Small Cap and Sensex

The process and state of diverging or a situation in which two things become different, or

the difference between them increases is called divergence.

From streets point of view, divergence is often seen as an ‘opportunity’ which inherently says that
something is going on with your charts that needs your attention.

But can a divergence occur between indices? – Yes! Have they occurred before? –Yes!

In 2009, the small caps index outperformed blue chips, setting the momentum for 2010. As per our
analysis, the small cap index has given a return of as much as 115 per cent whereas Sensex gave a return
of 75.3 per cent to the investors. But why ? Since, small caps do not need huge amount of money to
rally and thus managed to outperform their peers in the benchmark index Sensex in the year. Also, In
2008 the valuation gap or the divergence, as we see it visually, between the small caps and large caps
was significant which converged in 2009 due to heavy FII flow, improvement in the economic conditions,
and hence corporate performance.

From 2011 the small caps started underperforming compared with the Sensex, mainly due to low
participation from the investors and when things become worse, fears make investors exit these stocks
at the lowest valuations. Thus, When economy grows, mid-cap and small-caps lead the gains, but when
the slowdown comes, they are the worst affected.

Year 2012 was a better year in terms of small-cap and mid-cap as they did the catch up game with large-
cap in terms of valuation. But as the growth came down for small and mid-caps compared to large-caps
in 2013, there was huge valuation gap between the two.

In 2014, while mid-cap and small-cap indices rose 46.42% and 62.91%, respectively, BSE Sensex, BSE
100, BSE 200, and BSE 500 indices logged 29.89%, 32.28%, 35.47% and 36.96%, respectively. Such
tremendous gains compared with the Sensex again created a euphoria among the investors and they
started believing that the ‘sky is the limit’ adding a optimum mix of mid and small caps in their portfolio.

In 2016, the euphoria continued where the NIFTY / SENSEX lost over 1% and mid-cap and Small Cap
stocks performed well. Many names including Rushil Décor, DFM Foods, Dhampur Sugar Mills, Triveni
Engineering doubled during the year.

Then came the year 2017 where the investors were bamboozled with the gains from small caps where
over 150 stocks from the BSE Smallcap index more than doubled investor wealth. The index soared
nearly 50 per cent, with HEG and Indiabulls Ventures surging over 1000 per cent. Again at that time the
Analysts and Investors were predicting that small caps hold a potential to deliver big gains in year 2018
too.

But 2018 was the year when it all came crashing down, where the BSE Sensex might have fallen about
11 percent from its highs but the carnage was also visible in the small & mid-cap indices which have
tanked more than 20 percent each from highs, effectively entering bear phase. Theoretically, a bear
market is a condition in which stock prices fall continuously and the pessimism or fear pushes the stock
prices even lower wiping out considerable wealth of investors. Well, figures vary, but a fall of 20 percent
or more from the peak effectively puts a stock or an index in a bear market. The cuts were deep in the
small-cap space which saw as many as 8 stocks falling by over 90 percent and 230 stocks witnessing a
decline of 50-90 percent in the same period which includes D-Link, Force Motors, Zen Technologies,
Jindal Stainless, NBCC, Orient Green.

This question still persist, what should we do now?

In a nutshell, as per efficient market hypothesis, the Investors are rationale and all the available
information is priced in. But we believe, a rationale investor wouldn’t have bought small caps in 2017’s
bull euphoria and even if they bought they shouldn’t panic in current market scenario where everyone is
signaling a bear phase for small caps. We advice our clients to selectively buy stocks of smaller
companies with good governance, stronger earnings outlook, and those that are gaining market share.

We, believe that corrections in the market are common and small and mid-caps tend to react more
compared to larger peers. Both mid & smallcap indices have corrected after rallying by over 100 percent
from 2016. Hence, technically, we might be in a bear market but it would not be fair to call it a bear
market right now.

Investors should learn to look the small cap and large cap space as two different markets and treat the
divergence between the two to assess the inherent correlation and identify the right time to enter in
either of the markets. We have witnessed that whenever the small cap index peaks or bottoms out,
the beta coefficient is much more than compared with the Sensex indicating the irrational behavior of
the investors at large. Currently, the small cap index is bottoming out and given the huge valuation
difference, various steps by Modi government to boost economic growth and expected high teens
growth in the earnings we believe that investors could start accumulating niece small caps stock both
on quality and quantitative front.