#Portfolio Action: Stay Away from Small Caps and Mid Caps - Here's why!


Posted By : Kushal Kothari

It is never a good idea to predict market movements. Especially so as an adviser. Because the first rule of investment advising asks one to forget looking at market movements and stick to asset allocation over the long term. But when the market conditions get stretched to dizzying heights, one cannot help but wonder - What is really going on here!

 

A quick recap - About 8 months ago, when Nifty reached the levels of 9500, we sent out a blog post to all our users to be wary of any lumpsum investments, especially in the small and mid-cap segment. We didn't have much of a fundamental rationale for the same, but it was an opinion more from a valuation perspective, especially the PE ratio. You can read the entire post at -

#Portfolio Action: Markets are near all-time highs! Here's what you need to do with your portfolio

 

Fast forward today and we have been proven wrong. And how! The broader market Index is close to 11,100, nearly a 17% return in just under 9 months. The valuations have only stretched further and inflows to mutual funds have swelled to almost 22 trillion rupees. Yet again, we write to remind our investors about the perils that possibly lay ahead, with our rationale for the same.

 

1. Valuations:

We highly believe in the valuation metric of the PE ratio. Yes, it is prone to cyclical churns and, yes, the 'normal' levels vary from industry to industry. But when you are looking at the PE ratio for a broad market index such as Nifty or Nifty Midcap, especially with respect to its historical levels, one gets a very good sense of how rational or irrational the markets are. For more info on the PE ratio, refer again to our post at - #Portfolio Action: Markets are near all-time highs! Here's what you need to do with your portfolio

For the sake of today's discussion, let us look at the PE ratio for Nifty Midcap as downloaded from NSE India's website.

Nifty Midcap PE 2011 to 2016

Between Jan 2011 and Jan 2016, the average PE of the Nifty Midcap was 15. Even at a level of 20 on Jan 2016, it was nearing statistical highs relative to its historical levels

Nifty Midcap PE 2011 to 2018

Once you look at the dataset between 2011 to 2018, the average PE shoots from 15 to 26!! The current level of PE is a mind-numbing 86 (which is still much better than 108 that was recorded in December 2017). The market is almost at 3 Standard deviations from its historical average PE. Assuming a normal distribution curve, this means that there is a 99.85% chance that these valuations will come down.

This is how to interpret the current PE level of 86 - For a security that earns you 1 rupee per year, you are willing to pay 86 rupees to buy it, while the rule of average says that you should not be paying more than 26 to own it!! (26 being the average PE level over last seven years)

 

2. An ear to the ground

We spoke to Fund managers, PMS analysts, Sales personnel from many fund houses and their view was pretty much the same. While most agree that broadly markets are euphoric to levels not seen since 2007, the movements in the small and midcap segments have been causing a heartburn to everyone associated with the industry. Everyone, except the many retail investors who expect to continue getting 40%+ returns that this segment has given in the last 3 years. Many small and midcap schemes have stopped accepting investments and some PMS (Portfolio Management Schemes) have started returning money to their investors for the lack of reasonably priced opportunities in this space. Maybe this time things are different, but in that case, all you are hanging on to is hope while ignoring every solid evidence on the ground.

 

3. Fundamental Speaks

The economy is growing at a good pace of 7%+ this year. The inflation is much better under control. The effects of GST and DeMo shocks are starting to wear off and there is a whole lot of hope of better corporate earnings in the coming two years. Even accounting for everything to go right over the next few years, including a second election win by NaMo, by all historical accounts we are pretty richly priced. 

 

Actions:

#1 Avoid lumpsum investments in Small Cap / Micro Cap at all costs - Stay away from lumpsum investments in any small-cap and mid-cap schemes at this stage. With lumpsum investments, timing matters significantly. And that is pretty much the crux of our article today - It's probably not the best time to invest in the small-caps/mid-caps in today's scenario. If you have a significant chunk of savings, consider parking them in a money-market or a debt fund and initiate an STP from the same. More on this in our last article here - What is a Systematic Transfer Plan (STP) and how to use one?

 

#2 Don't pull the trigger on SIPs yet. More from a behavioural perspective - The biggest risk to an investment plan is not the market movements, but the risk of not investing at all. As long as your investment horizon is greater than 5+ years, your SIPs in Equity schemes will pay off eventually. One could consider limiting the investments in small-cap schemes but do not stop investing. Pay attention to your asset allocation and make changes accordingly. 

 

#3 Normalize your expectations - If there's one message that we would want you to take away from today's article, it's this. The 40-70% returns that many of the small-cap schemes have delivered over the last 2 years are an aberration; it's a combined effect of a euphoric global market combined with improving economic and political conditions in India. Learn to expect less from your investments in these schemes. Look at the long-term average of these schemes, which is usually just about 20% or less. Expect even less going ahead as markets mature and growth moderates over a long-term horizon.

 

Risks:

Market's are anything but rational. Is another 10% upside from these levels likely? Sure. Should you expect it? Perhaps not. What we can do for sure is to pay heed to some glaring signals such as the ones we've highlighted and act on them. For micro decisions such as stock picking, let's leave it to the experts. After all, that's the reason we invest in Mutual Funds, don't we?

 

Ping us for any further queries you may have. Happy Investing!

 

P.S: A reader pointed out to consider Nifty Midcap 150 instead of Nifty Midcap 50. The Midcap 150 index has a much shorter history available. Even so, the PE of this wider index is still at +2SD deviation over a history of last 2 years. We don't think this materially impacts the analysis and hence choose to stick to the analysis with Nifty Midcap 50.