Small stocks, big losses

Retail investors should limit exposure

Sell-off continues across global equity markets. As always during downturns, the mid-caps and small-caps have suffered more price erosion than large-caps. While the Nifty has lost 11 per cent since January, the mid-cap index has shed 14.5 per cent and the small-cap index 19 per cent. In terms of valuation, the market is trading at a price-to-earning (PE) of 19-20, but roughly two-thirds of the stocks in the broad NSE500 have lost over 30 per cent. There are several reasons why small-caps and mid-caps are inherently more volatile. One is that in fundamental terms, the larger a firm, the more likely that it has sufficient resources to weather a serious downturn. Another reason is simply that institutions have lower stakes in smaller stocks. Institutional investors are more capable of pursuing a “buy and hold” strategy to wait out cyclical downturns. This brings us to the corollary — retail investors have larger holdings in mid-caps and small-caps and they tend to suffer larger capital losses, and to indulge in bursts of panic selling during downturns.

Conversely, they get over-optimistic during bull runs, which is why small-caps and mid-caps tend to outperform large-caps during rallies. Most analysts concur price volatility and further sell-offs are likely in the short to medium term. Inflation continues to run high and every major central bank is likely to continue tightening. Moreover, global growth expectations have been downgraded, given supply-chain disruptions, the China lockdowns, and the Ukraine War. Foreign investors have run for the safety of hard currency after selling heavily through the past nine months. Their advisories continue to be negative about emerging-market exposure and India’s stock market is by far the most expensive in terms of valuation in this category. The rupee is under pressure due to a higher trade deficit and selling by foreign investors. Under normal circumstances, a weaker rupee could lead to an export boom. Although exports have done well, slowing global growth means demand will soften.
 

Information technology companies are complaining about margin pressure and cutbacks in discretionary spending by clients. The pharma industry is struggling to cope with supply-chain issues. Metals producers have seen demand destruction, apart from being hit by export taxes. In aggregate, India’s investors are exhibiting a blend of caution and optimism. Domestic institutions have been able to counter-balance heavy foreign selling to some extent on the back of large retail inflows to the equity mutual fund segment and insurance plans. Those inflows continue, which shows some retail investors remain committed to equity for the long term. But there have also been plenty of direct sales of equity by retail investors. One issue for the retail investor is that there are few attractive alternative investments. Real interest rates are still in negative territory, which makes debt unattractive. Gold prices are also volatile and may remain under pressure because of the strength of the US dollar.

Retail investors would need to hold their nerve if their portfolios do see more capital losses. They can focus on large-caps or, better still, instead of trying to pick winners in a falling market, continue to invest in diversified equity through systematic investment plans (SIPs). Broad downturns often lead to broad recoveries and SIPs are ideal in that they offer expanded equity exposures at averaged costs.