In 2018 large-caps, even with a minute rise, prevailed as small-caps as a group dropped by 28%
Every dark cloud has a silver lining. With small-caps leaving investors bruised in 2018, one could hardly complain if these investors seek refuge in large-caps this year.
But historical data shows that small-caps since 2006 have bounced back sharply after underperforming large-caps in the previous year. In 2018 large-caps, even with a minute rise, prevailed as small-caps as a group dropped by 28%. So 2019 could be a year when small-caps redeem themselves.
The sharp reversal in small-cap fortunes last year was no accident. After a rollicking run between 2014 and 2017, small-caps became the darlings of Dalal Street and commanded a valuation premium. But a series of events, including compulsory realignment of portfolios by mutual funds due to a Securities and Exchange Board of India (Sebi) directive, the introduction of Additional Surveillance Mechanism (ASM) and Long-Term Capital Gain tax as well as an overall spike in risk-aversion dragged down small-cap stocks.
As a result, small-caps with 28% drop underperformed large-caps (up 3%) by as much as 31% in 2018. This was the worst underperformance by small-caps in over a decade, data shows. Whenever small-caps perform poorly compared to large-caps in a year, the next 12 months see small-caps rise from like a proverbial phoenix. For instance, in 2008, small-caps fell 69% compared to 52% by large-caps. The next year, in 2009, small-caps jumped by 114%, 38 percentage points more than 76% return clocked by large-caps. In 2011, small-caps fell by 36% compared to 25% drop in large-caps. The next year, in 2012, small-caps rebounded with 38% gain compared to 28% in large-caps. In 2013, small-caps fell by 8%, while large-caps gained 7%. Continuing the trend, small-caps in 2014 zoomed 70% compared to 31% return notched up by large-caps.
Such trend holds true even for long-term investors. Investing in small-caps has proved to be rewarding when the last one year return is negative. When small-caps are down 20-30% in a year, their next five-year average return in nearly 14%. When small-caps are down 10-20% in a year, the subsequent five-year average return is 15%.
The 2018 sharp correction in small-cap stocks has hit most firms. About 25% small-cap stocks have fallen more than 50% from their peak while 53% small-cap stocks have fallen more than 30% from their peak. While this provides a good opportunity for investing in quality small-cap stocks, experts say that investors have to be careful about stock selection.
"What is important is to be disciplined and continue to scout around, especially in the mid and small cap space, companies which have solid balance-sheets, have less reliance on debt, are generating free cash flows and are market leaders have withstood the previous down cycles and emerged unscathed. So I think on the mid- and small-cap side one needs to keep the faith and use this as an opportunity to build a portfolio with medium-term perspective and look out for multi-baggers with a 24, 36, 48-month perspective,\" says Ajay Bodke CEO & chief portfolio manager PMS, Prabhudas Lilladher.
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