Small-cap stocks in a bubble? Experts tell you how to trade in smaller companies

Why are smallcaps rising?

The sharp rise in the smallcap space can be attributed to healthy buying by foreign portfolio investors (FPIs) after the Q1 numbers. They may still rise for some time as the valuations of some of these companies are still lower.

“Smallcaps have been doing well as FPI flows are largely positive, HNIs have tasted blood in these stocks over the past few weeks and hence are bringing in fresh funds, Q1 results of these companies were either in line or better than expectations as business volumes keep shifting from unorganised to organised sectors,” said Deepak Jasani, Head of Retail Research, HDFC Securities.

“Valuations of some of these companies are still lower than their midcap or large-cap peers. The absence of any large sell-off in the markets lasting more than a couple of days means that investors are not in a hurry to take profits and tend to overlook temporary overvaluations,” said Jasani.

Anita Gandhi, Director at Arihant Capital pointed out that smallcap stocks often outpace GDP growth in a growing economy, making them attractive to investors seeking higher returns.

Additionally, Gandhi added, sustained foreign fund inflows and anticipation of a favourable earnings quarter have boosted interest in equities, particularly in the small-cap segment. This renewed investor confidence and positive sentiment are driving the upward trajectory of small-cap stocks.

Smallcaps in a bubble?

Some experts are of the view that the smallcap space is staring at the risk of correction after the steep rise over the last few months.

Vinod Nair, Head of Research at Geojit Financial Services believes that the valuation of mid and small-caps still remains appealing when compared to the trends of the past seven years. However, considering the overall market consolidation, it may not be an ideal environment for investing in high-risk categories.

“Our view is that India is now more of a stock-to-sector play. We anticipate that the category as a whole will outperform in the medium to long term. Although there has been strong performance in the short term by mid and small-caps, sustaining this in the near term may pose a challenge,” said Nair.

G. Chokkalingam of Equinomics Research Private Limited believes that the domestic market – especially the small and midcap segment – faces major risk in the short-term because of a bubble in the valuation of many smallcap stocks, squeezing liquidity from the secondary markets through a boom in IPOs, several rights issues, and selling of equities by PE funds and FIIs and promoters, steady rise in global oil prices, possible uncertainty from the State elections in November and December, steep increases in many crop prices, and poor monsoon.

“Liquidity is getting chucked out of secondary stock markets and in our view, these resources are most unlikely to come back to the secondary markets in the short term. We are extremely bullish on the medium to long-term outlook of the markets i.e., post 2024 General Elections. However, we are quite nervous about the small and mid-cap segment in the short term,” said Chokkalingam.

How to trade in smaller companies?

Chokkalingam continues advocating some caution in the short term.

“Our preferred equity research strategy is around 5 per cent to 10 per cent cash (within equity asset class), 5 per cent to gold ETF, a tilt towards large and large midcaps to the extent of 40 per cent to 50 per cent (based on investors’ risk profile) and exiting over-valued individual stocks,” said Chokkalingam.

Gandhi of Arihant Capital underscored it is important to note that small-cap stocks tend to have higher risk and volatility.

“Investors should exercise caution and conduct thorough research before entering this space. While small-cap stocks have shown remarkable growth, it’s important to remember that they come with higher risk and volatility. Investors should carefully monitor market conditions, company fundamentals, and external factors to assess the sustainability of these gains. Diversification and a long-term investment approach can help mitigate risks,” said Gandhi.

Given the potential for overvaluation, choosing stocks with solid fundamentals and appealing valuations is crucial. Gandhi underscored that spreading investments across multiple small-cap stocks can reduce risk. A long-term outlook and readiness for market fluctuations are essential.

“Maintaining a disciplined investment approach is wise for those with faith in specific small-cap stocks’ long-term potential. Conversely, short-term investors should contemplate taking profits in segments where valuations seem stretched,” Gandhi said.

Trivesh D, COO of Tradejini advises exercising caution while trading in the smallcap space, focusing on companies with strong fundamentals and positive cash flows.

“While the small-cap sector has enjoyed a prolonged bull run, it’s essential to make informed investment decisions rather than succumbing to the allure of trendy stocks driven by fear of missing out,” said Trivesh.

Shrey Jain, Founder and CEO of SAS Online said for those with a horizon exceeding three years, it makes sense to remain invested in the small-cap equity market, given the exceedingly positive outlook for the upcoming three to five years.

“If you lean toward short-term investing, it may be wise to consider booking some profits in areas where valuations appear stretched,” said Jain.

Kaushik Dani, Fund Manager – PMS, Abans Investment Managers, said with SIP flows too sustaining at current levels, one can expect small-cap space to continue to display strength. However, a bottom-up approach to stock picking is key and one must stay invested based on individual merits.

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Disclaimer: The views and recommendations above are those of individual analysts and broking companies, not of Mint. We advise investors to check with certified experts before making any investment decisions.

Updated: 04 Sep 2023, 06:45 PM IST