Are small-cap funds the big tactical opportunity of 2020?
4 min read.Updated: 07 Jan 2020, 10:11 AM ISTNeil Borate
Investors must first allocate their money as per their risk appetite and goals. Neil Borate spoke to experts to find out if this indeed is a good tactical opportunity for making short-term portfolio adjustments in response to the market, without significantly altering the overall asset allocation
Small-cap funds have had a tough time over the past three years with a CAGR of just 7.05%. As the economy slowed down in 2019, the category delivered 0.94% returns on an average, as on 5 January. On the positive side, valuations have corrected and the segment is out of favour, making it cheaper for investors. While investors must first allocate their money as per their risk appetite and goals, Neil Borate spoke to experts to find out if this indeed is a good tactical opportunity for making short-term portfolio adjustments in response to the market, without significantly altering the overall asset allocation.
Vinit Sambre, Head-equities, DSP Mutual Fund
Stay away from small-caps if your horizon is only one year
The BSE Small-Cap index is down about 33% from its peak in January 2018 and many stocks have seen a decent correction from the peak. Many of these stocks have become relatively cheap as compared to the premium levels they had scaled earlier. Hence, from an investment perspective, it makes a good case to look at small-caps.
Whether the opportunity will play out in 2020 is a wild guess and will depend on the revival in economic growth. For small-caps to do well, they need support from the economy. It is difficult to produce returns if the economy is going through a slow phase.
Investments in small-caps need to be considered with a really long-term view, which may at times extend beyond six to seven years. During the great financial crisis, investors who had invested in small-cap funds at their peaks in 2008 didn’t see any returns for almost six years and then suddenly realized all the gains in the seventh year. We would advise investors to stay away from the category if their horizon is 2020 itself.
Nithin Sasikumar, Co-founder, Investography
Avoid tactical investment, stick to broad asset allocation
The past one-and-a-half years have seen prices of small-cap stocks correct by around 60%. In any other scenario, this would be a screaming buy. However, if you use valuations as a yardstick, the Nifty Smallcap 250 index had a peak valuation of approximately 120 times price-to-earnings (PE) multiple, which is now around 60 times PE. That’s not cheap in absolute terms. It boils down to the premise of whether the reward outweighs the risk today.
The previous bout of economic uncertainty, which everyone in hindsight refers to as a great investment opportunity was in 2013. And the following year (2014) was spectacular for small caps. But that was driven by the political “hope" trade. For 2020, there isn’t really a reason for a hope trade; so even if the earnings pick up, it just brings some much-needed sanity to valuations. While there will be attractive small-cap stocks, my advice would be to avoid a tactical investment into small-cap mutual funds for 2020 and stick to your broad asset allocation.
Improvement in economy can help small-cap companies
The Small-Cap index is down 38% in absolute terms compared to the Nifty, which is up 16% from the start of 2018. The reasons include the market giving back the excesses of 2017, the overall slowdown, the difficulty in accessing credit, which impacted the operating metrics of smaller companies, and the regulatory impact of the change in the classification of mutual funds.
The valuation of the index is interestingly poised. On a price-to-book basis, it currently trades at one standard deviation below its long-term historical average. At these levels of valuations, the returns based on historical data come in the range of 10-45% over the next two years with a 95% probability and the average returns of around 28%. Improving access to credit and the expected revival of the economy should help improve the operating metrics of small-cap companies.
The Small-Cap index has never underperformed the Nifty or has given negative returns for three consecutive years in the last one-and-a-half decade.
Anupam Tiwari, Equity fund manager, Axis Mutual Fund
Invest only if you have at least a five-year horizon
In the last two years, the markets have seen bouts of volatility due to global risk-off trade resulting from geopolitical developments along with local economic slowdown. The small-cap segment has specifically seen significant erosion; the Nifty Smallcap 100 index is down about 40% from its peak in January 2018, and is back at December 2016 levels. However, it is important to note that individual stock returns with the index have a high degree of variance; markets have rewarded as well as punished stocks.
Historically, it has been more rewarding to invest in small-caps in bad times; hence, this correction offers a good opportunity for investors who have a long-term horizon (five to seven years) and can withstand volatility. Over the long run, a growing economy offers potential for small businesses to create wealth for investors. Growth will drive more formalization of the economy, supported by measures like GST. Every investor who can withstand higher volatility and has a five-seven-year horizon can consider small-caps.