Small, medium-caps could be better bets

During the Jan-Nov period, domestic institutional investors pulled out Rs 15,000 cr

A recent analysis by the BS Research Bureau showed foreign institutional investor (FII) holdings in Indian equity rose through 2012. They have pumped in net investments of Rs 85,000 crore in the past 11 months. Most of these are concentrated in big stocks. FII holdings in the BSE-100 have risen to 38 per cent of the free-float (September 30), from 35.5 per cent on December 31, 2011.

During the same January-November period, domestic institutional investors (DIIs) sold Rs 15,000 crore. Matching FII-DII numbers, the lion's share of enhanced FII holdings in 2012 must have been bought off domestic retail investors. This is no surprise – it gels with mutual fund data and RBI estimates of a falling share of equity in household savings.

In technical parlance, this is a transfer of holdings from “weak hands” ( that is, shallow pockets) to “strong hands” (deep pockets). It should be a prelude to a rally since FIIs have better holding power. That is indeed the conclusion most would draw.

There are some interesting details. Assume the twin trends of FII buying versus DII-plus-retail selling continues. In that case, big stocks could outperform in 2013 since FIIs need big-ticket deployments.

This hasn't happened in 2012. The Nifty, the CNX-500 and the CNX Smallcaps have delivered returns of 23 per cent, 25 per cent and 25 per cent, respectively, since January 1, 2012. This suggests that at least some money received by Indian investors selling bigger stocks has been re-deployed in smaller stocks. Let's look at some other scenarios of changes in attitude. Suppose the Indian investors (DII-plus-retail) went net positive, while FIIs remained net positive. This would broaden the rally, pushing up smaller stocks faster.

Also, consider a scenario where FIIs sell while Indian investors also stay negative. There would be a crash. But the losses would be more marked among big stocks because Indian investors cannot absorb FII sales in those and supply would overwhelm demand. In yet another scenario, FIIs might sell while Indians buy. Big stocks would fall, but smaller scrips may even rise.

These scenarios, or variations where an investor category moderates attitude without changing it (FIIs buy less, or DIIs sell less), may not be equally likely. But in all, small-caps and medium-caps are likely to be safer – they have less apparent downside.

In some scenarios, small-caps and medium-caps will appreciate faster. There are two dangers in a small-cap focus. Small-caps can go illiquid and often, there is less attention paid to corporate governance issues and a lack of reliable information.

The author is a technical and equity analyst