Despite markets at all-time highs, small-cap funds remain worthy

Buzzing Stocks, Slideshow

The Nifty index hit a new peak on Monday, marking a strong start to the week. Many stocks saw new 52-week highs. However, the small-cap index is still hovering below its previous high. Many investors, especially retail investors, are invested in these stocks either directly or through mutual funds.

Investing in good quality small-cap stocks has rewarded many long-term investors in the past. After the frontline indices start moving northward, many expect small-cap stocks to follow suit. Many have started looking at them as long-term bets at relatively lower levels. Also, the new fund offer of Mahindra Manulife Small Cap Fund also opened on November 21.

Most investors look at small-cap stocks as high-return bets. But these are also very volatile, and to make money on these one need to buy relatively cheap and at a time the economy is expanding. Though economists may keep arguing about the actual rate, it seems certain that the Indian economy will post decent growth despite rising interest rates. Small-cap stocks with a strong underlying business and a healthy balance sheet may benefit from this broad-based recovery in the economy.

The stock market has seen a rally post the pandemic-induced lockdowns in India. Though stocks have corrected in the recent past, they are still far from being cheap. Investors need to look at them in the context of the relative valuations.

“Since 2011, on an average the Nifty Smallcap 250 Index PE (price-earnings multiple) quoted at 2.07 times that of the Nifty 50 Index. However, when PE ratio of the small-cap index went down to 0.7 times that of the large-cap index, the small-caps gave higher returns. Currently it quotes at 0.7 times,” says Yogesh Kalwani, head, investments, InCred Wealth, a Mumbai-based investment advisory firm.

While many investors look at small-cap stocks as a ticket to the high-growth, high-volatility and high-returns universe, many others do not favour them citing poor liquidity. However, after the categorisation of mutual fund schemes dictated by the Securities and Exchange Board of India (SEBI), things have changed. Small-cap stocks include all stocks from 251st stocks to 500th stock by market capitalisation. Small-cap funds have to invest at least 65 percent of their corpus in the shares of these companies.

“The small-cap stock universe includes companies spread across various sectors. Many of these are poised to grow exponentially in the medium term. These stocks are relatively under-researched and hence offer the largest scope for active fund managers to outperform the benchmark indices,” says Anthony Heredia, MD & CEO, Mahindra Manulife Mutual Fund.

The small-cap universe offers exposure to sectors such as capital goods, services, textiles, sugar and chemicals, which may not be available in large-cap space.

Over the three years to November 25, 2022, small-cap funds have given 30.16 percent returns, but gained only 0.32 percent in CY2022. Though the numbers look good over a three-year period, the variation in returns offered by individual small-cap schemes cannot be ignored. While the best-performing scheme, Quant Small Cap Fund, has given 51.54 percent returns, the worst-performing one, Aditya Birla SunLife Small Cap Fund, has given 19.72 percent. Across 32 dedicated small-cap schemes, mutual fund houses manage Rs 1.32 lakh crore in assets, as per Value Research.

CRISIL recently pointed out that the size of these schemes have gone up since the categorisation took place in March 2018. The size of the largest small-cap fund was at Rs 7,007 crore then, which has grown to Rs 22,158 crore as of September 2022. The study added that the size of the fund cannot be the sole factor deciding the scheme’s performance. Though traditionally it is believed that the small size of the funds help the fund manager stay agile, it may not necessarily help performance. Mid-sized small-cap funds did better with 11.2 percent compound annual growth rate (CAGR) over the same period, compared to 10.9 percent returns posted by small–sized funds and 9.7 percent returns posted by large-sized funds.

Kalwani says, “The size of the small-cap fund is important and we prefer to invest in small-cap schemes with assets under management ranging between Rs 500 crore and Rs 5,000 crore.”

Investing in small-cap equity funds can be a good idea if and only if you have a stomach for volatility. “Though Nifty Smallcap 250 Index is lower than the previous high and the space appears attractive for investments, a minimum five-year investment timeframe is a must for investors,” says Heredia.

Investments in small-cap equity funds should not be your first investment in mutual funds. Since these schemes can be more volatile than large-cap equity funds, if you are not comfortable with high volatility, you can steer clear of them. If you are looking for modest exposure to small-cap stocks, then you may be better off with multi-cap funds as well as flexi-cap funds. Even if you are sure about your ability to hold on to small-cap equity funds, restrict your exposure to a maximum of 20 percent.

“Within the permissible limits decided by your asset allocation, invest in small-cap funds through systematic investment plans for five to seven years,” says Amol Joshi, founder of Mumbai-based Plan Rupee Investment Services.

Within the equity asset class, allocate conservatively to small-cap equity funds with a good long-term track record.