Capitulation of the small-cap investor

By Guest |  06-06-18 | 
 
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Morningstar invites thought leaders from the investment community to share their insights. Views expressed are personal and should not be construed as investment advice.

Shagun Jain is vice president at Kotak Mahindra Bank. In this very engaging post, he warns investors how easy it is to get carried away, and how to proceed if you have burnt your fingers.

The heady Indian bull market was fueled by the liquidity rush post demonetization. But that was not the only reason propelling indices in India to new highs. Thanks to lower global interest rates, money was channelized into India in the hunt for better returns. A stable government at the center, lower crude prices and low inflation were other factors that contributed to the overall positive sentiment.

But many of us wanted more than what blue chips had to offer. We wanted to “beat the market”. Or, for that matter even the track records of legendary investors like Warren Buffet or Peter Lynch. Naturally, this led us to scenarios which offered potentially superior returns. And in the perpetual hunt for 10-baggers, we ended up investing in nano-, micro- and small-cap companies with questionable business models, corporate governance and promoter intentions.

We looked at:

  • Turn around stories
  • Hope stories
  • High growth small cap names
  • Formalization of informal sector across industries
  • Commodity stocks

Many stocks that fell in the above categorizations turned out to be 10-20 baggers over the last 3-4 years. But once the music stopped, we witnessed a vertical decline in stock prices that has stunned even seasoned investors.

What goes up, comes down for sure since markets, business models, sentiments, scenarios, promoter intentions etc. change for the worse more frequently than for the better. There are very few companies which can continue to grow at a respectable growth rate for a decade or two, my guess is probably one in a million. In India we might have 2-3 companies in the universe of 8,000-odd listed companies. You probably know the names.

In the chase for multi-baggers, we forgot the most important and basic tenets of investing – earnings, cash flow, debt management and corporate governance.

  • Instead we ended up giving 20-25 price to multiples (P/E) for commodity companies conveniently forgetting the historical average PE for such an industry was anywhere between 5-7.
  • We assumed some companies have indefensible pricing power, forgetting that super normal profits attract competition in ways we can never imagine.
  • We witnessed promoters buying their own stock from the market (for most names) implying a narrative that it indicates good results are on their way. We never cared who sold the shares to them in declarations filed to exchanges. One never know, it could have very well been their benami companies.
  • Companies started declaring profits which they never did for the past few years, indicating to many of us that we hit upon the elusive 10-bagger.
  • Neither did we care to find out how the Chinese can afford so much mass unemployment if they were going to shut out all their polluting factories permanently whose direct benefit moved to Indian companies.
  • The story moved from one sector to another - Paper, Chemicals, Steel, Metals etc and we investors tried catching the running train jumping when there was a halt at a platform.
  • We blindly followed well respected investors (all due respect to them) who made numerous media appearances, without comprehending that the stocks they are betting on is pocket change for them, but for small investors like us it forms anywhere between 5-10% of our portfolios.
  • Leave aside general stock market discussions, of which there were plenty. WhatsApp groups mushroomed not only for sectors (Defence, Infrastructure, Commodities etc.) but for individual companies, the next hot stock in the market. It was a race to get into such groups. Those who were not part of a particular group felt completely left out.

After a meteoric rise, we are now witnessing a dramatic decline in the prices of stocks we once loved. Since we love upward averaging, many of us will be negative on portfolio levels and will keep watching the prices tending lower day by day.

Winter has arrived. And has brought the bears along with it.

If you still believe that this is just a blip in the greatest bull market, or should I say, “the mother of all bull markets” you are most certainly delusional.

If you have made losses, take it in your stride. Consider it as tuition fees the market takes from you for learning valuable lessons.

So, what next?

  • Debt free blue chips (many many listed in India)
  • Growth stories (with good corporate governance)
  • Cash flows (with cash being generated at operating levels)
  • Return expectations (Buffet/Lynch – 27-28%, Fixed Income – 7-8%, Aspirations – 15% half of legends)

Over the past few years, I have been guilty of lapses in investing and have fallen victim to the market frenzy. We cannot become millionaires, and stay that way, by investing in markets in a jiffy.

It takes years of disciplined investing, surviving 2-3 cycles of bull/bear markets and greying hair (purely in terms of experience), to arrive at a decent-sized portfolio.

Get back to basics. Summer will eventually be here.

Shagun Jain blogs at liberatedsoul.com and tweets at @liberatedsoul3

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