Smallcap stocks: Dipan mehta on why smallcaps are the flavour of the season


We are seeing stocks go up by 5-10% easily in a day and maybe 30-40% in a week’s time. This trend may last for some more timesays, Founder & Director, Elixir Equities.

Our data suggests that there is the beginning of a rebound in some of the smallcap names?
You are right. Smallcaps are the flavour of the season and the trigger point of course was the Sebi circular that multi-cap funds need to be more broad based and that certainly has put the spotlight on the smallcap stocks. In any case, that particular segment of the market had been underperforming for the past almost two or three years or so. Stocks have come off significantly over there and they were further devalued on account of the Covid-19 problem because smallcap stocks have been impacted the most in terms of financial performance during the lockdown.

Now as and when the lockdown is lifting and gradually normalcy is coming back, investors are of the view that a lot of smallcaps are available at very attractive valuations. Some of them are at or below book value with relatively debt-free balance sheets. If you were to let go of 2020 and look at their performance based on what they could deliver in normal times, then valuations are also quite attractive and that is why we are seeing the money flowing into smallcaps.

Another specific issue with smallcaps is that even small amount of buying tends to result in an exaggerated up move or down move as the case may be and in this case, with every small bit of liquidity coming in, we are seeing stocks go up by 5-10% easily in a day and maybe 30-40% in a week’s time. This trend may last for some more time because investors sitting on profits as far as smallcaps are concerned and when you are sitting on profit and a particular strategy, you tend to over extend in that context. A lot of trading profits and trading money is going into small cap stocks and institutions are also looking at that segment favourably. Maybe this will last for a few more weeks or months.

What is your sense when it comes to IT? Are you going across the board or would you stick to purely largecaps?
We have been very positive on IT over the past quarter or so, especially since the March and the June quarter numbers have come through and this lockdown and global pandemic has been very beneficial to IT companies. Of course some of the verticals have been hit but the overall trend towards digitalisation and cloud computing has been accelerated maybe by two-three years or so ,which is why we are seeing a lot of opportunities for IT companies to offer their services. We are seeing very optimistic management commentary as well. HCL Tech management has gone ahead and raised their guidance as well.

A lot of midcap IT companies have also come out with a good set of numbers and very positive commentaries. Investors need to gradually increase their exposure to IT and over here, there is a lot of choice. So depending upon your risk appetite, you could go for the largecap stocks and in our opinion, with usual disclosure, the largecap stocks could outperform. Their peer group would be something like an HCL Tech or even Tech Mahindra or Wipro where we feel that the gap which they have in terms of valuation between these three companies and TCS, Infosys could be narrowed, assuming that the growth rates also are in line with the growth rates of Infosys and TCS which is likely to take place at least in this fiscal.

This offers a good risk reward ratio and then there are midcap IT companies which are quite interesting. These have a slightly differentiated business model or niche offerings or focus on specific verticals which are doing well and we would rate such companies as good buys. These would be something like Tata Elxsi or L&T Infotech, maybe even Mphasis Limited which came out with a very good set of numbers. Then there are certain companies with different business models, product based companies like Ramco Systems or Nucleus Software or event Intellect Design. One could add Oracle also to that list.

So there is a lot of choice as far as IT companies are concerned and investors can look at large cap companies or go for a basket of midcaps, both will do equally well although our preference would be for the small and midcap companies where we feel that base effect is beneficial to them and valuations also are comfortable.

There is no denying the fact that despite the competition from large IT companies, smallcap and midcap IT companies have found their place, have found their niche and they are able to grow at double digit growth rates slightly higher than largecap IT companies as well. Just to sum up, these last two-three years we felt that the IT industry was growing at a low double digit or perhaps high single digit. In the next two-three years, they could easily grow at somewhere around mid teens at least as far as the midcap companies are concerned and maybe strong double digit 12% to 14% as far as largecap IT stocks are concerned. But just give them a quarter or two to get aligned and let some more normalcy come into the global business scenario.

Are you willing to recommend these stocks even for new entrants? Can they buy these when most of these stocks are already sitting at their 52-week highs?
I have been tracking IT for last 20 years plus or so, right from and what I see just now is a multi-year trend and this trend can easily last for three-four years or so. This trend perhaps had started around March or I would say once the March quarter results were out. From April, May onwards we are seeing good traction coming to the IT companies. They were, of course, hit when the entire market was hit on account of the pandemic. But they have made a V-shaped recovery. IT shares will build on these gains. There is scope for PEs to get re-rated as far as IT companies are concerned and earnings also will look pretty good.

In this lockdown, we have seen that work from home offers a lot of flexibility as far as costs are concerned for the IT companies and that is a new X factor as far as the performance of IT companies are concerned. So even at these levels, despite the fact that some of the software midcaps may have already doubled by now, they still have a longer way to go. There will be corrections along the way but three-four years from now, a lot of IT companies will be trading at a significantly higher value than they are at this point of time.

Some of the IT companies may undergo or come off mergers and acquisitions and lots of interesting events are happening within the IT space. So investors need to get aligned over there. I would say that at least 25-30% of your portfolio should be in IT companies. Make a basket of good large and midcap IT companies and that will really be an outperformer and in times like this when we are facing so much uncertainty as far as the domestic economy is concerned, it is a good idea to hedge your portfolio with businesses which are externally focussed.

Most analysts are finding metals an interesting proposition in the next three to six months. Do you concur?
I would think so and it is the China factor which is playing out and China is a big consumer of metals and their economy is now roaring. It is the best performing economy in the world at this point of time. And because of the pandemic, the Chinese are going to look at even more infrastructure projects and try to grow domestic consumption. All these trends are very positive for commodity stocks, especially metals ferrous and non-ferrous. A lot of the price points and the volumes are gradually coming back to pre-Covid levels. But some of the costs are remaining low for a lot of the metal companies.

You could see expansion of operating profit margins as well. The next few months could be very positive for metals. But investors seem to know that at the end of the day, metals are good trading stocks. They do well for three-four months or so but you cannot have them as part of core holdings which you want to hold on to for three-four years or so. On a longer term basis, metals have never really created a great deal of value. So that portion of your portfolio where you would want to trade, you could consider metal stocks.

But By and large, you have to be in the secular growth stories which could be in software, telecom, pharmaceuticals and select banks as well. So while a large portion of your portfolio has to be in these four-five performing sectors, you could have a small trading portfolio which is aligned to metal stocks.

Within banks what would you select because even after all the upgrades and the consensus on the Street, two of the big boys — ICICI Bank and SBI are still underperforming?
You have to be a bit patient as far as all banks and NBFCs are concerned and you should be prepared for some ugly surprises as far as NPAs are concerned also for the sector as and when the moratorium ends and restructuring of loans takes place and what provisioning is required.

Right now, it is very difficult to get a handle on what the credit costs are and by December end, we should have a good idea as to what the credit costs are at the company level. And on account of that, you may have a few nasty bruises, a few companies which may kind of show accelerated or higher NPAs and that may sour the sentiment over there. But once you are beyond this hump or escalated and higher credit cost, somewhere around 2021 or so when our economy starts to chug along, banking shares will do very well. Low interest costs and normalising of credit cost will lead to a spike in their earnings. A lot of the banks and the NBFCs which a lot of investors are interested and invested in have raised their capital levels significantly and they will follow the strategy of making full provision for the NPAs as far as possible.

“I would be a bit cautious in trying to chase real estate stocks endlessly. One could see another 5-10-15% upside from these levels for largecap real estate companies but beyond that, you need to be a bit careful.”

— Dipan Mehta

So, the strategy of the large banks which have got capital will be to provide for upfront and in a very conservative manner and try and convince the Street that this is all the credit cost they will have for that particular quarter and then going forward their credit cost will normalise and therefore investors will have a good visibility as to what actually profitability will be in normal times and when they have a look at that profits in normal times post this accelerated credit cost then the valuations will look quite attractive.

Something is brewing and it will brew for some more time but in six, eight months from now, banks could be getting back into leadership positions and delivering exceptional returns going forward. They have been an underperformer for the past almost two years since the IL&FS crisis, the tide will turn and the process will start once we have crystallised what the NPA losses are. So I am keeping a very close eye as far as the banks are concerned.

There could be a few banks which are hit harder than the others, there could be a few banks which get lucky and do not have to make as much provision. All of those factors and data points will come out over the next two, three months or so. And once everything is clear then, banks will do exceptionally well. So I would not want to be underweight in banks at this point of time. You could be equal weight and again depending upon your risk appetite go for the best like and HDFC Bank or a Kotak Bank and then there are tier-2 banks in terms of risk return like say an ICICI, Axis or an IndusInd and then there are smaller banks, high risk high return like IDFC First Bank or Ratnakar Bank or AU Small Finance Bank as well.

So there is a lot of choice over there and within the PSUs, maybe stick to an SBI but you are going to find a few winners in the banking sector in the calendar year 2021 and the latter half may be a golden period for the banks.

Where are you seeing potential within the capital goods space?,
The capital goods sector has been an underperformer for many quarters. The stocks have corrected significantly and you could see investor interest coming back. The order flow has been pretty decent for the sector as a whole although execution has been a bit of a question mark. And with usual disclosure that we and our clients are invested, it is best to go for the market leader L&T and this is one company which is cash rich with a great balance sheet and a lot of potential to unlock value as far as their subsidiaries are concerned.

I am not talking about subsidiaries like IT and NBFC but some of the infrastructure projects where the company is an infrastructure operator. They could look at divestments and raise further capital. In times like this, they are very well positioned to bid for larger orders and because of the balance sheet and their past track record they may be actually be awarded those orders as well.

So I am very positive on L&T per se and if I had to buy one stock in the capital goods then I would go with L&T but there are other smaller niche capital goods manufacturers as well and one of them is ISGEC. It is a niche engineering company with a decent track record. They are focussed on the sugar sector as far as their machinery manufacturing is concerned and are now diversifying into some of the other industrials as well. That is one interesting small cap company which comes to mind.

Another smallcap company where we and our clients are invested in is ITD Cementation and that is benefitting from metro projects which are underway in various cities. After coming to a standstill, these projects have started to pick up gradually. There could be a few winners as far as capital goods are concerned but at the end of the day, these are cyclical businesses and they do well for two, three or four years or so but one has to be careful about longer term prospects.

Do you think the time has come to be a contra investor in some of the realty names?
These stocks are trading at a deep discount to their intrinsic value if you aggregate their land bank and the potential to profit from that land bank. DLF of course has a steady stream of rental income as well through its subsidiary company so that is an added advantage. What is happening in real estate is that as normalcy is coming back, as we are getting news that the sector volumes have picked up and prices have stabilised, we are seeing that correction taking place back to normalcy as far as stock prices are concerned. Real estate had been hit pretty hard in this pandemic and those stocks had corrected 50-60% even higher and now there is an endpoint in terms of as and when normalcy will come back for the sector.

I think investors are just buying into these stocks as a trading opportunity to see if the valuation gets corrected to pre Covid levels and eventually profits and revenues also will come back to pre Covid levels. So we are seeing that trend play out in real estate companies. Once the particular correction from deep value to normal value is over and done with, then beyond that I do not think that real estate companies will do as well going forward and build on these gains because challenges will continue even after normalcy returns.

I would be a bit cautious in trying to chase these stocks endlessly. One could see another 5-10-15% upside from these levels for largecap real estate companies but beyond that , you need to be a bit careful because the margin of safety would not be there in the event of a slowdown which we saw even prior to the pandemic and during the lockdown and what is persisting now.

If the slowdown in the sector continues for a few more quarters then the stock prices of the real estate companies will go nowhere just because of stagnation of performance.





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