ET Wealth
12,248.2567.9
Stock Analysis, IPO, Mutual Funds, Bonds & More

Small-caps score over mid-caps now. Mutual fund SIPs can help you enter this space

Mid- & small-caps have corrected sharply. The risk in betting on smaller companies is more pronounced, particularly in the midst of a stifling economic slowdown. Investors can enter the small-cap space by taking the SIP route to mutual funds.

, ET Bureau|
Dec 09, 2019, 06.30 AM IST
0Comments
Getty Images
p12
The risk in betting on smaller companies is more pronounced, particularly in the midst of a stifling economic slowdown.
The sharp polarisation across market segments has been visible for a while now. Frontline indices have breached all-time highs even as mid- and smallcap indices have seen sharp corrections. This divergent performance has prompted calls for shifting allocation towards midand small-cap stocks. But how should investors play this space?

The earlier valuation premium of midand small-cap indices relative to large caps has eroded completely. While the BSE Sensex is trading at a price to book value (PB) of 2.95, the BSE 150 Midcap index and BSE 250 Smallcap index are trading at 2.32 and 1.71 respectively.

With large-cap valuations out of the comfort zone, experts say the valuation differential has turned riskreward in favour of mid and small-caps. “Over the long-term, the performance of small-, mid-cap vis-a-vis large-caps typically converges. So, the headwind of small, mid-cap underperforming should go away in due course,” Prashant Jain, ED and CIO, HDFC Mutual Fund, said at a recent event. “The current situation presents an interesting opportunity to invest for the long term in mid-caps and small-caps, which are currently available at attractive valuations,” says Nimesh Shah, MD & CEO, ICICI Prudential Mutual Fund.

Mid- & small-caps have corrected sharply...
...But since January 2018, frontline stocks have soared.
inp121
Source: BSE

Clearly, there is enough reason to warrant a closer look at mid- and small-caps. However, the risk-reward dynamics between mid-caps and small-caps are quite different. According to some, small-caps offer a better opportunity now. ICICI Securities analysts Vinod Karki and Siddharth Gupta point out in a report that the risk spread has risen sharply for small and micro caps, whereas risk spreads for mid-caps (relative to large-caps) continue to be low. Risk spread is defined as the difference in trailing earnings yield between two types of stocks (such as mid-caps over large-caps). The comparatively higher risk spread for small-caps over large-caps makes this segment more attractive than mid-caps. “Sell-off since January 2018 has ensured the significant relative outperformance of small-caps has disappeared while mid-caps have held on to some of the outperformance,” the report states.

Experts recommend playing the smallcap space by taking the SIP route through mutual funds. Given the limited information available on smaller businesses, picking stocks directly in this space is akin to throwing darts in the dark. Besides, returns from small-cap funds are highly volatile and come through sporadically. At times, this segment may not offer returns for 3-4 years at a stretch, but then a sharp spike within 6-12 months can bump up the return profile by several notches.

Small-cap funds have lagged in recent years
In past year, there have been several fund launches in this space.
inp122
Source: Value Research. Data as on 3 Dec. 3-year returns annualised

Besides, experts insist revised definitions make small-cap funds a more compelling space to invest in. As per new rules, small-cap funds can pick stocks ranked beyond the top 250 in terms of market capitalisation for their core portfolio, comprising 65% of the fund corpus. This has opened up a wider hunting ground for small-cap funds, as several erstwhile mid-caps now qualify for inclusion in the portfolio.

Small-cap fund managers can now create a more hygienic portfolio and not compromise on quality. “Fund managers in this space can invest in more proven names across sectors and not be compelled to dabble in lower quality names,” says Taher Badshah, CIO–Equities, Invesco Mutual Fund. “The investable universe of midcaps is much narrower than small-caps. At this juncture, we prefer SIP in small-cap funds for long term wealth creation,” says Shah. Over the past year, there have been several fund launches in this space. For now, investors should stick with funds with a proven track record. It is advisable to keep allocation towards small-caps limited to 15-20% of the portfolio.

Even when investing through mutual funds, investors should come into this segment with the right perspective. The risk in betting on smaller companies is more pronounced, particularly in the midst of a slowdown. This segment comprises relatively weaker business models with higher mortality rate that may not withstand high turbulence. Fundamentals of smaller businesses can weaken further if economic activity contracts and liquidity becomes scarce.

However, within this segment, some companies are in a position to hold strong owing to being in niche businesses with a sizeable market share. “Exceptions do exist where relatively small companies enjoy a dominant position in small but rapidly rising sectors,” say Karki and Gupta. They prefer non-commodity stocks that offer earnings yield yield greater than or equal to bond yield, stable earnings outlook, return on equity greater than 13%, low financial leverage, positive free cash flow and preferably be linked to the domestic economic recovery.

Also Read

Why are value mutual funds underperforming?

Is my mutual fund portfolio diversified?

NIPPON INDIA MUTUAL FUND ETF

Is my mutual fund portfolio diversified?

AN INSIGHT TO MUTUAL FUNDS

Comments
Add Your Comments
Commenting feature is disabled in your country/region.

Other useful Links


Copyright © 2020 Bennett, Coleman & Co. Ltd. All rights reserved. For reprint rights: Times Syndication Service