Invest directly only if you can pick stocks with good earnings potential

Investors who have entered the markets recently and are gravitating towards mid- and small-caps need to be cautious about the companies they select
Mid- and small-cap stocks have outperformed large caps in the ongoing market rally. Since the market’s low on March 23, the Sensex is up 49.5 per cent, the S&P BSE MidCap Index is up 55.4 per cent, and the S&P BSE SmallCap Index is up 67.6 per cent. 

After this run-up, experts say they are seeing signs of momentum-chasing in some mid- and small-cap counters, which could result in retail investors getting their fingers burnt.

The mid- and small-cap universe underperformed in 2018 and 2019. It also got battered during the March downturn. “After the March lows, the mid- and small-cap indices were at extremely attractive valuations, which led to the recent run-up,” says Pranav Gokhale, fund manager, Invesco Mutual Fund. 

The rally has been broad-based so far. “In future, it is likely to become more selective. Only stock prices of those companies will continue to rise that show strong earnings growth,” says Jatin Khemani, founder and chief executive officer, Stalwart Advisors, a Securities and Exchange Board of India-registered independent equity research firm. 

The economy at large will have to turn around for more mid- and small-cap stocks to show improved earnings performance. “For that to happen, the rural recovery must continue, private capital expenditure must revive, and the government’s Make-In-India initiative must fructify,” says Madanagopal Ramu, fund manager, Sundaram Alternate Assets.

 

 
Valuations are no longer as attractive as they were in March. “Mid-cap valuations are above their 10-year mean, but small-cap valuations are still below their 10-year mean on the basis of positive, adjusted price-to-earnings ratio. Valuations are at the higher end, but they are not extremely stretched,” says Gokhale. 

Valuations have turned frothy in some stocks. “Current prices discount a few years of earnings growth in some cases and some of these stocks are running based purely on momentum,” says Ramu. Things could end badly for retail investors in such stocks.

Many new entrants have chosen to invest directly. “These investors may have made money in the past few months. But now they need to reorient their portfolios towards stocks that will be able to grow their earnings. If they do not have the time or the ability to identify such stocks, they should hand over their money to fund managers who are better equipped to do so,” says Ramu. In stocks where valuations have become overheated, investors should book profits.

When investing in mid- and small-cap stocks, Gokhale emphasises the need to identify strong, scalable businesses with superior return ratios, which generate sufficient cash flows that give them the ability to withstand downturns. 

According to Khemani, investors should stick to stocks where the debt-to-equity ratio is not high, so that the company’s survival itself does not become an issue if the Covid-19 pandemic continues. Investors also need to go with companies whose business models are likely to stay relevant for the next 10 years or more. Finally, they must enter mid- and small-cap stocks with at least a three- to five-year horizon. 


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