The Nifty Midcap 150 index and Nifty 250 index hit all-time highs in January 2018. Since then, the mid-cap and small-cap indices have been on a slide even as the Nifty 50 large-cap index continues to scale new highs. As a result, in the last six months, market watchers have been recommending the mid- and small-cap space for investors with a horizon of over three years. While mid-cap stocks find a place in many investors’ portfolio either through mid-cap or multi-cap funds, small-cap funds may not be as visible in their portfolios. So should investors use this opportunity to take exposure to this segment of the market?
The small-cap category
Small-cap funds have been defined by the Securities and Exchange Board of India (Sebi) as those that invest at least 80% of their assets in the stocks of companies that fall in the band of 250 to 500 on a market capitalization-based ranking. Small-cap companies have the advantage of benefitting from opportunities when an economy is in revival mode. But they are also more vulnerable to failure in a downturn since they are likely to have less financial muscle to weather a slowdown in business revenues and profitability.
Funds that invest in this segment gave a stellar performance in 2014 and 2017, with the total return indices giving returns as much as 71.13% and 60.8%, respectively, but saw deep drawdowns in the intervening years. Year-to-date, the small cap index has fallen 8% even as the large-cap index went up around 11%.
What makes this category a preferred investment decision at this stage is the attractive valuations relative to large-caps that are seen as over-valued. “You should consider this space if you are willing to invest for four to five years. Start an SIP and in the periods that this category does badly, consider lump sum investments to reap higher returns in the upturn. It is a high-conviction investment for the long duration," said Shyam Sekhar, chief ideator and founder, iThought, a Sebi-registered investment advisory firm.
Small-caps can find a place in the portfolio of all categories of investors but the exposure should be limited to 5% of the portfolio, according to Renu Maheshwari, CEO and principal advisor at Finscholarz Wealth Managers LLP, a financial advisory firm. “We look at a combination of relative market valuations and macroeconomic conditions to decide how the money will be invested. We have been moving money into small-cap funds for our investors in the last six months. Within the allocation to equity, we are giving greater exposure to small-cap funds at this stage," she said.
The attractive valuation in the small-cap space makes a compelling case to include this category of funds in your portfolio at this stage. Investors who are familiar with the risks in equity investing may be more comfortable with the steep gains and periods of losses that these stocks are prone too. Have a strategy on how you want to include these funds in the portfolio. Have a sub-asset allocation within your equity portfolio across large-, mid- and small-cap stocks to reflect your risk preference and the ability of the portfolio to withstand volatility.
Sekhar cautions about the risks this segment faces from Sebi’s categorization. “Companies that are outside the defined bands get left out of the consideration universe of institutions that have to follow the categorization and this may mean that they are missing out on an opportunity to invest in stocks that may be fundamentally better. Whatever is ‘category-fit’ is getting a higher valuation since there is a lot of money chasing it and anything that is out of the category tends to be de-rated," he said. “Per chance if there is a fatigue in this space, money will start flowing out and that is when the stocks will start getting de-rated. That is a real risk," he added.
If you are a seasoned equity investor, consider this sub-category if you don’t already have it. Build your allocation to small-caps through SIPs and systematic transfer plans (STPs). But make rebalancing an essential element of managing the portfolio to book profits in small-caps and keep the exposure within acceptable limits. “You have to be able to get out at the right time too," said Maheshwari. “In 2017-18, we had reduced the exposure to zero, though the strategy has changed in the last six months."
If you are a new equity investor, you may consider small-caps if you have a large enough portfolio that can take some strain from a downturn in this segment. But it may be overwhelming to invest directly in this segment, given its volatility. “There have been phases of four-plus years when no money was made in this space and then all the money is made within one or one-and-a-half years," said Sekhar.
You can instead consider a multi-cap fund that takes greater exposure to the mid- and small-cap segment. Even mid-cap funds will help get some exposure to small-cap stocks.