Small-cap crash: 20-stock portfolio strategy

After closing at a record high of 57,703 on 11 December 2024, the BSE SmallCap index has tumbled to 45,157 in just over two months, a fall of almost 22%, thus putting it in the category of a bear market.

Individual stocks have taken a much worse beating, some even falling by as much as 50%.

Opinions on what the market will do next and what should be the next course of action are extremely divided as expected.

Some anticipate the markets will fall further, while others believe that this could be a good time to start accumulating fundamentally strong small caps.

The current correction takes me back to July 2018 when the BSE SmallCap index entered into a bear market for the first time after crossing 20,000.

The situation then was similar to the situation right now when the index has entered into a bear market after reaching a lifetime high.

Now, suppose that someone wants to take advantage of the current fall in the small-cap index and wants to put together a portfolio of 20 stocks for the next three years.

Should she do so? Besides, what kind of stocks should she have in her portfolio?

In all honesty, while history does not repeat itself in the stock market, it certainly rhymes. Hence, it will be a good idea to check out how a portfolio of 20 stocks would have done over the next three years in a similar bear market in the past.

I just alluded to the bear market of July 2018, where the BSE SmallCap index crashed more than 20% after crossing a lifetime high of 20,000.

Well, let us use this bear market as a case study to determine whether it makes sense to invest in the small-cap index after a 20% fall.

Here’s what I did. I put together a portfolio of 20 small-cap stocks back in July 2018 and tracked its performance over the next three years.

I took three years because it is an ideal time period—neither too short nor too long. It gives enough time for a bear market to end and for a new bull market to start.

So, a fall of 20% from the top is a good time to start building a portfolio in my view.

What about the stocks though? What kind of stocks should be included in the portfolio?

Well, here also, I’d like to keep it very simple. I will include only those 20 small caps that are available at a PE ratio of between 10 and 20 and have as little debt as possible.

The idea is to include fundamentally strong companies that are available at attractive valuations.

A PE range of between 10 and 20 is indeed attractive in my opinion as it is neither too cheap nor too expensive. A PE below 10 may lead to a lot of value traps in case you are not careful while a PE greater than 20 makes the stock price too sensitive to the company’s earnings growth rate.

Hence, a PE ratio of between 10 and 20 consists of stocks that aren’t too fundamentally challenged, and even a small improvement in earnings growth over a historical trend can lead to a sharp jump in the share price.

It is these characteristics that led me to create our 20-stock portfolio.

Now, if I am allowed just one financial ratio to assess a stock’s fundamental strength, I’d like it to be the good old debt-to-equity ratio.

A consistently debt-free company is a company that’s usually consistently profitable, has a product or a service that is regularly in demand by its customers and has a management team that usually prioritises stability and safety over high growth.

And these are all the qualities that you need in your stock.

Hence, in addition to a PE ratio of between 10 and 20, I also insist on a debt-to-equity ratio that’s as close to zero as possible. I want each of the 20 stocks in the portfolio to be nearly debt-free.

So, here’s what we are doing. We are going back in time to July 2018 when the small-cap index suffered a more than 20% drop, and we are building a three-year 20-stock portfolio of small caps with a PE ratio of between 10 and 20 and debt-to-equity of almost zero.

This is what the 20-stock portfolio would have looked like: 

Rites Ltd, Navin Fluorine International Ltd, Engineers India Ltd, Bharat Dynamics Ltd, Tejas Networks Ltd, Maharashtra Seamless Ltd, Nocil Ltd, Persistent Systems Ltd, Balmer Lawrie & Co. Ltd, Avanti Feeds Ltd, eClerx Services Ltd, JB Chemicals & Pharmaceuticals Ltd, Kaveri Seed Co. Ltd, VST Industries Ltd, D.B. Corp. Ltd, TV Today Network Ltd, Cyient Ltd, Godfrey Phillips India Ltd, Greaves Cotton Ltd, and Force Motors Ltd.

Do you know the returns that this equal-weighted portfolio has given over the three-year period between July 2018 and July 2021?

Well, it stands at an impressive 82%. Yes, that’s right. A simple portfolio of 20 small-caps that are both fundamentally strong as well as attractively valued, would have outperformed the 68% returns earned by the BSE SmallCap index during the same period.

Hence, an investment strategy of investing after a 20% fall in the BSE SmallCap index, has certainly worked out in this case.

In fact, at almost 19% CAGR, even the BSE SmallCap index has given good returns during this period. However, at 22% CAGR, our 20-stock portfolio has done better than the BSE SmallCap index.

Ok, what do you think about these 20 names now:

Mahanagar Gas Ltd, Aditya Birla Sun Life AMC Ltd, Godfrey Phillips India Ltd, Supreme Petrochem Ltd, eClerx Services Ltd, Amara Raja Energy & Mobility Ltd, EKI Energy Services Ltd, BASF India Ltd, KRBL Ltd, Alivus Life Sciences Ltd, UTI Asset Management Co. Ltd, Gujarat State Petronet Ltd, Finolex Cables Ltd, Zensar Technologies Ltd, Graphite India Ltd, VST Industries Ltd, Triveni Turbine Ltd, Jubilant Ingrevia Ltd, FDC Ltd, and Rites Ltd.

Again, looks like a decent portfolio, isn’t it?

This hypothetical portfolio was created back in June 2022 when again, the BSE SmallCap index had taken a more than 20% tumble from its highs, i.e., the same situation that we are in today.

Besides, the criteria were also the same, i.e., a PE ratio of between 10 and 20 and almost zero debt status.

So, how did this portfolio do between June 2022 and now (17 February 2025)?

Well, it almost doubled in value. Yes, that’s right. Buying after a 20% fall in the BSE SmallCap index has again proved to be a rewarding strategy with the portfolio doubling in value.

It’s worth highlighting that even the BSE SmallCap index did quite well during this period and notched up gains of almost 86% point to point. Yet again, our simple 20-stock portfolio outperformed the BSE SmallCap index.

Based on these two events, it is clear that investing in fundamentally strong and attractively valued small caps after a more than 20% fall does have a chance of working out well over a three-year period.

And if this is evidence enough for you to start thinking of building your own 20-stock portfolio, here are the names you can have on your watchlist.

Zee Entertainment Enterprises Ltd, Avanti Feeds Ltd, Force Motors Ltd, Gujarat State Petronet Ltd, Gland Pharma Ltd, Shriram Pistons & Rings Ltd, Sun TV Network Ltd, Finolex Industries Ltd, Chambal Fertilisers and Chemicals Ltd, Mahanagar Gas Ltd, Cyient Ltd, Redington Ltd, UTI Asset Management Co. Ltd, Quess Corp Ltd, Ircon International Ltd, Aditya Birla Sun Life AMC Ltd, NCC Ltd, Welspun Living Ltd, Amara Raja Energy & Mobility Ltd, and Vardhman Textiles Ltd.

So, these are the stocks that you can keep on your watchlist if you are looking to invest in small caps at the current levels.

The last two times the index fell 20% from the top, a portfolio with the same characteristics as these 20 stocks, did really well over a three-year period.

Will history repeat itself? Will these stocks also give similar returns over the next three years?

Truth be told, there are no guarantees in investing. All you can do is follow a sound process and then hope for the best.

And if it is some consolation, our process is indeed sound.

We are not considering investing at all-time highs but after a significant fall. Plus, we are also looking at building a portfolio of fundamentally sound companies trading at attractive valuations.

So, if the small-cap index does well over the next three years, there is a strong chance this portfolio will also do well.

If you still have some doubts, you can always consider partial buying right now and the remaining after some more correction, which may or may not happen.

The choice is yours. Please note there are no certainties in investing, only probabilities. And this is how you should always approach the market, with a probabilistic lens.

Happy investing.

Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such.

This article is syndicated from Equitymaster.com.