Is there a bubble in smallcap stocks? Not yet, say fund managers

For example, the third biggest smallcap fund, by SBI MF (assets of Rs 18,625 crore), has been accepting investment via systematic investment plans (SIP) capped at Rs 25,000 per month per PAN since February 2021. Lumpsum investment is barred in the scheme.

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Tata Mutual Fund recently stopped accepting lumpsum investments into its smallcap fund from July 1.

Also, the biggest scheme in the category, Nippon India Small Cap Fund, stopped accepting fresh, additional subscriptions or switch-ins in the scheme from July 7.

“Of late we are seeing large flows of bulk money coming to this category, which may not necessarily have a long-term view. If a lot of money comes during bull markets, it puts a lot of undue pressure on fund management and the research team, which may sometimes lead to some errors. Therefore, as part of our overall risk management process, we had to curtail the flow,” said Samir Rachh, fund Manager, Equity Investments, at Nippon India Mutual Fund.

How funds are placed

Despite the surge in assets under management (AUM) of smallcap schemes, most fund houses have been selective in expanding their exposure.

For example, the number of stocks held by HDFC Small Cap Fund, the second biggest scheme in this category, have ranged in the 65-70 zone over the last four years. Further, the stocks held by DSP Small Cap Fund have inched up from 63 to 71 from June 2020 to June 2023. A similar trend was seen in Edelweiss Small Cap Fund.

Ideally, with a universe of 4,000-5,000 stocks, the smallcap market-cap offers the most opportunities in terms of plain numbers. With the increase in mutual fund inflows and formalisation and digitisation in the economy, the number of investible names was supposed to go up and by extension the number of stocks held by smallcap funds ideally should have increased.

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As per Trideep Bhattacharya, Chief Investment Officer (Equities) at Edelweiss Mutual Fund, “What this (flat growth in stocks held) shows is that the conviction in individual stocks has gone up. Over the last 12 to 18 months, particularly from the midcap and smallcap standpoint, earnings have gone up.”

However, Nippon India MF has been an outlier in this regard. The number of stocks held by its smallcap scheme rose to 177 in June 2023 against 106 in June 2020.

“We have a large research team amongst whom we divide the responsibility of tracking these companies. Recently, we have added one more person (Tejas Sheth) as co-fund manager to Nippon India Small Cap Fund,” said Rachh.

Note that, smallcap funds also invest some part of their portfolio in midcap and largecap stocks for the purpose of liquidity.

Where is the value?

“In the smallcap space, there are pockets that have performed well in the recent past led by earnings, news, and narratives. These pockets are now approaching expensive zones. Then there is the other end of the spectrum, which has ample opportunities but is largely ignored because of the lack of immediate triggers. Therefore, the areas of opportunities are there but the lack of depth will remain a deterrent if the flows continue to increase,” said Hemang Kapasi, Head of Equities, Sanctum Wealth.

The return on smallcaps over the last three years has been good. On an average, this category has delivered 21 percent on a five-year basis and 42 percent on a three-year basis. Therefore, it won’t be easy to get those kinds of returns in the near term after markets have already run up smartly in the recent past. However, from a valuation perspective, overall, smallcaps are somewhat cheaper at this point due to their larger universe.

“If you look at the valuation charts of all the three market-caps, then smallcap is closer to average while midcaps are above the average by 15-20 percent,” said Resham Jain, Fund Manager, DSP Mutual Fund,” said Resham Jain, Fund Manager, DSP Mutual Fund.

Rachh of Nippon India MF and Edelweiss MF’s Bhattacharya also agree that smallcaps are sitting comfortably in terms of valuations. Data shows that the PE ratio of the Nifty Smallcap 100 was 13.81 as of July 14, which was near its 10-year average.

What should investors do?

“There has been a big move in both midcap and smallcap funds in a compressed time, which is why there can be some sort of halt or dip before the earnings catch up. However, the returns shall continue to be robust in the space over longer time horizon albeit with volatility. As Indian economy flourishes there would be newer segment and spaces which shall continue to offer long term investable ideas,” said Kapasi.

The surge in inflows notwithstanding, fund managers believe that there isn’t a problem of plenty.

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“There are enough names within the existing portfolio where we could invest more. We have to churn and look at the names, which are still cheaper than the other ones, and we have to basically then switch between the names,” said Jain of DSP Mutual Fund.

The majority of the investment decisions, and the surge in smallcap fund inflows, are driven by the recent performance.

“Investors need to have a balanced approach and stay put with whatever allocation they have decided with their distributor or advisor in terms of largecap, midcap and smallcap. Keep in mind that correction in smallcaps has always been very sharp,” said Deepak Chhabria, CEO, Axiom Financial Services.

“Further as large money comes in, and opportunities in good-quality midcaps and smallcaps start looking expensive, the quality of the portfolio will start deteriorating. The fund manager will start looking at stocks, which he/she was avoiding or uncomfortable with, but suddenly they will start appealing because there's a huge difference in the valuation,” Chhabria said.

Smallcaps can be volatile on both the sides of the market, in a bull run and in a correction.

Therefore, it’s very important that investors coming into smallcaps have a long-term view and have a risk profile to withstand this kind of volatility, if the newsflow turns negative.

Therefore, one should have broad allocation discipline and not keep jumping from one category to another as it is very difficult to take this kind of category call on a consistent basis.