SMIN: Caution Warranted Towards One Of The Dazzling Equity Counters Of The World

Rock-Solid Alpha Generation

The iShares MSCI India Small-Cap ETF (BATS:SMIN) is an $800m sized ETF that covers close to 500 small-cap stocks in India. Note that over the past year, this has proven to be one of the stellar equity pockets across the world, generating returns of over 40%, also translating to 10x the return profile of emerging markets in general! Even against a more diversified and broader pool of global stocks it has come out on top by over 2x.

Even within India as well, it appears as though much of the volumes are going away from the largest stocks to the broader markets. Note that the large-cap dominated Nifty 50’s turnover as a proportion of total turnover has slumped from 0.6x levels seen in the early days of the pandemic to almost 0.2x now.

Underlying Conditions Look Good

The euphoria towards Indian small-caps is firstly founded on the dazzling growth landscape of the country. The most recent official GDP data showed that India’s economy expanded by a whopping 8.4% in the final quarter of last year; note that this was well ahead of average consensus numbers (Reuters) of 6.6%, and even a good 100bps higher than the most optimistic forecast of 7.4%.

Looking ahead, the IMF now expects India to generate solid enough GDP growth of 6.5%, not just in FY24, but in FY25 as well. In contrast, the globe is only expected to grow at half that pace at around 3.1-3.2%.

Investors are lapping up small-caps because they are considered a high-beta play on the exemplary growth runway. With small-caps, one is also likely to get exposure to niche budding industries where the sky is the limit, as opposed to diversified large-caps whose growth potential can could be subdued by conflicting developments across various focus markets. Large-caps are also more susceptible to the vagaries of global conditions.

These small-caps will also likely benefit from the political stability that India offers; the latest polls suggest that the Modi government looks all but certain to manage affairs for the third straight term. With the BJP-led NDA government also poised to garner an overwhelming chunk of Lok Sabha seats, the prospects of salutary structural reforms look increasingly bright (the previous Lok-Sabha was described as a game-changer). These reforms could play a key role in removing some of the long-standing bottlenecks that small-cap businesses often have to contend with.

Nonetheless corporate India’s optimistic stance towards the Modi government can be captured by the Business Confidence index which is currently at levels of 135.4 (just to highlight how high this is, note that the average reading from 2000 to 2023 only stood at 118.85).

Note that SMIN’s small-cap portfolio is primarily oriented towards industrial stocks, and here too, conditions look very healthy. The latest industrial production readings pointed to a growth of nearly 4% YoY, up from the 2.4% runrate seen in the previous month (market expectations too were only for a 2.4% print). Meanwhile the forward looking manufacturing PMI rose to 5-month highs (even otherwise do note that the PMI has been in expansion territory for a good 32 months now). The margin outlook for these industrials look particularly bright, as input price inflation has dropped to its lowest level since August 2020. Besides, the recovery in export markets (export order growth is at 21 month highs), will also help drive strong operating leverage.

Closing Thoughts- SMIN Isn’t A Good Buy Now

Up until now, we may have painted an impression of things being hunky dory, but we feel investors would do well to be a little cautious now.

Firstly consider that Indian small-caps look inordinately pricey at the moment, and one does wonder if prices have already moved way ahead of the fundamentals. Given the long-standing merits of the Indian economy and the political landscape, it is expected that Indian stocks will almost always be priced at a premium to the rest of the world, but in SMIN’s case one does wonder if things have gone too far. Basically, if you want to own this product, you’d have to shed out a heightened P/E of 28.1x! In contrast, a diversified portfolio of emerging market small-caps can be picked up at a much lower P/E of 13.8x.

In graphical terms, see how the Indian small-cap to EM small-cap ratio is at record highs, and trading a good 48% over its average.

The overextended nature of SMIN can be gleaned not just against EM small-caps, but against the most popular India-themed ETF as well -INDA (INDA covers large, mid and small-caps), where the RS ratio has now hit levels last seen in 2018 from where we saw a reversal.

Note that we aren’t the only ones flagging concerns about Indian small-caps. AMFI- the body which regulates Indian asset managers is now looking to take steps that could curtail inflows towards small and mid-cap funds. Some of the steps mooted could cause some liquidation pressures in small-cap stocks. Already we’ve seen some major domestic fund houses such as Tata, Nippon, Kotak, limit inflows towards their small-cap funds.

Separately, it’s also worth noting that SMIN itself has recently come under some meaningful fund outflow pressure. After months of positive fund flows, in just one week in March, we’ve seen nearly $50m of outflows. For an $800m sized product that translates to a figure of over 6%.

Finally, if we look at SMIN’s long-term chart, it looks like the price has been forming a rising wedge pattern, which points to a risk of a breakdown. Even if you want to dismiss the risk of a breakdown, do consider that the reward to risk (considering the two boundaries of the wedge) within the wedge does not look too comforting for a long position. Separately, also note that the RSI indicator is now signaling overbought conditions.