Take some exposure to the two segments if you are able to ride out the volatility
Valuations in mid- and small-cap segments have become attractive with one-year forward PE ratios below historic averages
With the new government taking office with a massive majority, it has the elbow room to push through the reforms. No wonder markets are expecting the government will take adequate steps to set right the slowing down economic trajectory and measures to address the liquidity and other concerns that beset different segments of the economy.
Many equity market watchers also believe it is the right time to take exposure to the mid- and small-cap segments. The valuations in these segments have become attractive with one-year forward PE (price-to-earnings) ratios below historic averages and the segments mostly staying away from the rally seen in large-caps. We tell you the role of mid- and small-cap investments in your portfolio to help you decide whether you should take exposure to these segments or not and how much.
The mid-cap universe of stocks comprises of those stocks that populate ranks 101 to 250 based on market capitalisation. The small- cap segment constitutes stocks that are ranked 251 to 500. Mid- and small-cap stocks are most likely to do well in a phase of economic recovery when interest rates are low and there are growth opportunities to exploit. Their smaller size makes them more responsive to changes and opportunities. At the same time, they are most vulnerable when there is a downturn in business cycles. Their revenues and profitability are likely to take a greater hit and, with lower financial muscle to withstand such slowdowns, they are more susceptible to go out of business. In a market downturn, these stocks are likely to see a greater cut in stock prices, too, since they are illiquid. Mid-caps are in the sweet spot between large- and small-caps. They still have the flexibility of the small-cap and the relative stability of a more established business.
The new government is expected to take steps to arrest the slowdown in the economy, focus on economic growth with employment growth and relieve farm distress, among other economic prerogatives. All of this will give a fillip to the economy and the markets. “We still see an upside of 5-8% from the current levels in the benchmark indices in the next six to eight months. Once they stabilize at higher levels, investors will start exploring investment opportunities in the mid- and small-cap segments," said Gaurav Dua, senior vice-president and head - strategy and investments at Sharekhan, a subsidiary of BNP Paribas and a leading stock broking company. “But smart money would move into the space much earlier," he added.
He, however, cautioned against painting the entire segment’s prospects with one brush. The demand will emerge for companies where there is greater predictability in growth and valuations are better, he said.
For you, the retail investor, mutual funds are the best vehicles to take exposure to the equity markets, including the mid- and small-cap segments. The categorization of mutual fund schemes by capital markets regulator Securities and Exchange Board of India (Sebi) specifies mid-cap funds as those that invest not less than 65% of the assets in the mid-cap segment and small-cap funds as those that invest not less than 65% of total assets in the small-cap segment of the market.
A look at the performance of these funds shows that in bullish markets they have outperformed the larger segment significantly. For example, in the bull market of 2014, the average return from the top five funds in the small-cap segment was 85% higher than that from large-cap funds. Similarly, in 2017, their returns were 45% higher than the large-cap segment. The outperformance of the mid-cap segment over large-caps in 2014 was 56% while it was a more moderate 10% in 2017. On the flip side, in bear markets, they see a steeper fall along with greater volatility.
Over the last three-year investment horizon, the best performing large- and small-cap funds averaged around 16%, with mid-cap funds coming in slightly lower at 14%. However, the average standard deviation, which measures the volatility in the returns, of the best-performing small-cap funds was much higher at 17.61% as compared with just 12.57% for large-cap funds and 14.9% for mid-cap funds, indicating that small-cap funds were riskier than the other two categories.
Over the five-year and seven-year investment horizons, too, while the mid- and small-cap funds have outperformed the large-cap segment in terms of returns, the higher volatility in returns, especially in the small-cap segment makes them riskier. The Sharpe ratio, which measures the return generated for every unit of risk taken, was at just 0.56 for small-cap funds, while mid cap funds had a lower Sharpe ratio of 0.55. Large-cap funds, on the other hand, had a much higher Sharpe ratio of 0.85, indicating that the returns generated for the risk taken was much higher in large-cap funds, while small-cap and medium-cap funds are unable to generate higher returns commensurate with the risk they take.
The slowing economic trends pose greater risks to this segment and it is important to be able to identify sectors and companies that will be able to sustain in this scenario. If you are willing to ride out the volatility, you can consider some exposure to these segments through mid- and small-cap funds to give a boost to your portfolio returns. But there are caveats to be followed.
While well-researched mid-cap funds with consistent risk and return performance can find some exposure in your core portfolio, small-caps should be designated for the satellite portfolio to generate some alpha when the opportunity is available. “Mid- and small-cap space investors have to be nimble-footed. The gains will be sharp and the corrections are sharper still," said Dua.
Historically, too, while the longer-term returns from the small-cap segment have been higher than that from the large-cap segment, the significantly higher volatility makes them a difficult investment to hold as part of the core portfolio. Most investors may be unable to stomach the volatility in the long run and choose to exit, typically when markets are down.
Those looking for exposure to these segments have the option to invest through a dedicated small- cap fund or through a mid-cap fund that will take some exposure to the small-cap segment as well or through a multi-cap fund or a large-and-mid-cap fund that will also seek opportunities in the mid-cap space.
Melvin Joseph, a Sebi-registered investment adviser and founder, Finvin Financial Planners, does not recommend small-cap funds but makes one mid-cap fund a part of every client’s portfolio. “Most mid-cap funds have a 15% to 20% exposure to small-cap stocks. Multi-cap funds have some exposure to this segment too and that is adequate for an investor’s portfolio," he said.
Dilshad Billimoria director, Dilzer Consultants Pvt. Ltd, a financial planning firm, recommends not more than 5% of the portfolio in mid- cap funds and 2-3% in small-cap funds. “This is the satellite portfolio to take advantage of available opportunities. The core portfolio is invested only in large-cap and multi-cap funds," she said. She also emphasized the need for an adequately long investment horizon to manage volatility in such funds.
Dua recommended systematic investment plan (SIP) into mid- and small-cap funds for the next two to three years. “Mid- and small-cap space is what provides alpha to you. Not having exposure is not the right strategy," he said.
A well-diversified mid- and small-cap portfolio reduces the risk from the failure in one or few companies, though the returns will be lower too. Some funds in this segment hold concentrated portfolios that will perform well if the stocks selected do well. But the flip side is that if the selection goes wrong then the impact on the fund will be also higher.
You should select the fund characteristics according to your preference for risk.