How To Play The Small & Mid-Cap Resurgence

Contrary to popular belief, Small and Mid-Cap stocks do not always provide better returns than Large-Cap stocks.

In academia, the thesis is that these "riskier" Small and Mid-Cap stocks should provide a higher potential return than more mature "Large-Cap" stocks. If they didn't, then rational investors would not own them because they're not being adequately compensated for the risk they're taking.

In the real world, we know that this theory is absolute nonsense. Instead of the consistent outperformance from the SMID (Small/Mid-Cap) segment of the market, we see periods of outperformance, periods of in-line performance, and performance of underperformance.

Since 2018 the SMID market-cap segments have been absolutely clobbered, but the weight of the evidence is suggesting that we may be at a major inflection point and SMID stocks are beginning a period of long-term outperformance.

Here we're going to explore the SMID resurgence thesis, what it would mean for Equities as an asset class, and how we're taking advantage of it.

First, let's start with the Nifty 50/Nifty Small-Cap 100 ratio. Since January 2018 it has been in a strong uptrend, signaling outperformance from Large-Cap stocks...but it is now confirming a failed breakout. Failed moves often lead to fast moves in the opposite direction and can mark important turning points in a trend.

Click on chart to enlarge view.

From our perspective, as long as prices are below their former highs near 2.30 then the bias in this ratio is lower, meaning that Small-Cap stocks are set to outperform their Large-Cap peers.

If Small-Cap stocks are outperforming, what does that mean for Equities in general?

We've written an extensive educational piece on the meaning behind this ratio which we highly recommend reading, but the short version is that Small-Cap outperformance is a positive for Equities as an asset class.

Whether it's a coincident indicator or leading indicator is up for debate, but regardless, it's hard to ignore the fact that major market tops/bottoms in the Nifty 500 are accompanied by major bottoms/tops in the Nifty 50/Nifty Small-Cap 100 ratio. Peaks in the Nifty 500 are often accompanied by troughs in the ratio, and vice versa.

So was the recent low in the market and top in the Nifty 50/Nifty Small-Cap 100 ratio "the inflection point" and now we're off to the races?

It appears so.

In addition to the Nifty 50/Nifty Small-Cap 100 ratio being below 2.30 as discussed above, here's how we'll know our thesis is correct.

We have to look at stocks on an absolute basis. The Nifty Indices and a lot of Equity Indices around the world are at long-term resistance levels, which can either be turning points before stocks roll over again...or the last levels we need to clear before we can see further upside in stocks.

Here's the Nifty 50 chart from that post testing a confluence of resistance near 10,000. A new bull market in stocks can ONLY occur if prices of the Nifty 50 are decisively above 10,000. If we're below that, then the risk in stocks is still to the downside.

The main point of these charts is this: while Small-Caps have outperformed over the last 3 months, for them to experience sustained outperformance for months, quarters, and years to come, stocks need to be in an uptrend on an absolute basis. And what would signal to us that stocks have an upward bias on an absolute basis? The Nifty 50 being above 10,000.

So now that we have our thesis and what would signal us being right/wrong, let's figure out how to take advantage of it.

Given how beaten up the Small and Mid-Cap space has been, we want to position ourselves in stocks where the reward/risk is extremely well-defined and skewered in our favor. The reason we're focused on the risk is because if we're wrong, we want to minimize our downside relative to the potential reward if we're right.

Our favorite way to identify stocks that foot this bill is by looking for trend reversals sparked by a failed breakdown and bullish momentum divergence. We're constantly discussing setups like this, but the main characteristics we want to highlight are these.

1. The stock reaches a long-term support level;
2. Momentum is diverging positively; and
3. A failed breakdown sparks the rally and allows us to define our risk.

Here's a good example in Birla Corp. Ltd., which we highlighted on May 26th. Prices briefly broke below long-term support near 385 as momentum diverged positively, quickly reversing to the upside and confirming the start of a new move to the upside.

So far so good, with prices continuing to advance and nearly halfway to our 800 price objective.

While this isn't a Small-Cap, another stock we outlined in that post was Tata Power, which had broken briefly below support at 31 and quickly reversed.

And as we saw with Birla, prices are already halfway to their 55 price objective.

This isn't to say that you can't also take advantage of the Small and Mid-Cap outperformance by owning the strongest stocks in those market-cap segments. That's an approach we like as well, but given how beaten-down a lot of these stocks are there is potential for massive upside if we do indeed catch them near the start of a long-term trend reversal.

And given that this broader thesis is centered on a long-term resurgence in Mid/Small-Cap stock relative performance, it seems like an appropriate time to bottom-fish. But not blindly. We're going to bottom-fish using the failed breakdown setup that defines our risk extremely well and skews the reward/risk ridiculously in our favor.

It really just depends on the type of market participant you are. Some people are comfortable buying stocks near a long-term inflection point and seeing how they develop, while others prefer to buy stocks already in uptrends and just ride those.

Neither is right or wrong and is why we highlight setups of both types on the blog constantly. Deciding which is appropriate for your portfolio is a question only you can answer.

With that said, let's get into some of the best bottom-fishing setups in the Small/Mid-Cap space right now.