Smallcaps: Big opportunity or treading on thin ice?

stock investment

Tata Mutual Fund’s recent move to stop accepting lump sum amounts and switch-in investments in its Small Cap Fund has sparked concerns about whether there are any opportunities left in the smallcap space.

Going forward, Tata Small Cap Fund will only accept investments through systematic investment plans (SIPs) and systematic transfer plans (STPs). The fund was launched in November 2018 and manages assets worth Rs 4,458 crore. The scheme has emerged as one of the top performers in the smallcap category with 40.34 percent and 40.25 percent returns in one and three years, respectively.

Anand Varadarajan, Head- Institutional clients, Banking, Alternate investments and Product strategy, Tata Asset Management, explained, "Our smallcap fund has been doing very well and has attracted strong inflows. However, due to the illiquid nature of smallcaps, deployment takes time as one has to wait for the right opportunities. Chasing the stocks may drive up the price, thereby defeating the very purpose of investing."

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Speaking to Moneycontrol, Vardarajan said the move is aimed at merely slowing down the inflows, which have been higher than the money deployed, leading to a surge in cash levels.

Stating that the fund is not in a rush to deploy, he said, “We want the rate of deployment and cash levels to stabilise before we start accepting lump sum and switch-in payments again.”

He added that there is no timeline as of now to start accepting lump sums again.

According to the mutual fund data, monthly inflows for smallcap funds increased from Rs 44,000 crore in 2019 to Rs 1.48 lakh crore as of May 2023.

Siddharth Oberoi, Founder and Chief Investment Officer at Prudent Equity, said this threefold growth rate is the highest of any category and demonstrates the high investor interest in smallcap stocks.

Data from the Association of Mutual Funds of India (AMFI) showed that smallcap and midcap focused MFs saw net inflows of Rs 20,900 crore year to date in 2023, which is almost two times the inflows seen in large and multicap equity funds. The sharp surge in inflows into small and midcap funds is reflective of the increasing risk appetite of investors.

Size matters

Oberoi said the major caveat here is that because smallcap inflows are increasing, MFs are finding it difficult to deploy capital effectively as their size expands.  Tata Small Cap Fund has a size of Rs 4,500 crore, which makes it difficult for it to generate significant returns, he added.

Anil Rego, Founder of Right Horizons PMS, said that a large fund house could face challenges while investing in smallcaps as getting in could still be easy but getting out could be tricky.

Yet Mohit Nigam, Head & President of Portfolio Management Services, Hem Securities, looks at it differently. According to him, even though challenges regarding deployment and liquidity exist while investing in the smallcap space, a staggered payment might mitigate these difficulties significantly.

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In the past, SBI Small Cap Fund and Mirae Asset Emerging Bluechip Fund had also capped their inflows.

Even now SBI Small Cap Fund continues to take limited inflows through SIPs. R Srinivasan, Chief Investment Officer – Equity, SBI Mutual Fund, believes smallcaps are still unfavourable even with the recent surge seen in the sector.

“We are short of ideas and believe valuations are expensive for the stocks we like and wish to potentially initiate exposure or add,” he said.

“There is also a liquidity issue. The fund is fairly illiquid and the impact cost in the smallcap space is high. And last, but not the least, we presently have more than 50 positions in the fund; if we weren’t capacity constrained, we would have had much less,” Srinivasan said.

The challenge is the overall size of the fund, he added. Institutional buyers also have a large corpus, and hence the larger the size, the more difficult it is to size up positions based on liquidity. “Also, the reason you need liquidity is not just from a potential redemption perspective; it is also to handicap your probability of going wrong on the stock call,” he said.

The corpus of smallcap funds with SBI Mutual Fund stood at Rs 17,567 crore as on May 31, 2023.

Opportunities galore?

A pocket of the market believes there are ample opportunities in the broader market, particularly among smallcaps.

Even at an all-time high market, Sreeram Ramdas, Smallcase Manager and Vice President, Green Portfolio, sees multi-bagger opportunities in the smallcap space.

“This is where we are seeing huge opportunities. Despite the market rally, there are companies in niche sectors available at 8-10 times price-to-earnings while their business is witnessing 20-30 percent growth. Q4 results were a hint of positivity and acted as a catapult,” Ramdas said.

Moreover, the management guidance in most sectors is pointing towards a robust first quarter, which markets are yet to factor in, he said.

In the smallcap space, Ramdas said his fund’s exposure to IT and financial services companies is currently low but is overweight on chemicals, pharmaceuticals, and textiles. “In our overweight sectors, margins are coming back, revenue growth is being reinstated, and management guidance is indicating strong recovery.”

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Oberoi of Prudent Equity too believes that the opportunity in this space is enormous. “These companies are starting from a low foundation, and as their earnings begin to rise, their entire financial profile will be lifted to a whole new level. Furthermore, such businesses benefit the most from ongoing government initiatives such as the PLI scheme,” he said.

Smallcap stocks have stronger growth rates and offer more acceptable valuations than their peers in the current environment, according to Oberoi, who is bullish on infrastructure, be it renewable energy, civil construction, specialised engineering or railways. “Every day there is order bagging going on, and an approximately 20 percent growth rate for such companies in the next 12-24 months cannot be ruled out,” he added.

This segment is undervalued as compared to large-caps, pointed out Rego. He expects smallcaps and midcaps to outperform over the next three to four years.

Disclaimer: The views and investment tips expressed by experts on Moneycontrol.com are their own and not those of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.