How small-caps can increase your chances of long-term success

India has more than 5,000 companies, which are listed on the regular stock exchanges.

Any fund which predominantly invests in companies, which are beyond the top 250 companies in India by size, is called a small-cap fund. Investors would do well to understand that a small-cap fund has the largest universe to invest in and they should not have an impression that these companies are small in a conventional sense.

Here’s why:

India has more than 5,000 companies, which are listed on the regular stock exchanges. As per regulations in the mutual fund industry, the top 100 are called large-cap companies. The next 150 are classified as mid-cap companies. The rest — 4,750-odd — are categorised as small-cap companies, irrespective of their size.

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Many of these companies have grown to become large. But calling them a small-cap company is a bit of a misnomer. They are dominant in their area of operation, have ever expanding customer bases, could be industry leaders with great profit record and impressive management but are yet classified as a small-cap company, due to a technicality.

New industries and market leaders

The chances of long-term success are higher if one invests in small-cap companies through the fund route.

India is growing at a faster growth rate, as compared to most large countries in the world. There are new sectors emerging, new companies are getting listed, opportunities are arising in sectors which did not exist earlier or were not meaningful in size. All these unique or emerging themes can be invested only through small-cap companies. Even within existing industries, the universe of companies is much more vast in small-caps, as compared to large- or mid-caps.

For example, in the infrastructure sector, large-cap universe has one company, contrary to the small-cap world that offers 32 companies to date. The fund managers have multiple growth opportunities to choose from, in case of small-caps. Given India’s growth trajectory, as per consensus estimates, large-cap companies are expected to clock an earnings growth of 8 per cent over the next two years, while small-caps are expected to grow earnings by 18 per cent at the index level. Adjusted for earnings, it appears that small-cap index is valued more reasonably, as compared to large-or mid-cap indexes.

A long runway for growth

The steepest growth path a company experiences is when it is relatively small and the runway for growth is wide open. The largest number of multibaggers have emerged from the small-cap space in the past. Not all small companies will grow sustainably. Some companies fail and become worthless as well.

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It is not easy to get reliable information about industries and about companies and it is difficult to judge the future growth prospects for individual companies. One can invest in mutual fund schemes where professional fund managers conduct thorough industry analysis, meet company management, assess growth prospects on a relative basis, track market events closely and allocate the funds into companies in a way that optimises the risk-reward ratio in the favour of the investors.

Should you invest in a small-cap fund?

Small-caps are an emerging and sustainable asset class which no investor can ignore, if they want to participate in Indian businesses that are growing faster than others. There is a wide plethora of existing and emerging unique themes and existing and emerging leaders. While direct investments can be made, but the very wide and diverse choice which is a positive for a professional manager can become a negative for individual as there is a high chance of staying invested in a small-cap company whose prospects may turn sour. A better way to invest in small-cap companies would be through the mutual fund route.

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One more important distinction needs to be made while choosing small-cap schemes. A very large-sized small-cap scheme, say of Rs 40,000 crore, could take meaningful exposure to the comparatively larger small-cap companies. A smaller small-cap scheme can take exposure and capture the growth opportunities of smaller sized small-cap companies effectively. One should make sure that one has adequate exposure of smaller-sized small cap funds as well as the exposure one gets could be very different.

(Sandeep Bagla is the CEO at Trust Mutual Fund)

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