products etc.

(iii) Companies which are older, stronger but their businesses are not scalable.

(iv) Companies which have no meaningful business, but are listed on stock exchange for a variety of reasons.

(v) Companies which have highly cyclical business. These companies do very well when their business cycle is good, but usually lose the entire gains in down cycles.

· New companies with high growth potential and strong older companies with sustainable high dividend yields are the categories that create tremendous wealth for the shareholders.

· Highly Cyclical businesses give massive returns to the investors who understand the business cycle and are able to buy the stocks at cusp of the upcycle and sell before the party ends.

· Rest all categories usually inflict losses on investors; which in many cases result in erosion of entire capital invested.

· Another noteworthy observation is that many small and midcap companies that appear to have given stupendous return in one market cycle, just disappear from market clandestinely. All hopes of recovering the losses made from investing in such companies, in future market cycles, are usually belied.

From the above observations, it could be deduced that to make meaningful money from small and midcap companies, one has to either have strong knowledge of the business cycles or have materially higher risk taking ability.

Smaller investors like me therefore should resist the allurement of quick gains. If they must, they should prefer to invest in a small and midcap fund managed by the professional fund managers, who have good knowledge of the business cycles and are usually emotionally unattached with any particular stock.

Wednesday, March 18, 2020

2020 not like 2009

The sentiment on the street eerily looks similar to the one we saw during 2HFY09, post collapse of Lehman Brothers. In those days, the rumors of large banks declaring bankruptcy, sovereign defaults, imminent EU breakup, market freeze, sounded absolutely believable. These were not only market grapevines believed by the common investors. Many senior analysts at global investment banks wrote scary reports about these eventualities. Globally reputable, economists and strategists pained doomsday scenario of global economy slithering into a deep abyss to compete with the great depression post WW-I.

In India, many depositors transferred money from private banks to the public sector banks. Investors summoned their advisers for details of their liquid fund portfolios. The fixed maturity plans (FMPs) backed by bank CDs were pre redeemed by paying penalties. Capital protected structured products were also called prematurely by incurring material losses.

Some of the readers have likened the current situation to the 2009 panic sell off. A few believe that going by the reactions of central banks in the developed world, it appears to be already worse than 2009. Many readers have wanted to know my view as to how much worse it could go before the rock is hit.

To all my readers, I would request that I am no Taleb, Rajan, or Roubini who can assess the gravity of situation and make a prophecy almost instantaneously. I am an ordinary micro investor in the local Indian financial markets, who can access the data relating to past trends with some efforts and roughly correlate that data with the present conditions to make a naive assessment of the situation.

My assessment of the present situation is that presently we are nowhere close to the rout in asset prices seen in 2009. In 2009, Sensex had ended 18% lower than the July 2006 level from where the bull market had started. The BSE Midcap and BSE Small Cap had ended the cycle 36% and 41% lower than the starting point.

The current bull market started from end of February 2016. As of yesterday, the Sensex was higher by 36% from the start date. BSE Midcap and BSE SmallCap were higher by 24% and 16% respectively. Besides, the gains recorded during 2006-2008 were much higher than the gains made during 2016-2018. The severity of the fall in 2008-09 was therefore much more intense and deeper.

In my view, we may not a fall like 2006 this time, because of the following four simple reasons:

(a) Foreign investors had pumped in huge money during 2004-2008 in Indian equities. This time they are huge net seller during 2016-2020 period.

(b) The earnings growth fell off the cliff during FY09 to FY11 period leading to de-rating of Indian equities. This time the earnings growth has remained anemic and has little scope to disappoint materially. In fact it may surprise on the upside from 2HFY21 onwards.

(c) Indian's economic growth has seen multiple downgrades in past two years, unlike 2008-10 when the world had great expectations from India's economy.

(d) Presently, the leverage in Indian stock market is significantly lower than the 2008-09.

Nonetheless, we may certainly fall further from the present level, before hitting the rock.

Tuesday, January 7, 2020

There may not be enough fishes at the bottom

Couple of days ago, a friend forwarded the following chart which suggests that small cap stocks may be offering once in many year opportunity, as the value of small cap index compared to the Sensex has fallen to the point from where this index has rebounded sharply on each of the previous three occassions since 2003, when the BSE Small Cap Index was first launched.

If the strategy notes for the year 2020 published by various market participants are any indication, a significant majority of the market participants appear inclined towards this view.

Since some people have asked, I would like to share my view on this aspect. In my view, this is a purely academic exercise for three simple reasons:

1. There is no mechanism whereby an investor can directly invest in a Smallcap Index. To my knowledge there is no ETF available on the Small Cap index. It is almost impossible for an investor to buy all 60 stocks in BSE Small Cap Index or 100 Stocks in NSE Small Cap 100 Index to replicate these indices in his/her portfolio.

2. The elimination rate in small cap space is usually very high. A large number of Small Caps that performed very well during a particular market cycle, are less likely to repeat their performance in the next cycle. In fact, most "good quality" small cap stocks migrate to mid cap or large cap category in each market cycle, whereas a large number of small caps become micro cap or penny stocks.

If someone had invested in a basket of top small cap stocks in 2009 or 2014, there are almost 75% chance that stocks in that basket have either moved higher to mid or large cap or become useless losing 70-99% of their value. IN the next market cycle, wherever it happens, in likelihood we shall see a new set of "outperformers" and "multibaggers".

3. In 2001 and again 2013-14 the ratio become worse after hitting the rebound line. If one invested at the first hit, there are chances that he lost 25-30% before the rebound actually happened.

It is also pertinent to note that, while the Small cap to Sensex ratio has hit the rebound line, the Midcap to Sensex ratio is still some distance away.

What may not work in 2020 and how to separate the wheat from the chaff