June 2023 / Q1 FY24

01Twenty Years, Four Cycles — Small Caps Lead, Then Lag, Then Lead Again

We tried breaking up the returns in blocks of five years to get a better perspective of cycles. During the years when markets have done well, Small Caps tend to do better than the Nifty (2004–2008 and 2013–2018), and likewise suffer the most when the tide turns (2008–2013).

While one may be enthralled with Small Cap returns over the last 3 years (32% IRR vs Nifty’s 21%), on a 5-year block the small-cap index is lagging far behind the Nifty:

02Valuations Still Not Showing Any Bubble

Despite headline indices making new highs, current valuations are just around the long-term averages and way off the peaks made earlier. On the contrary, the Small Cap index valuation — even after the run-up — is still well below the average valuation at which it has historically traded.

2ACorrelation of Nifty and Small Cap Index

We looked at the Nifty and NSE SmallCap 100 data from 2005 and found the following correlation thresholds:

Normally, after touching 0.65 markets turn irrational and can go either way — back to 0.5 or continue overly optimistic. The same holds true below 0.5 — markets turn irrational and can go down to 0.41, but they will rebound eventually. Currently we are at 0.58 levels. Unless there is a trigger, we should not see a significant rebound till we touch the 0.65 ratio — last touched in December 2021, post which there was some correction. During March 2023 the ratio was at 0.51 (the lowest since December 2020), causing a sharp turnaround.

The last 5 years were a period of depression and pessimism for the small-cap space; this quarter that has changed to optimism — but we are still to see the markets turn over-optimistic.

2BWhy Are Some Small Cap MFs Stopping Fresh Inflows?

A couple of Small Cap Mutual Funds announced that they have stopped taking fresh inflows, which would have naturally created some anxiety in investors’ minds. One needs to understand a couple of things here:

It is for this primary reason that some of these funds have stopped taking fresh lump-sum allocations — and not otherwise. We believe this anomaly may give rise to some volatility as investors look to book profits in stocks that have seen quick run-ups. The key will be to stay disciplined while entering — and not budge on reasonability of valuation. It is this volatility that gets perceived as the risk of investing in the current market.

03Volatility vs Risk

Volatility is the tendency of something to change quickly and unpredictably — which means it includes both price corrections and rises, rapid and erratic. This movement can be caused by sentiment, domestic indicators, global causes, and liquidity. Most academics refer to volatility as a risk to consider while investing. But is price movement really a risk?

Risk refers to the potential financial loss inherent in any investment decision — put simply, the probability of permanent capital loss. In our experience, permanent capital loss takes place due to shortcomings in the business and/or industry, not due to market movements. While in the short term volatility might feel like a risk, over a longer period cycles of downside volatility are opportunities.

3ASmall Cap Investing: How Risky Is It Really?

A statement we hear quite often is that small-cap investing is a risky proposition. But is it really risky? There are broadly two types of risks:

Unsystematic risk can be avoided by thorough due-diligence, research, and understanding how companies and industries work. As Warren Buffett famously said, "risk comes from not knowing what you’re doing." Conversely, systematic risks can’t always be planned against and are difficult to anticipate.

But are these risks specific to small caps? History suggests otherwise. We have seen large reputed organisations fall prey to both these risks — for example, Yes Bank crumbling due to its poor corporate governance standards (unsystematic risk) or HEG / Graphite correcting substantially due to a change in the steel-graphite cycle (systematic risk).

Yes Bank — A Large-Cap Casualty of Unsystematic Risk

HEG Ltd — A Large-Cap Casualty of Systematic Risk

Large caps are not immune to risks; they are just less volatile — because they are well covered by brokers, traded into by institutions, and have adequate float. The lack of information available on small caps, the lack of discovery, the lack of free-float, and the untested managements of small caps is what leads to excessive volatility — but this is also what leads to superior returns.

We are constantly looking for pockets of value, and as an organisation look to gain from the volatility presented by implementing staggered buying. We do expect bouts of volatility and corrections, but continue to believe strongly in the long-term India story and remain upbeat about our investments. Like they say — this is India’s decade, and the biggest risk will be to not participate in this opportunity.

Please feel free to reach out to us for any feedback or further information.

Sources

01

Nuvama Custodian Services; Equitree Capital internal performance and NAV records (June 30, 2023); PMS Bazaar — Equitree ranked the best-performing PMS across all market caps and categories for Q1 FY24 with 38% return. Returns are TWRR, net of fees and expenses, and not verified by any regulatory authority/SEBI.

02

NSE; Equitree Capital — 20-year absolute returns: Nifty 50 +911% vs NSE Smallcap 100 +1012%; cycle-block returns (price-index basis) for 2004–2008, 2008–2013, 2013–2018, and 2018–2023.

03

NSE; Equitree Capital — IRR for Nifty vs NSE Smallcap 100 across the inception-to-2018 vs since-2018 windows (Nifty 13% / 12%; Smallcap 17% / 4%).

04

Bloomberg; Ace Equity; Equitree Capital — Nifty 50 and NSE Small Cap 100 valuation table: Forward P/E, TTM P/E, P/B (peak / lowest / average / current).

05

NSE; Equitree Capital — Nifty-to-NSE-SmallCap-100 ratio extremes since 2005 (avg 0.65, high 0.95, low 0.41); current 0.58; March 2023 0.51; December 2020 prior low.

06

NSE / yfinance — YESBANK.NS monthly closing prices, January 2010 through July 2023; peak ₹367.95 in July 2018; trough ₹10.80 in August 2021.

07

NSE / yfinance — HEG.NS monthly closing prices, January 2010 through July 2023; peak ₹859.35 (split-adjusted) / ₹4,296.75 (pre-Oct-2024 1:5 split scale) in July 2018.