Investment University

We were recently dwelling on this very interesting dichotomy that we have witnessed in the Indian stock market in the last 15 months or so.

The conventional wisdom prevailing last year, in the first quarter, was that the GST was going to drive out the unorganized sectors and all the business would flow into the arms of the organized sectors. And then the pandemic came. And this oversimplified opinion, turn into a snowball, with everybody saying that the pandemic would accelerate the demise of the small guy, small companies and would accelerate the market share gains of the large guys.

And therefore, the only game in town was to stick to the comfort of the large caps and avoid the smaller companies or the small caps. So keep buying HDFC Bank, HUL, Asian Paints, and you will keep singing all the way to the bank.

Unfortunately, markets have a very irritating habit (even unfair!) of destroying semi-baked, and yet highly rigid opinions.

So surprise, surprise: the best performing index in the world in calendar 2021 is the....BSE Small Cap Index, up nearly 45%!

And the NIFTY50, in which the alleged market share gainers are tightly clustered in, has delivered a princely 12% year to date, and ranks at a lowly No. 19, just ahead of Italy.

Therefore, when we talk about a bull market in India, do remember that it is tightly focused on the mid and small cap end of the market while the large caps have been largely somnolent.

The reason for this is very straightforward: large caps need a broad economic momentum to deliver growth on their already large bases.

And so far the data does not tell us that the larger, wider economy has recovered from the effect of the pandemic and even the recent lockdowns.

Small cap companies operate in niche areas of the market and they can thrive in periods of relatively low growth because even a small order or a small contract or a small new business line can markedly alter their growth outlook. 

This is exactly what has happened in India in the last several months.

The key question is what now?

I go back to First Global's invention: A proprietary model to look at and predict Equity returns: "The Lake of Returns Theory" (LORT). 

Each market, each asset class has a finite amount of return potential based on its long-term return characteristics. It is like the capacity of a lake or a reservoir. A lake can hold only a finite amount of water. 

When the levels of returns in any asset reach extremely low levels relative to its long-term returns, it becomes time for it to start filling up. And then the return (water) level keeps rising till it reaches overflow levels which basically means that the return levels of this particular asset class has overshot its capacity or long-term trend and then the water floods over and causes massive devastation through a Bear Market.

This proprietary theory of ours has led us to predict practically every single Bull Market or Bear Market in the last 25 years.

The returns from Indian small caps had reached the bottom of the lake because of the bear Market that came in 2018-19 and part of 2020.

The water levels started to fill up only from this year in some momentum.

How much further can the water rise? Well they have reached a certain level where in a small intermediate overflow is possible which basically in Market terms means a breather.

Some data is important: typically, small caps globally, return around 30-50% more than large caps.

Indian large caps have returned around 15% CAGR over several decades. 

Indian small caps, since start of their Index, have returned around 10% till date.

From Jan 2008 till now, they have returned just 5% CAGR! Well below their own "capacity" of 10% annual returns.

The data is clear: Indian small caps, while set for a small, short term "overflow" given recent strong gains, still have plenty of headroom capacity left in their "Lake" before a grand, devastating overflow happens.

Investors should take some gains off the table, remain diversified over at least 25 stocks, not be concentrated in any 1-2 sectors, and not panic in a pullback.

That would just be a temporary emptying of storm water from the "Lake of Returns". Nothing else.

(A version of this article first appeared in The Economic Times)

From the desk of 

Shankar Sharma & Devina Mehra 

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