Basic tenet of Capital market:

Allocational efficiency is a characteristic of an efficient market in which capital is allocated in a way that is most beneficial to the parties involved. This calls for successful companies should have greater ability to raise capital at attractive terms and the savers backing such companies should see their portfolios appreciate over time. Having seen penny stocks becoming small cap, small caps turning Mid-Cap and Mid-Caps catapulting into Large-cap over time, when backed by improved profits, an average informed retail investor tends to invest in them at initial stages hoping to see them become Large-Cap as the time passes by helping him/her build wealth.

Role of MFs in price discovery:

MFs, by virtue of the size of corpus with them, have become significant players in markets. MFs are normally expected to be driven by sound investment principles with least influence from external entities. It is well known that the price discovery in stock exchange is a function of demand and supply. In ideal market situations, strong operational performance should generate demand for stocks and poor performance should result in reduced demand and increased supply with investors off-loading stocks. However, SEBI has directed MFs to rejig their portfolio so as to hold stocks from its list of 250 based on the nature of MF Schemes. Though SEBI permitted a small portion to be beyond this 250, fund managers handling this large corpus of investors’ savings have been compelled to unload stocks beyond 250 list irrespective of their operational performance. Faced with a situation of possible disciplinary action, Fund managers rushed to dump even quality stocks in order to comply with SEBI direction and started chasing Large Cap stocks as safe bets.

This has resulted in serious distortion of price discovery in markets with several stocks falling by 25% to 50% in a very short time. This trend will possibly be reversed, when MFs come out with Multi cap or small cap schemes, mop up savings and begin chasing such battered stocks. This may take time, and the psyche of investors who witnessed meltdown of their portfolio stocks lays shattered. Confidence in markets is shaken and one wonders if this is the place to be for future growth. Unfortunately, despite the commentary in financial newspapers that the broad market has been reeling, no one seems interested to correct the damage.

Divergence between Nifty and MidCap indices:

Leading indices in our stock exchanges may be scaling new heights day after day, but average retail investors have been staring at a loss of anywhere between 20% to 50% in their portfolios from 2018 levels. The divergence between Nifty and MidCap stocks started from February 2018 and is continuing. In the period February 18 to November 7, 2019 Nifty went up by 9.03% while MidCap index dropped by 18.69%. This implies underperformance is over 27%. Trends observed in the past two years is anything but reflection of characteristics needed to term our capital markets efficient. 70% of stocks lost value while a handful of large cap stocks rallied because of pressures from powers that be.

Government may be patting its backs itself for the stellar performance of Indices. One often comes across faces of retail investors, filled with gloom and doom, amidst claims of superior and outstanding returns on capital market investments. SEBI’s classification of stocks into Large-Cap, Mid-Cap and Small-Cap based on market capitalization of stocks wreaked havoc in markets causing distorted price discovery process. Per SEBI, top 100 stocks are Large Cap, next 150 are Mid-Cap and all others are Small-caps. To understand the situation in right perspective, we have undertaken an exercise to read the relation between profitability and price performance of larger basket of shares. Our study focused on stocks traded in NSE that announce results regularly.

In the last two years, several companies have reported improved profits and margins. However, when we take a close look at how their prices moved in the same time frame, we are appalled to notice that majority of them lost sheen defying logic. The table below shows how they stack up.

Out of 1,358 stocks checked between 2017 and 2019, 795 stocks have improved profits. Out of them 65 were large-cap, 101 are from Mid-cap, if one goes by SEBI definitions. However, despite improved operational efficiency, small-cap stocks bore the brunt of falling stock prices. From the above table, when profits went up by 0% to 25%, 70% of Small-cap stocks have seen their prices correcting. 79% of small-cap stocks lost value despite profits surging by more than 25%, as can be seen in next two categories.

PE ratios contracted despite surge in profits:

At Vivekam, we carried out an analysis to short list the NSE listed companies that enjoy a minimum of 1,000 Crore Market cap as on 30th November. We wanted to see how many from each basket showed higher profits compared to two years ago period. 413 out of 587 stocks shortlisted showed higher profits. We also checked on how many of them managed to expand their PE multiple, meaning, being able to attract higher valuations from investors. The following table throws some interesting things, probably hinting you where to go for profitable investing.

PAT up (No & %)

PE Ratio Up

PE Ratio Down

Large Cap – 100

75 —— 75%

22——–29%

53——-71%

Mid Cap – 150

114 ——-76%

21———18%

93——–82%

Small Cap – 337

224——- 67%

12———–5%

212——-95%

When stocks report higher PAT over time, their PE ratios expand yielding higher returns to investors. However, in this time frame, when we checked PE expansion for SmallCaps, 5% stocks saw PE expansion while a depressing 95% stocks saw PE ratio compressing in sync with distressed selling from MFs. The picture is not brighter for other two classes as well. 29% of LargeCap shares and 18% of MidCap shares only managed to expand while 71% of largecap and 82% of MidCap saw PE ratios compressing.

This clearly shows that the rally in Indices is led by a very few large companies, who not only managed to see their prices up but also their PE ratios expand beyond reason.

Outlook for investors in Large cap stocks:

The fall outs of this dangerous trend are frightening. This amounts to endorsing large companies as more investment worthy irrespective of operational performance. Savings of investors will head towards these select stocks, assuming them to be quality stocks endorsed by powers that be. We checked their price to earnings ratio (PE ratio) and compared it with broad based Index like Nifty. Among the large cap stocks listed by SEBI, we removed loss making ones and Government owned stocks to focus on publicly owned stocks. Based on latest trailing twelve months earnings and current prices, this basket of shares are trading at 37.09 PE ratio Vs Nifty PE ratio of 25.77. Any experienced professional will admit that further expansion of this multiple is more unlikely than otherwise. Which implies, MFs and investors who are betting on large cap stocks will have to be content with meagre returns or moderate losses into the near future. That might cause reverse momentum towards other alternative avenues to park funds mobilized, which means smaller companies will have brighter chances.

Are MFs changing gears? Changed gears?

Role played by MFs in price determination of stocks on our exchanges is undisputed. Let us now focus our attention to see if MFs have taken note of hidden opportunities in stocks outside SEBI’s top 250 list and began working to moderate their strategies already. In order to achieve the objective of higher returns while strictly adhering to regulations from SEBI on investment patterns, MFs have begun coming out with Multi Cap Schemes, Small Cap Schemes that will give their fund managers operational freedom to choose opportunities based on merits. They are not subjected to irrational restrictions under these schemes. An average of 36.20% of the funds mobilized by MFs in last seven months was for Multi Cap and Small Cap funds, as against 38% for Large Cap and Large & Midcaps. This clearly implies that the support for quality stocks, not withstanding their classification of being Small Cap stock, is building up or just about to build up. More than a handful of such stocks have witnessed aggressive investments resulting in prices catapulting in short span of time from their lows. Look at the following few examples..

What should you do at this juncture?

It is apt to call this SEBI induced rally in heavy weights as “Irrational Exuberance” and is more likely to be countered sooner than later. The outperformance of Nifty over all other indices has enjoyed an extended run of over 19 months and must come to an end giving way to performing quality stocks outside the top few. To put things in correct perspective, one must seriously consider looking at hidden gems which are languishing at throw away prices, despite remarkable performance in operations. Vivekam has always been picking up stocks that are fundamentally strong, enjoy more than 1,000 crore of market capitalization and have scope to grow from current levels.

Across the world and across different time horizons underperformance of this magnitude is followed with stellar outperformance over popular indices. We firmly believe that value lies in these class of stocks and they will help one build wealth provided you stick to the core principles of investing.

Does Future hold promise?

However, investors laced with serious erosion of their portfolio values may lack courage to invest in them at this time. Investors with long term focus are staring at a huge opportunity of multiplying their wealth by being contrarian to SEBI’s policy of “Big is beautiful”. Moreover, most MFs have completed their churns and off loaded their holdings so as to comply with SEBI directive already. This means, further supply from proxy managers like MFs is far less likely. Liquidity of stocks is too low and no sooner a stock draws attention of fund mangers or HNI, the price tends to move up very quickly.

At Vivekam, we are eager to see smiling faces sooner than later. Happy investing!