In the past few weeks, we have seen the deepest of the corrections in the small and mid capitalization space since the post-demonetization correction in Nov’16. Let us analyze the reasons and the opportunities from it for long-term investors.

How has been the performance of indices and funds?

On year-to-date basis as of 20^thJune 2018, the large cap index (Nifty50) gained ~2.3% while the midcap and small cap indices (Nifty Midcap 100 and Nifty Smallcap) have declined 12% and 17.5% respectively.

The correction in individual stocks has been quite notable. Among the constituents of the midcap index, 40% of the stocks have lost at least a quarter of their market capitalization from their highs. This number stands at 70% for those of small cap index.

During the same time period, mid-cap mutual funds have fallen ~8.5% on an average, thereby out-performing the NSE Midcap 100 index by ~3.5%. The number stands at 10.5% and 7% for small cap. 85% of the midcap funds and 100% of small cap funds we track across the industry have beaten the indices.

Why did the correction happen?

After a calm 2017, there has been an increase in volatility driven by both global and domestic factors – increase in inflation, rise in oil price, hike in policy rates, trade war etc. Due to a global risk-off, the foreign investors have pulled out from the Emerging Markets including India. In addition, the introduction of the Additional Surveillance Mechanism (ASM) on certain stocks by SEBI and stock exchanges has impacted liquidity adding to the selling pressure.

What are the learnings from the past?

In the previous cycle of 2003-08, we have observed that the mid-caps corrected over 10% at least eight times. Two of the corrections were savage, with a fall of 25% in 2004 and 37% in 2006. What is interesting is that the recovery of all these corrections happened in a few months time frame. The same can be extrapolated to small cap stocks. As long as growth persists, recovery in stock prices could happen.

What is the projection for earnings growth?

The GDP numbers indicate that the economy is in course for a full-fledged recovery from the twin effects of demonetization and GST. The high frequency data points like vehicles sales particularly the commercial vehicle sales, cement production and tax collections among others point to the same. The earnings season indicates that the sales and profit growth for the broader universe of companies was in mid-teens if one excludes PSU and corporate banks. Three out of every four companies have indicated that the demand environment is improving and they are confident about robust growth in FY19. As per estimates, the earnings of sizeable number of small and mid-cap companies would be high atleast for the next two to three years.

Why is there an opportunity?

India has taken eight years for its GDP to grow from INR 1 trillion to 2 trillion, five years to reach the next trillion in FY20 and would take less than four years for the next trillion. This creates a lot of opportunities for companies. Also, India’s per-capita GDP crosses USD 2,000 in 2018 which is a significant inflection point for consumer behaviour benefitting companies.

The business environment is getting a long term boost through the recent reforms to ease the doing of business like the implementation of GST, removing limits for foreign capital, formalizing the banking channel, creating plat form for trade receivables, resolution of bad loans through IBC etc. Though future looks good for many sectors, the ones which stand out are building materials, financials (private banks, NBFCs, asset managers, insurance etc.) and consumer discretionary.

What should long-term investors do?

One of the frequent arguments one hears is that the mid & small cap stocks are expensive. What it usually means is that the indices’ P/E is high on a trailing basis. While we may not negate it, the reason for higher valuation is because of the sub-optimal earnings of the companies due to the effects of demonetization and GST. These effects are behind us. As of date, the indices have lost over a quarter in terms of valuation. As growth comes back, the valuations would look attractive.

In conclusion, the mid and small cap space delivered higher returns in higher teens on a long term basis and this comes with volatility. Post the erosion of froth in the recent correction; it is time for investors to start investing in the categories through mutual funds. This is because, unlike 2017 where many stocks went up, there would be divergence in stock performance which the fund managers are better equipped to capitalize on. The allocation could be small to start with and build over a period of time with the time horizon of atleast three to five years. We should remember that the money invested in the market corrections works its best to generate returns. This is one such correction – make use of it.

This article originally appeared on Hindu Business Line on 24^th June 2018

Abbreviations used:

US: United States; OPEC: Organization of Petroleum Exporting Countries; USD: US Dollar; GDP: Gross Domestic Product; EM: Emerging Markets; PE: Price-to-Earnings ratio; EPS: Earnings per share; GST: Goods and Services Tax; NBFC: Non Banking Financial Company; IBC: Insolvency and bankruptcy code; FY: Fiscal Year; SEBI: Securities and Exchange Board of India

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.