CNX Small Cap | Portfolio Yoga

When LTCM got into trouble, the only way out was to offload some of its positions and hope that they can reduce their leverage. Thanks to the fact that for many of the bonds, they had become the market and with negative news all around, volumes dried up. This meant that when they tried to sell a small quantity, they moved the market enough to lose even larger on what they continued to hold. We saw the same episode repeat in Amaranth in Natural Gas.

Liquidity begets Liquidity until it doesn’t. Bombay Stock Exchange is Asia’s oldest stock exchange but today, NSE is the leader when it comes to volumes.

In 2017, your portfolio would have been a happy portfolio if invested in small cap stocks. Cut forward to today, if you have a large small cap portfolio, you would have not only suffered enormous draw-down but as one PMS has seen, its unable to exit its stocks since the volumes are so low that any large quantity sell will impact prices making losses even larger for the rest of the clients.

SEBI’s new rules have meant that there is a clear classification of what constitutes Large Cap, Mid Cap and Small Cap. On AMFI, the first file with the new classification was uploaded on 2nd January 2018.

Using that data, I wanted to compute the average volume and value of stocks that qualified for those categories and then compare with what is seen in the same set of stocks today. The results aren’t surprising, but average 10 day volume for small caps (using market cap based Ranks from Rank 251 to 500) has plummeted 65% while average value is down 70%.

Volume and Value Comparison by Market Cap categorization as of 1st January 2018

One reason Institution coverage is basically negligible when it comes to small cap stocks is that there is barely any volumes is most counters making entry and exit humongously difficult. In fact, the above mentioned PMS is rumoured to have asked clients to take delivery of the stock in lieu of funds when they wished to close out the account.

Yet, such lack of liquidity and coverage is also the reason there is long term evidence of small cap premium {there is a dispute on whether this still exists when we adjust for volatility, but that is for another day}.

Small caps become Mid Caps and some later become Large Caps. Very few are able to make that journey, but those who do provide returns of a nature that is beyond what any active or passive fund can generate. The million dollar question of course is how to identify such stocks 🙂

Price Earnings Ratio is something I believe is an important number and the PE ratio for Index has a way of showing where we are and based on past data what can be expected (with a reasonable probability of success) in the forthcoming months / year.

Consequently I use Nifty PE (while Sensex PE has a much longer history, its now not available for Free). The other day a friend on twitter asked me whether I was tracking the Small Cap Index. Curiosity sake, I downloaded the same and was stumped on finding it showing moves that even a micro cap will not show.

Do look at the weekly chart of the Small Cap Index

It’s one thing to expect gaps in historical data when you are checking out a stock. But this is worse since the gaps are on both sides and worse, day to day changes are some times so huge so as to make little sense as to what changed.

For example, the Small Cap PE rose from 24.17 to 49.34 one fine day in September 2012. The change in Index on same day (0.8%). On 16th Jan 2013, PE fell by 20% even as the Index fell by 1.5%. Another 20% fall in the PE was noticed on 1st April 2013 whereas the Index that day actually climbed 2.2%

In March and July of 2013, we once again saw 2 bumps up of nearly 20% on the PE Index even as the Index itself remained more or less flat on those days.

And then we had the mother of all rises as the PE index jumped from 50.17 to 162.83 on 28th March 2014. The Index on the same occasion rose by just 2.1%

On 7th April, the Index went up by 15.5%, went down the same percentage on 5th May and made a pole vault as it jumped 48.5% on 12th May. Of course, since after jumping up the pole, the next way is down,, PE dropped by 46.8% on 19th May. 22nd saw the PE Index jump by 20% and yesterday, another 10% rise.

Since the whole thing made little sense to me, I wrote to India Index Services & Products Limited regarding the huge gaps and today they were kind enough to reply to my mail with the following reply

I understand that as stocks are added and deleted, PE does change. But the kind of change one has seen in the small cap Index makes the whole work of tracking valuation pretty worthless. I mean which Index (other than maybe Zimbabwe) has PE valuations of 296 and this is not a single stock Index but a Index comprising 100 stocks.

Unlike say the CNX IT Index where Infy alone contributes to more than 50% of the weight (the top 3 in sum contribute nearly 85% of the weight making the rest of the stocks just showpieces whose movements will have no significant moves in the Index), here the Top 10 in total contribute just 17% which signifies that the spread is good (Link)

As of now, we do not have a ETF tracking small cap’s, but I believe that as the financial markets mature, we should see a lot more ETF’s than those currently in operation and when that happens, this kind of data blows away any analysis that maybe used with good results elsewhere.

Tag: CNX Small Cap

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