Opinion: Stop doubting Small-Cap stocks, IL&FS crisis is controlled and over

Last Updated: Fri, Dec 14, 2018 20:13 hrs
A man looks at a screen across a road displaying the Sensex on the facade of the Bombay Stock Exchange (BSE) building in Mumbai

The recent downturn in the Indian stock markets has extensively fueled discontent among the investors. This can be attributed mainly to three major factors – movement in domestic macroeconomic indicators, political outcome of the on-going elections and global factors. Another key contributor to this worsened situation is the IL&FS debacle, which has created ripples in the country’s equity and debt markets.

The situation post IL&FS is so disastrous that many have labelled it as a ‘Lehman’ phase of the Indian banking system. The fall of Lehman Brothers in 2008 narrated a similar story that stunned the Western financial world with its massive subprime crisis.

And this IL&FS mayhem has extremely affected small-cap companies as well, resulting in their fall.

In the wake of such a fall, it’s critical for investors to seek companies that will continue to grow and later to those that maintained competitive positioning, that is the top 2-3 in the segment.

Also, it is found that investors mostly ignore the small and mid-cap companies despite their impressive future growth prospects. These companies have huge potential to grow faster and have high possibilities to become large companies in the future. It's more like the good old risk versus return concept. However, to stand as beneficiaries in such situations, investors should stay mindful and have a focus on identifying the future winners.

For this, investors must brave the sporadic changes in the prices of small-cap stocks, outsized volatility and of-course be more courageous to invest in these small-cap companies. But again, all this should be done by keeping in mind that investing in small-cap stocks could also land one into huge losses despite the big gains.

Let’s look closely at the pros and cons of investing in small-cap stocks.

In the real world, market analysts and advisors do not track small-cap stocks thoroughly. Hence investors fail to know the real value of good stocks.

This eventually creates a perception of risk from investing in such stocks. However, investors may get huge rewards if the real value of these stocks is found, because of their power to turn into midcap or large-cap over a period of time. On the flip side, selling or buying small-cap stocks can take a lot of time, much longer than expected due to their low equity base. Also, exiting a small-cap could be really difficult in case of a wrong purchase. Adding to their doubtful returns is a short track record, weak governance, the paucity of professionalism and unstructured dividend policies that make them riskier than large-cap companies. Hence it is always difficult to analyze their performance.

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Understanding The IL&FS Case

IL&FS group’s debt securities in terms of the credit quality appeared genuine and looked good till a month and a half ago. Initially, it was given the rating rationale of A1+ that denotes topmost rating in terms of repayment. IL&FS, however, experienced a sudden massive downfall on 17th September and the rating was dwindled from A1+ to D. The crisis began when it was found that IL&FS defaulted on it's interest payments for commercial papers of September.

This happened due to the lack of internal risk analysis, which is one of the key responsibilities of an asset manager.

It is clear that active management was missing in this case. The company showed sheer dependence on an outside agency, which was rather a sign of laziness. It also pans out that regulatory monitoring of credit rating agencies should further be enhanced to avoid such mishaps in the future. In a nutshell, we can say that both the asset manager and fund manager failed to perform their duties.

The Major Victims

Banking stocks topped the list of sufferers in the wake of IL&FS. Data by Value Research showed that the banking sector category was hit by a negative 13.37 per cent return in the month ended September 28. NBFCs stand second to take the sucker punch and fell by 15-60 per cent in the same month. The decline was followed by small-cap and mid-cap funds category that suffered a negative 12.19 per cent and 11.37 per cent average return respectively.

Research says that liquid debt funds are also the victims of the IL&FS fall. Rs 70, 000 crores have been redeemed from liquid funds itself. Also, ultra liquid schemes have suffered because of the net outflows of around Rs 20,000 crores.

A difficult situation for SMEs

Inflation rates were used to be around 8-10 per cent a few years ago. At that time period, it was not such a big task to borrow at 12-13 per cent. However, that era has transformed now. In today’s lower inflation of just 4 per cent, SMEs find it difficult to borrow at a rate as high as 12 per cent. It is not a threat that's only limited to SMEs, but to the entire financial system.

High-interest rates for prolonged periods will only increase stress on the existing SMEs. Therefore, for investors, small-cap segments that can give good returns at this point are FMCG, banking, pharmaceutical and information technology.

The present financial chaos at IL&FS exemplifies the company’s excessive leverage and inefficient cash-flow management.

The company was also close to the debt markets and the Indian economy, and now that it’s virtually shut out of the debt markets, it completely relies on its shareholders for asset liquidation and capital infusion. The company needs a sheer overhaul in its corporate structure, which is possible only by simplifying and pruning the structure further.

The Indian stock markets were already facing assaults from higher crude oil prices and rupee depreciation. IL&FS has been a new add-on. Companies in the financial sector have witnessed massive erosions in the values. SMEs being the major sufferers, thus, have to be keener from now on. Investors despite being scared of investing in small and midcaps should step forward and take bold risks, but only after proper research, to be on the safer side.

Rachit Chawla is Founder and CEO of Finway, an RBI approved NBFC. Chawla is also a registered Financial Advisor.

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