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2019 Can Be The Year Of Small Caps

2019 can be the year of Small Caps

Stability premium in large caps cannot last forever

Market has been giving a premium to stable companies all through 2018 as small caps have crashed. The companies that showed stable growth got high valuations compared to the ones that showed erratic quarterly performance. Corporate governance, able managements and the defensive have been the only stocks that have seen valuation re-rating in the past year and that is evident from the Sensex returns.

The large portion of the re-rating came in from strong domestic flows and FIIs preferred sticking to quality. This is evidenced from the below chart which clearly shows that the top quality and growth stocks are hitting all time high valuations.

Quality Stocks have never been more expensive

Source: Bloomberg, Plus Delta Research

*QSP portfolio contains the top 10 stocks at the start of each year by selecting companies having the best ROE (previous 3 years average)

What does this mean for an investor?

Expensive stocks continue to get more expensive and are now at their peak. PE inequality in the stock market is at a an all-time high with the one year forward PE differential between top 10 percentile and bottom 10 percentile. This indicates hoarding of people’s investment in sectors and stocks that have worked.

Investments are getting bundled up into large caps of select pockets and now the pressure on delivering earnings is high as the market will require higher earnings growth and more margins surprises for the same level valuation to sustain.  Hence, scope for re-rating in large cap and the so called quality stocks is limited which should also limit the returns in these counters to only those pockets that show substantial beat in earnings.

The Flipside – Small caps are at a low base with “rationalized” valuations

Normalcy has arrived in the small cap arena after the euphoria that took over in 2017 and most stocks have retraced to attractive levels. 2019 is a much better starting point for small caps compared 2018 as the base is far lower. 25% small-cap stocks have fallen more than 50%  and 53% small-cap stocks have fallen more than 30% from their peak As evidenced in the below chart, small caps have always had multiple years of high return immediately after a bad year. So the return for an investor will be the highest one should start investing right now in 2019 and as 2018 was a negative year for small caps as a whole.

Historical data in favor of Small caps

Source: Bloomberg

An Earnings surprise is more likely with small caps

The core philosophy of our Plus Delta CGM model states that a surprise in earnings is what begets momentum in a stock and helps it rally upwards. So when earnings beat estimates and surprise the market – Stocks tend to fly. Large caps are well researched by brokers, managements hold calls and meetings, and they get media attention, so it’s relatively difficult for large caps to surprise the market as expectations get discounted faster in the stock price. On the contrary, small caps are a huge universe (3000+ stocks) and they are relatively under researched. To illustrate, Average number of analysts covering large caps is 30 and mid-caps is 15. Further out of Out of 870 stocks in the BSE Small-cap Index 210 stocks are not covered by any analyst and 398 stocks are covered by less than 5 analysts. There is a large pool of undiscovered stocks in this area and fund managers like us get an opportunity to add the extra to our client’s portfolios by getting in early seeing these stocks compound and grow.

Looking ahead

Our Plus Delta portfolios research team is working in hard in identifying quality names in the small cap space. We are keenly observing this quarter and looking for out-performers and those companies that are displaying earnings growth. We are hugely optimistic about the market for 2019 and we expect all our portfolios to generate superior alpha in 2019.

Aditya Iyer
Fund Manager – Plus Delta Portfolios

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