What to expect from smallcap stocks in 2023

Also, time to be ready for whatever comes next.

You see, ever since China lifted the lockdown, there has been a spurt in Covid cases.

This has cut production. Be it auto or home sales, the figures are not looking encouraging for the dragon economy.

And while globalization is the flavor of the present, the macroeconomic outlook looks uncertain.

I’m not predicting a state of doom and gloom.

But knowing the unknowability of how the macro environment may behave amid several events of global importance, I want to be prepared for developments that may affect the smallcap space.

But here are some reflections first.

If you compare the returns of Sensex with that of smallcap stocks, then this year has been full of contrasts. While the former posted a flat 1% increase, the Smallcap index declined 9% since the beginning of the year.

For the record, in 2022, the BSE Smallcap index saw a gain of 63% against a gain of just 24% in the Sensex.

Since the covid cash, the total gain in Smallcap index is 207% vs 130% in Sensex.

So will 2023 be a mirror of the current year? Or is it time to be wary of smallcap stocks?

Let us see what the Smallcap Index to Sensex ratio suggests.

The Smallcap to Sensex ratio is 0.46 times. This is slightly higher than the long-term average of 0.43 times.

Despite the poor performance in 2022, the ratio suggests that there are not enough low hanging fruits in the smallcap space. In other words, easy money has been made in this space.

And if you’re still at a handsome projected profit on a stock where the growth path seems unclear and valuation makes you uncomfortable, or insiders are taking profits off the table, maybe you should follow them.

At the same time, it is notable that the ratio is still well below previous peaks.

In previous peaks, this ratio was 0.58 times in January 2018, 0.55 times in November 2010, 0.68 times in January 2008 and 0.8 times in August 2005.

Hence, till the smallcap index reaches its peak, there is scope for a good upside with respect to the Sensex’s current levels as well.

So what should you expect from smallcap stocks in 2023?

I for one am cautiously optimistic.

I believe in India’s long term growth story. The possibility of Sensex touching the figure of 1 lakh in this decade is a distant thing.

Even if I stick to the Long Term Median, if the Sensex touches the 1 lakh mark, the Smallcap index may touch 43,000 mark against the current around 27,000 mark.

And this is just the upside potential in the Smallcap index.

This segment of the market holds promise multibagger stock,

The rally in select smallcap stocks could be higher.

Investors should keep in mind that consolidation is taking place in the smallcap sector, with strong players gaining an edge over less capable peers, who have either disappeared, or are shrinking.

The balance sheet of the smallcap index stocks is now looking very clean.

And cash flow from operations has never looked so good in the last 5 years.

After a long lull, capex revival is here with banks having cleaner balance sheets and relatively easier access to strong players in the smallcap space at benign interest rates.

So while I am positive on this space, there are a few things that should ensure you win in smallcaps.

You should focus on those smallcap companies which are not only showing improvement in earnings but also have strong balance sheets.

You can further increase your chances of success by betting on market leaders and backed by promoters with an established track record of performance.

Yes, there are some clear market leaders in the smallcap space as well.

These include Moldtek Packaging in rigid packaging, Mayur Unicotters in synthetic leather, Kabra Extrusion Technik in plastic extrusion machinery (and Batrix has 15% market share in Li-ion batteries in its segment), Kaveri Seed as the largest listed company. Huh. World’s first in hybrid seeds and production area of ​​over 1 lakh acres, CCL Products – Largest instant coffee exporter and private label manufacturer worldwide, Oriental Carbon – India’s only company to manufacture Insoluble Sulfur with 60% . Domestic market share, Rajratan Wires with leading market share in a very niche segment of tire bead wire manufacturing in India, Sheela foam with 30% market share in organized mattress market, Nosil – largest market share in India Large rubber chemical manufacturing company.

The list of big fish in a small pond is huge.

Note that I am not recommending a Buy view on the above names.

The point is that in smallcap you will find players who are the biggest in their field and indispensable to their customers in the B2B or B2C segment. And these companies deserve special attention.

Some lessons that I have learned and would like to share for better returns in smallcap investing.

Peter Lynch once said that if you’re good at this business, you’re right six times out of ten. This is especially true for smallcaps, where volatility and smallsizes become fiercely competitive during any interim downturn.

In such times, what can help you is a better asset allocation.

There isn’t a single investor, no matter how famous, who hasn’t ended up with failed investments.

This could be a case of poor decision making, a negative development related to the industry, disruption, or poor decision making by management, or something completely unexpected and unrelated to the business.

What separates Legends from ordinary investors is not the lack of losers or bets on big gainers, but how little they lose when they lose, or how big they make gains on the stock’s performance.

In the end, it all boils down to asset allocation.

A stock falling 80% may not be too bad for you, as long as you are not exposed to it. So always keep the possibilities in mind, be humble and allocate wisely.

Rather than overloading on a stock based on speculation, it is okay to build a position overtime with more conviction. Investing isn’t just about winning big, it’s about staying in the game. A well-diversified portfolio ensures survival.

If you work hard, make the right choices, do the right things, and stay disciplined, you’ll find companies that eventually ride out near-term volatility and headwinds and generate sustainable profits.

While a 100% success ratio in investing, especially in smallcaps, would be an overly ambitious and unrealistic goal, you can improve your chances of winning with a long-term investing mindset by letting compounding work its magic.

But this strategy only works if you invest in the right team which brings me to the next criterion – the importance of management quality in successful long term investing.

Investing is like a business. In this sense the management is your business partner. If you invest from this perspective, it is obvious that you want to invest in jockeys who think big, have good skin in the game, are intelligent and are good at execution.

Most importantly, you should invest in honest people. Otherwise all the wisdom of the management may work against you as a minority shareholder.

Pick any big winner in the stock markets in India or globally – Amazon, Tesla, Facebook, Avenue Supermarts…

Why Did Hundreds of Businesses Die in the Dot Com Crash While Amazon Became a Global Giant? Why did Future Retail and Avenue Supermart end up so differently despite being in the same industry?

It is clear that the journey of these stocks would not have been the same without the vision and execution of their promoters.

It definitely needs some work to assess the quality of management, rather than buying into the next hot tip you come across on social media. But a small work done here can brighten your luck in a big way. Once convinced, you can invest and forget. All the hard work is being done by the management. Can enjoy fruits.

next important parameter Enjoy great performance in smallcap stocks Building endurance.

This may seem contrary to my positive long-term outlook on smallcaps. But here’s the thing.

There is a 100% chance that you will be scrutinized when the market fluctuates.

It could be the next wave of Covid or lockdown, inflation out of control, a global recession or the sudden onset of war. Certain events can cause your portfolio to crash 20% to 40% within days or weeks.

If this causes you to panic and freak out, you’ll never get to see a rebound in quality businesses.

This reminds me of the fall in smallcaps that started in January 2018. At the lower end, the Smallcap index had fallen over 50%.

As I shared in the opening statistics, the rebound more than made up for that crash. But only those who had the capacity to enjoy the cycle could enjoy it. What helps in developing this ability is the hard work and conviction that you develop while picking stocks.

Therefore, while smallcaps are not in the cheap zone from a valuation perspective, the potential for strong returns from select smallcaps is huge. If you follow this template, chances are you’ll have the odds of success in your favor.

I wish you all a very rewarding and happy New Year.

Disclaimer: This article is for information purposes only. This is not a stock recommendation and should not be treated as such.

This article is syndicated equitymaster.com