Opinion | Investments in small-caps will be beautiful, but only selectively

The market rarely repeats a winning theme, so you should be circumspect on small-caps

Is this the right time to buy small-caps? This question will easily qualify for the most frequently asked question award within the investment community. Everybody wants to know when is a good time to back their truck into the small-cap space. Institutional managers have already begun giving calls that this is a good time to invest into small-caps. The obvious reason given for this advice is that small-cap valuations have significantly moderated from the peak levels seen in 2017 and early 2018. Relative to the elevated valuations seen during the last bull market, stocks definitely look much cheaper. And, small-caps becoming multi-baggers within a short burst of time are fresh in public memory. But are they cheap enough for an aggressive re-entry? Will valuations of small-caps revive the way they did in 2014-2018?

The debate on which segment of the market will perform well in future is a recurring and endless one. From one bull market to another, investors seek to understand the big investment theme of the future. Everybody wants to be on board early to the winning theme of the next bull run. So, the search for the best way to do it begins after markets sharply correct. And, with every market fall, the investor’s search gains momentum. The first point of stopping is the best theme from the last bull market. So, as we come out of a bear phase, the easiest port of call is the favourite theme from the last bull run. We simply head to that point by sheer habit of force. Moreover, many among us will be regretting that we did not benefit enough from the last bull run. What better way than getting ahead of the market and entering the very themes which ruled sentiment just a year ago?

The hurry among market participants is quite palpable. But the fears are still running high, such has been the erosion in the valuation of small-caps. The small-cap indices don’t tell the real story of the bloodbath. Individual stocks have lost more than half of their peak valuations. Most of us are anchored to the peak price of favourite stocks and it comes naturally to expect these stocks will regain lost value and recapture old peaks soon enough. We think the peaks are easy to reconquer. But, history has lessons for us. And, the market context in which small-caps hit it big always have a strong regulatory angle.

There are some serious pointers which address the questions raised in this piece. Firstly, the regulatory context in which stocks gained valuations rapidly during 2014-2018 has dramatically changed. Volatility is being aggressively addressed now by advanced regulatory processes. This makes it impossible for stocks to regain valuations within short bursts of time. This was easy in the pre-ASM (additional surveillance mechanism) era when stocks gained price with minimal safeguards against price volatility. But the future will see aggressive market action always taking a force-pause when price volatility spikes. Regulatory and surveillance processes followed by stock exchanges are definitely going to effectively cool tempers and soothe nerves. So, expecting the old price moves is hardly right.

A greater reason to be circumspect on small-caps is that the market rarely repeats a winning theme in successive cycles. Our needs to find new winners, better themes and investing on trends are always compelling. Investors shift focus and start looking at the future to identity the newer trends. While the small-cap as a category could well throw up some exciting ideas, these may not be the market favourites of the recent past. Investors must get ready to play the game by adapting to emerging market conditions, reading the trends smartly and identifying the smart businesses of the future. Small will be selectively beautiful.

Shyam Sekhar is chief ideator and founder, iThought

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