'Investors may have made money in mid and smallcaps due to market momentum, but now they need to focus on fundamentals.'
Over two-thirds of mid and smallcap stocks on the National Stock Exchange (NSE) have entered bear market territory, slipping 20 per cent or more from their 52-week high, according to a recent analysis in Business Standard.
Reasons for the correction
High valuations are the primary reason behind the correction in mid and smallcap stocks.
"When valuations are on the higher side, anything can become an excuse for a correction," says Jatin Khemani, managing partner and chief investment officer, Stalwart Investment Advisors LLP, a New Delhi-based Securities and Exchange Board of India (Sebi)-registered portfolio management services firm.
The current dip may be attributed to disappointment with second-quarter earnings and an alternative investment opportunity arising from the Chinese stimulus, which prompted foreign institutional investors (FIIs) to withdraw Rs 1.25 trillion from the Indian market.
Global factors have worsened the sentiment.
"Uncertain global macros in light of the big win by Donald Trump in the US elections also contributed to the correction," says Sandeep Daga, managing director and CIO, Nine Rivers Capital.
State elections-related uncertainty also played a part.
"After what happened in the Lok Sabha elections, there was uncertainty regarding the outcomes of the elections in Haryana, Maharashtra, and Jharkhand," says Pawan Bharaddia, co-founder and CIO, Equitree Capital.
Investor complacency about consistent domestic flows, including monthly systematic investment plans (SIPs) worth Rs 25,000 crore, was another factor.
"As history suggests, flows drive momentum, but in the long run, fundamentals and valuations play an important role," says Khemani.
Until now, investors may have made money in mid and smallcaps due to market momentum, but now they need to focus on fundamentals.
Stay put or sell?
Investors must distinguish between price corrections due to market conditions and those caused by business-related issues.
"Stay invested in businesses with excellent profitability, ethical promoters, and significant long-term growth potential," says Ankur Kapur, head of investment, Plutus Capital.
Daga echoes this view. "If high earnings growth is visible over a three-year-plus period, stay invested as valuations will catch up in such stocks," he says.
Nothing changes for long-term investors with carefully constructed portfolios.
"Such investors should look to buy or add to their existing stock holdings gradually," says Khemani.
He suggests that investors who do not have surplus cash should rotate within the portfolio, increasing the weights of stocks that offer better risk-reward.
Selling should also be based on fundamentals, not price declines.
"Exit a stock if its business is not panning out as expected, if corporate governance issues emerge, if the management diversifies into unrelated businesses, or valuations don't offer comfort," says Bharaddia.
According to Daga, rising debt and an unsustainable working capital cycle are other valid reasons to sell.
Common pitfalls to avoid
Falling stock prices alone do not make a stock a good buy.
"Don't make the mistake of averaging down on a stock without understanding its fundamentals," says Bharaddia.
Also, avoid loss aversion bias.
"Many people compound the mistake of purchasing the wrong stocks by getting into inaction mode or blindly waiting for the stock price to return to their purchase level," says Khemani.
Poorly performing stocks may never recover or take years, yielding subpar returns.
Finally, do not shy away from mid and smallcap stocks altogether.
"They are likely to offer superlative returns over the next five years to investors who can endure their volatility, and don't buy junk or momentum stocks, or overpay for quality companies," says Daga.
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Feature Presentation: Ashish Narsale/Rediff.com
