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Thursday, October 31, 2019

Will History Repeat Itself in 2019 for BSE Small Cap Index?

Dear Reader,

The BSE small cap index is still down by 32.8% from its peak made in January 2018. The liquidity crisis in NBFCs, the DHFL and IL&FS defaults, collapse in stock price of Yes Bank, lenders dumping stocks of debt laden companies, layoffs in automobile sector with production cuts, and GDP growth slipping to 6 years low of 5% in June quarter have dampened investors sentiments towards broader market. Fear and misinformation has shattered investor’s confidence and hence quality businesses are back to cheap valuations.

There is lot of hopelessness with least participation by investors in small and mid caps in 2019.  The reason is the carnage in stock prices of many well-known companies. Retail investors have taken the back foot and lost their faith and conviction towards investing in small and mid caps due to existing pain in their portfolios.

However, we are quite excited about opportunities emerging in small and mid cap space. You may argue that most of small and mid caps have wiped out your hard earned gains over last couple of years. In fact those who invested in small caps over last 2 years are sitting on significantly higher losses and may be thinking to stay away from them.

But we beg to differ. We firmly believe that these are the opportune times to invest in broader markets instead of large caps. During bear phase in broader markets, negative sentiments around small and mid caps have brought down excellent businesses down to historically low valuations, there are companies which have not seen any change in business fundamentals, continue to grow during these tough times but are now available at decade low valuations. The fall in stock prices of many small and mid caps by more than 50% from their peaks has not happened for the first time. This has happened in past and companies with good business fundamentals have always bounced back strongly.  When overall market sentiments are negative like we are witnessing now due to various reasons along with slowdown in economy, quality businesses also face the heat. As bad stocks go down, good stocks go down with them too. But good companies make a stronger come back with earning revival once economy cycle starts its upturn.

Moreover, the bold decisions and corrective measures taken by the Government recently must augur well to get economic growth back on track sooner than later. Last month, FM Nirmala Sitharaman announced a historic reform by reducing tax for Corporate India. Government slashes tax on domestic businesses to one of the lowest rates in Asia, providing a more than USD 20 billion boost to revive economic growth from a six-year low. Effective from April 1, 2019, tax on all domestic companies will be lowered to 22% from a base rate of 30% currently. The effective new rate will be 25.17% including all additional levies.

Earlier, the Govt had reduced effective tax rates on companies with turnover up to 400 crores to 29.12%, now those companies will also be taxed at 25.17%. The new tax structure for new companies formed from 1 Oct 2019 will attract a base tax rate of 15% and effective rate of 17.01%.

India now has amongst the most competitive tax rates in the region. At an effective rate of just over 25 percent inclusive of all levies, businesses in India need not find ways to reduce or evade their tax burden. With more money in hand, Indian firms can choose to further invest in business growth doing capex or can reduce their product prices to boost sales or reward employees giving higher pay cheques. All these moves will eventually have positive economic impact. New manufacturing companies enjoying a tax-friendly entry is definitely a big positive for "Make in India" initiative, an effort to boost productivity-oriented jobs for lower-skilled Indians.

Slashing corporate tax rate will invite big global manufacturing companies to India as well as encourage Indian companies to expand their operations. Indian Government has not only gave a super dose of steroid to revive weak economic growth but also rolled out red carpet for global companies to invest in India, make in India and grow & prosper with India.

Will History Repeat Itself in 2019 for BSE Small Cap Index?

Looking at past performance, BSE Small Cap Index has never delivered negative returns for 2 consecutive years in past. Small cap index was down by -23.4% in 2018, and as on date it is down by another -8.2%. BSE Small Cap Index which was at 14,767 on 1st Jan 2019 closed at 13,558 today.

BSE Small Cap Index YoY Returns
Now if history has to repeat itself, BSE Small Cap Index has to close well above 14,767 by end of this year. It means minimum upside of 9% from current levels. Looking at dirt cheap valuations of small caps at current juncture and change in sentiments with Government announcing major reform i.e. cut in corporate tax, we believe it is very much possible. And in case if history fails to repeat itself in these 2 months, it will not disappoint long term investors who are accumulating fundamentally strong small and mid size companies at current levels.

More importantly, we are not just looking for recovery, we firmly believe that lot of wealth will be created from small and mid size companies which are doing all the right things without any change in business fundamentals but witnessed crash in stock prices just due pessimism in markets. Over next 2 to 4 years, the same set of companies not only recover their lost ground but also turned out to be multibaggers for long term investors.

In past, BSE Small Cap Index went up by 69% in 2014 and during the same year numerous small and mid cap stocks turned multi-bagger delivering mind boggling returns. These returns were enjoyed mostly by those who held on to their stocks during painful years like 2011 and 2013. BSE Small Cap Index rallied by 58% in 2017 when we witnessed lot of retail participation in broader markets and most of small and mid caps were expensively valued, later broader market went into bear grip with significant sell off in many small and mid caps due to expensive valuations and series of negatives developments followed by slowdown in economy.

If you analyse BSE Small Cap Index YoY returns, you will realise that small cap index not only recovered but also delivered astonishing returns in short span of time once tide turns favourable. In last 16 years, small cap index delivered significantly higher returns in single year every four years. In past, we experienced fierce rally in small caps in years like 2007, 2009, 2014 and 2017. 

Do not stop investing in small caps looking at these turbulent times, its time to do the opposite, this phase has happened before and small and mid caps have always bounced back. Good sentiments as well as bad sentiments do not last forever.

Wish you happy & safe Investing. 

Team - Saral Gyan