After several months of posting strong sequential returns, the small and midcap space posted negative returns for the month of August 2021. The benchmark smallcap index BSE Smallcap was flat for the month and does not reflect the correction in the majority of smallcap stocks in the broader market.
Since our strategy has a lion’s share of allocation to small and midcap stocks, it is natural for us to turn cautious and introspect on how we should handle a sharp correction or the onset of a bear market in the worst case.
The past 1.5 yr or so have been great for the equity markets and we have also benefited from the broad rally in equities. However, it is now important for us to not only protect our past returns but generate healthy absolute returns from hereon.
Over our long investing career, we have witnessed several market cycles and our experience and mistakes have taught us some key learnings from what we have seen working successfully in a bear market. Read on.
Patience is key
The most important thing is to remain patient and not get scared by the correction. One should remember that a bear market is actually an opportunity and outsized returns can only be made if one remains invested or initiates investment in differentiated and durable businesses during a bear market.A bear market is actually an opportunity. Outsized returns can only be made if you remain invested or initiate new investment in differentiated and durable businesses during a bear market Click To Tweet
Whenever the cycle turns, the top of the next bull market is always much higher than the previous bull market top. Even the bull market in equities that started in April 2020 had its beginning in a very sharp market correction of over 30% during February-March 2020. The longest and most rewarding bull market of 2003-2008 in Indian equities had its beginning in a very severe bear market of 2001-2003.
Similarly, the sharp rally in small and midcap stocks over 2014-2017 had its beginning in the bear phase in small and midcap stocks over 2010-2013. Exceptional equity returns cannot be made without enduring some pain during a bear market phase.
Timing the market is not as easy
Several prospective clients ask us if now is a good time to enter the market since returns have been so high. Our answer is always that the best time to start investing is immediately because we have seen that it is impossible to time the market. The only caveat we clearly mention is that we believe investing is for the long term and one needs to remain invested at least 2-3 yrs especially to reap the benefits of a medium- to long-term focused fundamentals strategy like ours.
It is impossible for anyone to predict the onset of a bear market and fully exit before it and similarly predict the start of a bull market and invest meaningfully then. Just as an example, we believe very few investors would have been able to predict the sharp and quick correction during February-March 2020 and exited immediately to enter subsequently in June-July 2020 when the rally started.During times of market correction, you should not try to predict the bottom and time your entry but initiate investing or remain invested Click To Tweet
What we saw was that investors who panicked and sold out during the crash of March 2020 were never able to meaningfully enter the market until much later thus missing out on a large part of the huge rally especially in small and midcap stocks. Anchoring bias of having seen stocks at much lower levels and fear that the rally is unsustainable made it impossible for such investors to enter until they missed out on a substantial portion of returns.
On the other hand, investors who invested with us in 2019 much before the crash of March 2020 and remain invested during that painful phase went on to enjoy very handsome returns on their invested corpus despite suffering the large and sharp correction in the interim.
So, a key learning for us during times of correction or a bear phase is to not try to predict the bottom and time your market entry but initiate investing or remain invested. Time spent in the market is always more important than time of market entry/exit.Time spent in the market is more important than timing your entry or exit Click To Tweet
Don’t fear corrections
One should not be scared of corrections during a bear phase. However, one should also not be absolutely passive and do nothing. It is a fact that every bull market rally is clearly led by a new sector and it is seldom the case that different bull markets have common sector leaders. So during a bear phase, it is very important to evaluate one’s portfolio and determine which investments will do well and correct less during the bear phase and subsequently lead when the cycle reverses.
We have a strong focus on evaluating industry fundamentals in our investment framework and we only invest in companies from sectors that we believe will enjoy strong tailwinds during the investment horizon. Even once we are invested, we continuously track industry developments to check which industries are doing well as per our expectations and which are not.
We are very objective in exiting industries that are facing challenges and increasing allocation in industries that are doing well. This disciplined method of force ranking industry prospects becomes even more important in a bear phase as it is important to exit industries that will come under stress during a bear phase and increase allocation to industries that are poised to do well and lead when the cycle reverses.
We did this during the correction of March 2020 when we increased allocation to sectors like IT and pharma that witnessed relatively lesser correction and then initiated the market recovery. We continued to track and evaluate which sectors will do well subsequently and later on rotated into sectors like auto and cement that started outperforming during the later phase of the current market rally.
Stick to your investment philosophy
Lastly, we believe it is important to stick to one’s investment framework during a bear phase. It is natural to start doubting one’s investment philosophy when one witnesses a sharp correction. However, it is critical to remember that such corrections are majorly driven by temporary market factors such as a sharp drop in liquidity, extreme fear among investors, etc. rather than by business fundamentals.
It is important to separate the business performance from the stock price performance and continue to follow one’s investment process. For us, we try to maintain the discipline of only investing in high-quality businesses run by honest and competent management.
During sharp corrections, we try to maintain our calm and avoid jumping to other investment philosophies like only investing in large caps just because they are perceived to be better businesses, investing in stocks that have fallen the most and seemingly offer great value despite poor business fundamentals, investing concentratedly in sectors that led the past bull market, etc. We have seen that changing one’s framework during a bear phase can lead to disastrous results.
While we think it is too early to say that the volatility in August is the start of a bear phase, we believe we should be able to handle it and in fact, take advantage of it by following our learnings from previous bear market phases.
Check out smallcases managed by Prescient Capital, whose co-founder is the author.