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How to approach small cap and mid cap allocation in your equity portfolio now?

Small caps and mid caps are the darlings of the market again and outperforming the index stocks.

Let’s examine the performance of small cap index over the last 5 years:

NIFTY Small cap index

NIFTY small cap saw a one-way rally from 4,900 levels in April 2016 to 9,580 by Dec 2017. This was followed by a one-way fall of 67% to 3340 levels in March 2020 (the last leg of the fall was exacerbated by Covid panic but even without this, the fall was significant). And finally, a one way rise over the last 1.5 years from 3,300 in March 2020 to 10,200 now.

Here’s what the Nifty has looked like during this period:


If one summarizes the general public mood:

2017: Everyone loved small and mid caps

2019: There was an aversion 

Come 2021: Everyone loves them again

While the performance of individual stocks would vary a lot, it is clear that the love and hate cycle is much more pronounced in smaller companies than in large caps. Why, you ask?
The image below says it all:

Image credits: Kal Print; www.Kaltoons.com

As early entrants start making money in small caps, more are attracted. Some buying takes the prices much higher in smaller caps (versus large caps) due to lesser volumes. More people get attracted. In some companies, promoters take the help of operators in shoring up prices through circular trades and other means. The movement upwards continues.

This trend finally breaks when a large volume of sell orders from investors or operators finally hits the market. This fall is accompanied by some explanatory reason or the other as a justification for the fall. And, so the cycle reverses and gradually risk aversion takes over. Everyone now wants to exit, but the liquidity dries up. The investors who entered late in a rising stock hoping to make a quick profit are often left holding the bag.

Therefore we arrive at the important question:

What percentage of equity allocation should today go towards Small cap and mid caps?

The larger question, of course, is what should be equity allocation in one’s portfolio. There is no one-size-fits-all answer to that, and is a function of individual goals and risk profile.

The answer on allocation to smaller companies is again that there is no simple answer! Small caps are more difficult to analyze because of:

  • Inadequate analyst coverage and lower transparency 
  • Weaker accounting standards 

If you have seen multiple market cycles AND you or someone you trust spends time and effort in understanding these companies, then by all means decide your small and mid cap allocation depending on your risk and return objectives.

If you have entered the market recently, and specfically in 2020 or 2021, do read on...

Many new investors have entered the market in 2020. Congratulations to them. They did better than many Ultra-HNIs. Many of the Ultra-HNIs we speak to became too cautious and missed investing in the bear market of 2020. We hope that many of the new investors will become permanent investors in the equity market and create wealth for themselves. 

Here are some lessons for small cap investors from bull market history:

1) Look to create wealth over years and not months

We have seen that in every bull market, many new investors enter. Some stay in the markets for a long duration and enjoy the benefits of compounding. A few keep allocating more money as smaller companies rally hard in bull markets, and make large losses when the bull market ends. Then they swear never to enter the markets. Think it over. 

You will probably know a friend or relative who has lost money in a previous bull market and now only invests in property and fixed income. What’s not taken typically into account here is that only a small part of their loss is what they lose in money. The much bigger loss is that they miss out on the benefits of compounding in future years.

One take-away is, don’t increase allocation to smaller companies at this time as they are now more expensive compared to their own historical averages as well as large caps.

2) Recency bias in part of human DNA – don’t become over-optimistic

Recency bias works favorably in many other situations but not necessarily in investing. Recent great experiences in mid and small caps can make it tempting to allocate more and more money to smaller companies now. However, increasing allocation at this point could be a risky proposition after the huge outperformance of small caps over large caps from April to July. 

There is anecdotal evidence in August that some money is being rotated to large caps from small caps by some large PMS funds and others. 

3) We believe that only half of investing is about understanding companies and businesses. The other half is psychology and can only be learnt by personally experiencing market cycles. It is part of a process of self-discovery and learning. Hence, keep room for investing in smaller companies if their prices go down in future and dont be fully invested in smaller companies today.

Recommendations:

For new investors, post the recent rally, small and mid cap exposure as % of overall equity exposure could range from 5% to 35% depending on their conviction in the operating performance of the underlying companies. Here is what you should do:

  • Maintain decent large cap allocation to protect against volatility in smaller companies as they are now expensive compared to historical averages
  • Avoid stocks in the Z Category
  • Avoid stocks where promoters are reducing their stake. We have prepared a handy list for you!
  • Avoid stocks where the upside story revolves around things like “huge land bank worth x times the market cap” or “a reputed investor or MNC is about to acquire a stake” and not around operating performance.
  • Go through every small/ mid cap in your portfolio and be doubly sure of cash flow generation over the next 2 years. Be selective.

Net net (my take):

I remain positive on equities, given the global low interest rate environment and strong demand momentum in the economy. Housing (the big one), steel, non-ferrous metals, cement, textiles all are doing well. 

But in the small cap space, conviction on quality and cash flow generation is key to get you the future multibagger (which number would have reduced after recent run-up) and not the loss-making stock. In absence of that conviction, replace smaller companies with large caps. We are seeing some signs of money rotation from smaller companies to large caps in August.
All the best! 

Regards
Sandeep Baid
Co-founder, Multipie

Read more on the Multipie Blog and subscribe to get articles such as this directly in your mailbox and to join the Multipie App Waitlist. Check out our podcast ‘Breaking Investment Stereotypes’ where we talk to world class investors/wealth managers and deep dive into their investing journeys.

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