Large-caps get attention amid uncertainty, but don't ignore mid- and small-caps

The risks associated with investing in mid- and small-caps get mitigated if the investment period is longer.
The risks associated with investing in mid- and small-caps get mitigated if the investment period is longer.

Summary

  • In all practicality, investors looking to compound their wealth are better off with mid- and small-cap stocks over a longer period. Large-caps help protect your capital, but mid- and small-cap stocks help compound it greater.

When we welcomed 2024, a cloud of uncertainties loomed large. Central banks worldwide grappled with the challenge of taming red-hot inflation, while rate cuts lingered on the horizon but were not in sight, and fears of trade disruptions stemming from geopolitical tensions remained. Fast forward three months, one quarter of 2024 has gone by, yet these uncertainties persist.

During such times, fund managers and financial advisors tend to have a bias toward large-caps. After all, large-caps are considered safe and predictable. The higher number of shares issued, and the many transactions happening regularly give a sense of relative safety. On the other hand, liquidity concerns and sharp drawdowns in mid- and small-caps can create panic among investors. Large- caps give less heartburn.

This year has been no different. The narrative has favored a higher allocation to large-caps, given that valuations are more reasonable. On the other hand, the narrative around mid- and small-caps has been that there is too much ‘froth’ in the current market prices. Market regulator Sebi even asked mutual funds to perform stress tests on such schemes, making investors nervous and prompting them to exit, which further pushed prices downwards.

That said, numbers do not lie. This year so far, the Nifty 50 has yielded a return of only 4%, while the Nifty Midcap 150 and Nifty Smallcap 250 have delivered returns of over 5%. 

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In all practicality, investors looking to compound their wealth are better off with mid- and small-cap stocks over a longer period. Large-caps help protect your capital, but mid- and small-cap stocks help compound it greater. With the beginning of the new financial year, we looked at historical data to help establish this fact. Though history might not repeat itself, there is a pattern that can be looked into before making your asset allocation plan.

Our study shows that if investment is made for a longer horizon, ideally for more than 5 years, mid- and small-caps have given significantly higher returns than large-caps. The risks associated with investing in mid- and small-caps get mitigated if the investment period is longer.

The Nifty 50 TRI (Total Return Index), the most widely used benchmark, particularly for large-cap funds, yielded the lowest returns among all other indices across all time horizons, ranging from three months to 10 years, except for the one-month horizon. This index is typically regarded as the "market return" and serves as the target for many funds, fund managers, advisers, and investors, who aim to either match or outperform it.

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What's noteworthy is that in time frames ranging from one year to 10 years, it's consistently the small- or mid-cap indices that emerge as top performers. In the one-year time frame, the Nifty Smallcap 100 TRI leads the list; in two years, it's the Nifty Midcap 100 TRI; in three years, the Nifty Smallcap 250 TRI takes the lead; and in the five and 10-year periods, it's the Nifty Midcap 150 TRI.

Therefore, when advising on asset allocation, if a longer investment horizon is assured, it's advisable to prioritize a higher allocation towards mid- and small -cap stocks to potentially boost portfolio returns. And why shouldn’t the investment horizon be long term? After all, the longer the investment duration, the lower the risk in the case of equities.

In the short term, amid uncertainties, mid- and small-cap stocks will inherently exhibit higher volatility and price swings. Once the impact of the news or event is assessed and adequately factored into the prices, the stocks will begin to take direction from thereon.

As the economy grows and new-age enterprises emerge, they will be classified within the small- and mid-cap segment until they grow significantly larger over time, with predictable, large, and stable cash flows, enabling them to transition to the large-cap space. While there may be many companies in this space whose growth eventually slows down, the segment as a whole is expected to outperform the large-cap space in the longer term.

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The big picture for mid- and small-cap stocks remains intact as they represent many strong sectors such as capital goods, infrastructure, energy, power, railways, defense, real estate, electric vehicles, automation, etc., which may not be adequately represented in large caps that are more skewed towards banking and IT.

Shashank Pal is chief business officer of Prabhudas Lilladher Wealth Management.

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