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The Indian stock market is in a clear downtrend. We had barely taken a breather from harsh tariffs, and now we find ourselves caught up in the consequences of a war.

Given our dependence on oil and gas imports and trade with West Asia, this has serious implications for India. And the markets are reflecting that.

The pain is much sharper in broader markets than what indices reflect. If you own small-cap stocks, you have felt the pain.

Could the war end soon and cause the market direction to turn up again? Sure, it's possible, but the way things have panned out in West Asia so far, there doesn't seem to be an immediate light at the end of this tunnel.

The first and most important thing to remember is:''This too shall pass'. Wars, just like any other disruption to global financial markets, are temporary.

During Operation Sindoor the stock market reacted negatively at first, but things returned to normal very fast. In fact, after the conflict, it seemed like the bull market had resumed.

Even in 1999, after the Kargil war, the market delivered strong gains once the conflict ended.

When Russia attacked Ukraine in February 2022, there was a serious disruption in global markets, and the stock market did not recover for a few months. But then the market did recover and soared to new highs. That bull market lasted till September 2024.

Expect something similar this time as well. There will be a period of gloom and bearishness. Then stock prices will rise again.

Those who bought stocks during the war will profit from the upmove that follows. Those who did not buy will be left with regret.

Of course, you cannot buy any stock, especially smallcaps. You have to be selective. Do your due diligence. Identify fundamentally strong small-cap stocks. Keep the on your watchlist.

Buy them when the share price offers a good margin of safety in terms of valuations, i.e., low price to earnings (PE) and price to book (PB).

There is another thing you will need to check…

With so much uncertainty around, it is worth tracking what managements are doing. This signal is better than what the so-called market experts are saying. Tracking insider trades is a good way to see what promoters and the management are doing.

Check for insider buying or selling. That will give you a hint about what the promoters/senior managers are thinking about the business.

To be sure, insider buying is not a tip or a shortcut. It's a way of thinking about businesses. It helps investors sit through long periods of stagnation, avoid panic during corrections, and remain invested when nothing appears to be happening on the surface.

This is especially true for investing in smallcaps because these companies tend to be run by small management teams and often by one promoter.

In a prolonged bull market, small-cap stocks across the board tend to soar. Most well beyond their fundamentals.

Smallcap valuations get frothy over time. Yet investors pile on to the stocks in the hope that markets will continue to rise.

Eventually, investors go wrong, markets crash and many lose their shirts.

What draws investors to smallcaps is the idea of fetching bigger returns from relatively smaller amounts of capital. And that is a perfectly good idea when the smallcap valuations are cheap.

But when the stocks of high-risk businesses are valued at a premium, with the assumption of steep earnings growth, they become double-edged swords.

A majority of smallcap business lack fortitude, sustainability, and good governance. Hence, they tend to falter on investor expectations. And that is when their valuations come crashing like nine pins.

The biggest wealth creators almost never announce themselves loudly.

They don't show up first on TV tips, they don't trend on social media, and they rarely look exciting in the early years.

More often than not, they begin quietly, when most investors are distracted, impatient, or looking for quicker gratification elsewhere.

To invest successfully in smallcaps, you need to find companies with good growth prospects, low or zero debt, strong cash flows, and decent return ratios (around 15% at least).

Further, check the historical growth rates for both revenue and profits, the company’s position in the industry and finally insider activity.

Even if you have done all this, remember small companies need time to grow and become mid-sized companies. The stock prices will follow along. Don’t expect quick profits.

This ongoing market correction offers a good opportunity to consider high-quality small-cap stocks for the long term.

Just ensure a decent margin of safety in terms of valuations.

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

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