5 parameters to be taken into consideration before buying small & midcap stocks:
Brokerage houses have come out with their preferred picks in the small & midcap space that makes the job of investors easy but investors should do their homework as well.
The focus on the broader markets for multi-cap funds has been put forth by the Securities and Exchange Board of India (SEBI). Although nothing is certain about the money that could move into small caps investors should try and keep some factors in mind before pressing the buy button.
Last week, Sebi came out with a new set of rules for portfolio allocation for multi-cap funds. By January 2021, these funds will have to invest at least 25 per cent of their portfolio each in large-cap, midcap and smallcap stocks.
Data shows that most of the multi-cap funds invest about 70 per cent in large-caps, 15 per cent in midcap and the small-cap space has a single-digit allocation.
Deepak Jasani, Head of Retail Research, HDFC Securities told Moneycontrol that, " Post the SEBI circular and the clarification, buying in smallcap and midcap is expected by traders in anticipation of fund buying that can come later once they finalise their strategies. This buying can sustain for a couple of days and then if the institutions don't turn up to buy, traders can get impatient and start to unload their positions." He further added, “A lot will depend on how reasonable the valuation of these stocks remains to attract long-term buying from institutions. Mutual funds have expressed their hesitation in buying small and midcaps just to meet the SEBI requirements without getting convinced about the stocks or their entry valuations."
Experts suggested 5 factors for investors to be taken into consideration before pressing the buy button:
1. Low Liquidity:
According to experts, many mid and most small-caps don’t have adequate liquidity in terms of daily turnover in the exchanges.
“The average daily turnover of many small-caps below Rs 5,000 crore market cap is around Rs 2-3 crore only and hence the impact cost in most of them is high,” Rusmik Oza, Executive Vice President, Head of Fundamental Research at Kotak Securities told Moneycontrol.
He further added, 'Analysts’ coverage is also another important factor to keep in mind when it comes to midcaps. Companies having regular post-result conference calls, analysts meet and widely covered by brokerages are preferred by both FIIs and DIIs.
Oza added that in the case of small caps, one should ideally prefer companies falling in the Nifty smallcap index as these are known and actively covered.
2. Avoid the herd mentality:
Mutual funds hesitate to buy small and midcaps just for the sake of meeting the SEBI requirements and a similar checklist which is followed by retail investors.
“Joining the herd on the buying side without having enough conviction in the story could bring pain for investors,” Jasani of HDFC Securities said.
He further stated, "The SEBI prescription could have lifted the P/E ratio that one ascribes to good mid and small caps by a few percentage points; even then if the run-up is too sharp and the story is not convincing, the runup in stocks prices could fizzle out soon."
3. Do your own research:
Investors could take the hint from mutual funds managers regarding their buying and selling but the final decision should be based on their research about the company and management as well as the firm’s product basket.
Oza stated, "Smart investors who understand balance sheets, financials and have been analysing companies can venture on their own in smaller unknown companies."
He further connoted, "One must do some basic homework on the hygiene factors like promoter holding, pledged shares, ratios, cashflows, debt-equity ratio and valuations before taking higher exposure in any mid or smallcap company."
Experts remarked that the change in multi-cap allocation+ policy for mutual funds will see some shift towards small-caps and a little bit towards midcaps in order to make a high conviction bet, the earnings growth of the company should continue for some quarters.
"An investor should focus more on the size of the opportunity, high earnings growth sustenance and management’s execution capability, which is what our 5GCPM framework focuses upon,” Pritam Deuskar, Founder of Wealthyvia.com told Moneycontrol.
He further added, “When your small or the midcap stock becomes a large-cap then only substantial wealth is created. Forbes list changes many people every five-seven years. Many companies grow."
5GCPM is a method developed by Arthavruddhi Research Analysis that includes:
- 5 types of growth in a company business
- Corporate governance check
- Practicability of investment becoming fruitful and
- Magic parameters that tell about fundamental and technical long term trend.
Investors would have to do their due diligence before putting in the money since most smallcap companies are not covered by the analyst community. The expected inflow in the broader market is likely to draw investor interest in small and midcap stocks as fund managers begin to align with new guidelines.
“A retail investor planning to put money in broader stocks should remain mindful of basic factors like considering fundamentals of the business, credibility of the management, and past track record in terms of relation with other stakeholders of the company,” Dinesh Rohira, Founder, CEO - 5nance.com said.
He further told, "It should be remembered that the strong business fundamental drives the price of the company and not the market-cap classification. It is also equally important to check the liquidity of stocks in a market while buying companies."