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Is it a good time to buy small-cap or mid-cap stocks?

The stock markets are down. Even if you factor in the recent run-up there are several stocks still available at a discount. Historically, small caps and mid-caps don’t perform well during an economic downturn. As their smaller size makes them more responsive to changes.

This time around as well the small-cap and the mid-cap indices fell a lot more than the large caps.

BSE Index levels

 

Index

20th February, 2020

24th March, 2020

12thJune, 2020

S&P BSE 250 Small-Cap Index


2,020

1,231 (Down from Feb levels 42%)

1,617 (Up 31% from March levels) (down 32% from Feb)

S&P BSE 150 Mid-Cap Index


5,095

3,170 (Down 37%)

4,155 (Up 31%, Down 23%)

S&P BSE Large-Cap


4,639

2,993 (Down 35%)

3,847 (Up 30%, Down 17%)

Source: BSE India

 

Small-caps are most vulnerable to downward shifting economies and underperform largely as: smaller companies lack the financial strength to withstand slowdowns. Especially the highly leveraged ones, which are more susceptible to go out of business. 

Besides, their low-level liquidity also leads to greater cuts in their prices.

However, Mid-caps enjoy a sweet spot somewhere between the large- and the small-caps. They still have the flexibility of the small-cap and the relative stability of a more established business.

Since small-caps and mid-caps fall the most in an economic downturn, their potential for growth is also greater. Even now when the markets have run-up the mid-cap and small-cap stocks haven’t recovered as much as the large-caps. Although they fell more and grew by the same %(~30%) they are still much below (-32%) their index levels in February 2020. Indicating that they still have some steam left, attracting investors looking for a bargain. 

Furthermore, historical patterns indicate that as economies recover, small-caps and mid-caps generate stronger returns. Which makes sense, as they are relatively more responsive to changes.

But 'buyer beware'. As tempting as these vulnerable small and mid-cap stocks may seem they carry a lot of risks.

Understand the risks

The stock market is afroth with volatility. And its level only increases as you ascend down the capitalization ladder, where your mid-caps and small-caps lie. They offer relatively better returns but also come with higher volatility. And high volatility always equals steep rises and falls.

Furthermore, keep in mind that small-caps and mid-caps are long-term plays, which require you to be very patient. Invest only if you have surplus funds that you won’t need for the next 5-7 years at least.

Take this market crash for instance. When my small-cap and mid-cap stocks crashed I didn’t panic. As:

a. I was full aware I didn’t need that money anytime in the near term and

b. I was more accepting and comfortable with the fall. I could absorb it better and wait for its recovery.

What I’m trying to say here is that my portfolio was reflecting my financial goals. Which is why I could keep calm. Also, I understand investing in equities is like buying into volatility. And black swan events like these can occur anytime without warning and cause pain. 

So you must also ensure that your portfolio matches you’re long-term financial goals. Accept volatility and understand that these stocks will be adversely affected in a downturn. 

Note, that even during the financial crisis of 2008, while large-and mid-cap funds fell by more than 40% and 60%, respectively, small-cap funds fell by about 70%.

Knowing the kind of reward and the level of risks these stocks carry is imperative. It won’t eliminate the risk, but it will prepare you to address it and reap the benefits. As Mr. Buffet also says: Risk comes from not knowing what you are doing. He also says:

“Never invest in a business you cannot understand.”

Which holds in any economic scenario. And lowers your risk to a large extent. As understanding the underlying business of the stock enables you to assign a fair value. And buy it at a discount so if things don’t pan out you have a safety net. 

Keep in mind that these Covid-19 times are different. And for a company to do well it will have to emerge successfully out of these crises. And for that it will require:

1.    A Healthy balance sheet - Low levels of leverage, a high debt-equity ratio, high-interest coverage ratio is positive. Imagine owning a business with a large pile of debt facing a sudden collapse in demand. Repaying loans or even the interests payments might become difficult.

2.    Strong cash flow generation - a company with strong cash flow will take a lot less time to re-start operations. As they won’t need additional money/funding for the same.

3.    Attractive Valuations that provide a margin of safety - buy a stock with a margin of safety. In case your expectations don’t pan out you have a cushion to absorb the shock.

4.    Competent management to handle these crises

5.    Bright business prospects –Market leaders in their fields are always preferable. The company should either boast a great relevant product or service. Just steer clear of companies that have been ruined by competition or have outdated products and services.

Truth be told, you must use these filters every time you want to invest in a stock. I do! But these uncertain times call for special attention towards the level of leverage in a company. As that will be a major determinant of who survives the storm in these uncertain times. 

Don’t be fooled by the market activity, we are still not out of the woods. The markets can fall just as easily as they have risen. The virus is unrelenting. And this is just the first wave whereas other countries are at the precipice of a second one. 

We all want the next multi-bagger. But for your stock to get there it must sail through these turbulent times. The key is to develop a well-diversified portfolio of fundamentally strong companies, with great prospects and at a discount to fair value.