Showing posts with label Small Cap. Show all posts

Tuesday, September 12, 2023

Mice chasing the pied pipers

In the past few days, I have picked up many red flags that have further strengthened my conviction that the markets may be running far ahead of fundamentals. In my recent posts, I have pointed out how the market participants have been extrapolating events like ISRO Moon mission (see here).

For example, the following three occurrences underline greed's dominance and gradually permeating irrationality in investment decision-making.

1. Recently, one popular finfluencer tweeted a list of some small and micro-cap stocks highlighting that their market cap is less than their current order book. Many of these stocks witnessed heightened buying interest, apparently from small household investors, following the tweet. The message was fervently circulated on other social media, like WhatsApp. I received the message through at least nine forwards from different sources.

All forwards appeared to endorse this seemingly manipulative message. No one on social media questioned the correlation of market cap (or enterprise value) with the order book. No one bothered to highlight the sudden jump in the order book, not substantiated by the overall economic activity. No one bothered to check the margin profile of orders received.

In fact, there are many instances in the market where the stock rises 10-15% just on the news of receipt of an order. One mega-cap company’s stock rose 5% in a day on the back of a news item that the company may have received two orders worth US$4bn from a foreign entity, to be executed over the next five years. The annual execution of this order would be less than 3% of the company’s annual revenue, and the margin profile of the order is still unclear. In the past, such orders have not been too profitable for the company.

2. On August 10, 2023, the Prime Minister, replying to the debate on the no-confidence motion, said in jest that stock market investors should invest in PSUs, which have been criticized by the Opposition parties in the past. Most PSU stocks registered material gains after the PM’s statement (see here). A case in point is the share price of a trading public sector company, which has incurred operating losses in the past four quarters. The share price of this company rose over 80% within three weeks after the PM’s statement.

3. A large reputable brokerage yesterday sought to caution the market by dropping its midcap recommended portfolio. The brokerage noted, “We see limited point in trying to find fundamental reasons behind the steep increase in stock prices of several mid-cap. and small-cap. stocks. There is no meaningful change in the fundamentals of most companies; in fact, they have worsened in many cases. The primary driver of the rally appears to be irrational exuberance among investors, with high return expectations (and purchase decisions) being driven by the high returns of the past few months.”

A strategy note released by the brokerage highlighted that “market sentiment is quite exuberant, based on (1) steep increase in the prices of many mid-cap and small-cap stocks; (2) large inflows into mid-cap. and small-cap mutual funds, and (3) huge number of new retail participants in the mid-cap and small-cap funds.”

The small-cap and mid-cap indices recorded strong gains yesterday, mostly ignoring the caution to the wind.

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.

Tuesday, September 15, 2020

My two cents on this multicap chaos

The last weekend was unusually hectic for most participants. Friday evening, the market regulator issued fresh guidelines for asset allocation by the mutual fund schemes operational under the "multicap fund" category. The guidelines specify that these mutual fund schemes must allocate at least 25% of assets under management to each of large cap, mid cap and small cap category of stocks. SEBI also directed that the minimum equity allocation of these funds shall be 75% (presently 65%) at any given point in time. The mutual funds are required to comply by these directions in six months, i.e., by February 2021. SEBI further clarified that these guidelines have been issued further to the guidelines regarding categorization and rationalization of Mutual Fund Schemes issued in October 2017.

It is pertinent to note that as per SEBI directions, top 100 listed companies in terms of market capitalization are categorized as Large Cap. Companies ranked 101 to 250 are categorized as Mid Cap and the others come under small cap category. As such, NMDC is 100trh ranked stocks with Market of Rs27500cr; P&G is 250th ranked stocks with Rs8100cr market cap. So stocks below Rs8100cr market cap are small cap stocks.

Over weekend most of the brokerages and AMCs came out with their views on the proposed changes. The brokerages' reports were mostly focused on two aspects" (i) how much money will have to be reallocated from large cap to mid and small cap stocks to comply with these guidelines; and (ii) which are the stocks that could see higher demand due to this reallocation exercise and what is the trade opportunity in this. The AMCs mostly focused on highlighting the challenges in compliance.

I am sure that any guideline followed or not followed by mutual funds has any bearing on my investment process or investment strategy. Given the past track record of a large majority of Indian mutual funds, I do not draw any comfort from the due diligence done by mutual funds as to the quality of any business or credibility of any company (and management).

I do not find any substance in the argument of higher demand from mutual funds leading to sustainable re-rating of a stock. We all have seen in recent past, the high MFs holding into a small cap stock is a two edged sword. In the good times, the stocks run up sharply; and when the tide recedes the losses are also overwhelming (remember 8K Miles, HEG, Graphite, Eveready etc.) Even the best of the fund managers have lost huge money in stocks like JP Associates, HCC, NCC, Jet Airways etc. In the present times also I find many mutual fund schemes holding commodity (including chemicals) stocks where the companies have seen sharp rise in earnings due to temporary commodity price cycle. We shall see a repeat of HEG & Graphite in these stocks in 2021 for sure.

Another thing I am missing is that no one has dared question the validity of the rationale and authority behind the October 2017 and the current circular of SEBI. In my view, the following questions need to be asked to SEBI:

1. Why AMFI does not have an SRO status? As a signatory to IOSCO charter, it is responsibility of SEBI to promote self regulation in securities market. It is 28years since private mutual funds were allowed in Indian markets. The industry has grown materially in past 10years. Why SEBI is not able to persuade AMFI to become an SRO?

2. A mutual fund investment is a contract between an investor and AMC. The Key information Memorandum (KIM) is an essential part of this contract. SEBI forcing MFS o change KIM for the investments already made may not be good as per the law of contracts.

3. Fund management is not one of the various businesses of SEBI. Why it is not left to AMCs? In case SEBI finds that AMCs are indulging in unfair practices or their conduct is prejudicial to the interest of investors or securities' market, it has enough powers to reprimand and punish the respective AMC, including cancellation of its registration.

Wednesday, July 8, 2020

Are you being fooled to buy junk?

The history appears to be repeating itself for the n^th time in the stock market. The small time traders, who normally join the band wagon right at the top of the market cycle, have once again jumped into the market arena. Completely overwhelmed by the left-out syndrome, they are queuing in hordes in front of the counters where they had lost their fortunes, not long ago. Many of these scrips are trading at a fraction of the price they were trading just six months ago. Some notorious stocks are topping the volumes charts. A strong urge to prove a point, rather than greed, appears to be the dominating factor here. Everyone wants to prove that it was their bad luck rather than lack of financial acumen, which caused them loss last time. I wish luck favours these traders this time. But in my heart I know for sure, this is not going to be the case. This reminds me of a very popular stock market story, which I think needs to be revisited.

“Once upon a time in a village a man appeared and announced to the villagers that he is willing to buy monkeys @ Rs. 10 each. The villagers lured by his offer, went out in the forest and started catching monkeys. The man bought thousands @ Rs. 10 and as supply started to diminish and villagers appeared tiring in their effort, he revised his offer. He announced that now he would buy monkeys @ Rs. 20 each.

This renewed the efforts of the villagers and they started catching monkeys again. Soon the supply diminished even further and people started going back to their farms. The man increased his offer rate to Rs. 25. The villagers would now spend hours in the forest to catch even a few monkeys. Soon no monkey was left in the forest. The man would coax the villagers every day to go and get more monkeys. The villagers would try their best but in vain. As the frustration grew, the man made the offer even more lucrative. He announced that he would now buy monkeys @ Rs.50 each! But there was no monkey.

At this point in time, the man left his servant in the village and left for the city. In the absence of the man, the servant told the villagers, "Look at the monkeys in the big cage that my principal has collected. To help the poor villagers, I am willing to cheat my master. I will sell these monkeys to you @ Rs. 35 each, so that you could sell them back to my master @ Rs. 50 when he comes back from the city.” The villagers queued up with all their saving to buy the monkeys. Soon the servant had sold all the monkeys back to the villagers. He then also left for the city with all the money he had collected. Then there was no trace of the man or his servant. Only monkeys were left in the village.

Thursday, June 11, 2020

I shall hold my horses tightly

In my April review of investment strategy, I had emphasized that "the current crisis is unprecedented in the sense that it has seriously impacted the liquidity, solvency and viability of a large number of businesses, all at the same time. The number of businesses going out of business before this crisis ends would therefore be much larger than the crises faced by global economy in past 75 years since the end of WWII.

The only way out of this crisis is to inflate a colossal bubble in asset prices, which is equally unprecedented." (for full strategy review note see here and the presentation of "the big call" could be seen here)

Incidentally, the global markets have been behaving mostly like I have been anticipating. The central bankers world over continue to inject billions of dollars in new liquidity almost every day. Consequently, the asset and commodity prices are racing to pre COVID-19 period, despite there being definite signs of recessions in the global economy. The more noteworthy part is that the markets have been largely ignoring the warnings that recession this time is not a post facto thing like on previous occassions; it is likely to be there for much longer period than earlier anticipated.

I am not competent enough to make intelligent comments on the economy and markets. Nonetheless, I do possess some wisdom collected over past three decades of investing and studying economy and markets closely. I usually find this small piece of wisdom I own, sufficient enough for making and executing an investment strategy for myself.

I continue to believe that the inflation of bubble in global asset prices will continue. I also believe that Indian assets will participate in the global buoyancy but may not be able match the performance of its peers due to a variety of reasons. The socio-economic conditions in India are worsening at a fast pace and so far there is no hint of any reversal. At this pace, the economy may take much longer to revert to a sustainable growth path of 5-6%, than presently estimated. The rise in Indian asset prices will therefore be mostly dependent on the global events and liquidity. Hence, the volatility and risk may be much higher than usual.

In this context, it disturbs me to note that since the lockdown was implemented from 25 March 2020, the smaller companies (small cap) have outperformed the benchmark Nifty by a whopping 34%. Incidentally this is the segment of economy which is worst affected by the demonetization, economic slowdown, GST, and COVID-19 induced lockdown. The outperformance of this segment is worrisome to the extent that it is commensurate with the facts that domestic flows have receded materially and foreign flows have dominated in past 5-6 weeks. The conventional wisdom is that foreign investors usually invest in large cap liquid names. I am therefore inclined to suspect recurrence of some malpractices by the broker-promote-financier cartel.

I shall totally avoid this space no matter how much my sense of greed incites me.

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