As market correct, it's better to stay away from leveraged businesses

Movng to stronger, more diversified ones will be prudent

In past episodes of steep market corrections, such as that of 2008, the BSE Small-cap Index (72.3 per cent) had declined much more than the mid-cap (66.9 per cent) and the large-cap index (52.4 per cent). This time, however, this category has fallen in line with its larger peers. The BSE Sensex, Mid-Cap and Small-cap indices are down 33.9, 36.1, and 38.8 per cent respectively over the past month. Mid- and small-cap stocks have been languishing since January 2018, barring a truncated recovery at the start of the year. Since they have not seen much upside over the past couple of years, they have also not declined as much as they usually do in times of extreme fear and volatility.
 
Direct stock investors need to orient their portfolios towards small-cap businesses that are more likely to survive this onslaught. “Companies that survive will be those that have a low level of leverage on their balance sheets, regular cash flows, a competitive business model, and larger runway for growth,” says Vinit Sambre, head of equities, DSP Mutual Fund. Once growth revives, he says, these companies will rebound more strongly and will capture market share from their weaker rivals.
 
A few other changes may also be required. “For those fully invested, consider rotating out of some of the manufacturing businesses to move into digital, service-oriented ones,” says Jatin Khemani, founder and CEO, Stalwart Advisors, a Sebi-registered independent equity research firm. Manufacturing businesses are more susceptible to lockdowns than digital, service-oriented ones that can operate remotely at least partially and safeguard their revenue flow. Khemani also suggests moving out of smaller players with leveraged balance sheets and concentrated operations—those dependent on a single market, few buyers, vendors, outsourcing partners, etc. “Get into stronger, more diversified players,” he says. However, avoid the urge to go into cash.

“If a vaccine or cure were to be discovered tomorrow, the rally would be so sharp that you would not get a chance to participate in it,” he adds.
 
The biggest issue small-cap businesses are facing currently is liquidity. “Many of these businesses, which have suspended their operations right now, could have a difficult time meeting their financial and operational expenses as their sources of income have dried up," says Sambre. Many leveraged players in this segment could go belly up if lockdowns and work disruptions continue for long.
 
On the positive side, valuations are no longer expensive. “Even quality businesses in this segment are now available at attractive valuations," says Sambre.
 
Mutual fund investors should examine their small-cap fund’s portfolio. If it contains businesses likely to survive this downturn, and the fund has a sound long-term track record, be patient and stick to it. Above all, stick to your asset allocation. Ideally, allocation to small-cap funds should not exceed 10-20 per cent of your portfolio. If it is higher, reduce it. Due to the market correction, your asset and category allocation would have got disturbed. Those with cash to spare may make periodic investments over the next three-four months to bring their asset and category allocation back to the original level. Keep existing systematic investment plans (SIPs) going. Under no circumstance should you exit small-cap funds now, as doing so could lead to the realisation of what at present is a notional loss.
 
New investors will be better off sticking to time tested large-cap oriented active or passive funds. “The best options at present are an index fund or exchange-traded fund (ETF), followed by actively managed large- and multi-cap funds. When the markets recover, they will lead the revival and not small-cap funds,” says Pankaj Mathpal, founder and chief executive officer, Optima Money Managers.