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Business News/ Mutual Funds / Mutual Funds: Stretched valuation concerns around small and midcaps - How should you react?

Mutual Funds: Stretched valuation concerns around small and midcaps - How should you react?

Small and midcaps facing valuation concerns and caution from SEBI. Investors advised to assess risk appetite and liquidity needs. Proper asset allocation crucial for managing risk. Long-term investors should stay invested despite current market conditions.

SEBI cautions on small and midcap froth. Indices show recent decline, but historical returns have been strong.Premium
SEBI cautions on small and midcap froth. Indices show recent decline, but historical returns have been strong.

The SEBI chairperson had cautioned about pockets of froth in the small and midcaps. How should an investor or a prospective investor approach and react to this? This is to provide guidance to investors on appropriate steps to be taken in this premise based on the investment objective and the phase of investment they are in.

The recent drawdown in mid and smallcaps

Nifty Midcap 150 index is down by 2.95% from 1st of March 24 to the 22nd March and the Nifty Smallcap 250 is down by 6.71% in the same period. This drawdown would mean if you have invested in a midcap or smallcap mutual fund your investments are impacted somewhere in line with this and could be the case if you own a basket of small and midcap stocks.

One also needs to bear in mind that small and midcaps have had a great run in the last five years and the indices have delivered over 20% CAGR in the last 5 years. The top smallcap mutual funds have delivered a return of over 50% in the last 1 year and over 25% annualised returns in the last 3 years. Midcap funds also have delivered similar returns. After such a massive run, it’s quite natural and logical that small and midcap stocks will have to consolidate.

The talks about valuations being stretched, coupled with the caution from the regulator, is pulling down the mid and smallcaps which has led to investors worrying about this. If you are an existing or a new investor in these segments of stocks or funds, how should you react to this.

Also Read: FY24 Market Review: Nifty Midcap and Smallcap surged over 60%; check best-performing stocks

Existing investors

Does stretched valuations warrant a total exit from the small and midcap space. There is no straight answer to this as the answers are based on the investment phase the investor is in and based on his/her risk appetite and liquidity requirement.

Before further extrapolating this, it needs to be borne in mind that proper asset allocation needs to be ensured and within the asset class also further diversification needs to be followed so that there is no undue concentration to any. Small and midcap stocks and funds are meant only for those with a high-risk appetite.

If an investor has a longer investment horizon of about five years or more, it is advisable to stay invested and the mid and smallcap stocks would turn around after a consolidation to further compound your returns. The argument of moving completely to largecaps or any other asset class which is performing well deviating from your ideal asset allocation is never a smart move. 

This is simply because the purpose of asset allocation is to diversify not just the return generation engine but also to spread the risk. This purpose will be defeated if you become a fair-weather friend on the investment front concentrating on only the performing asset class of the moment and this can badly backfire.

If you are an investor who needs liquidation in the near term of 3 to 6 months, then better to liquidate your equity investments not just small and midcaps, to the extent of the liquidity requirement and park in liquid or arbitrage funds, evenly withdrawing from all market cap stocks/funds without tampering the asset allocation proposition.

Also read: Smallcap, Midcap indices: 4 reasons why J.P. Morgan sees 5%-10% further downside risk

New and to-be investors

If you are a new investor or a to-be investor in small and midcaps the ideal route will be mutual funds and that too through the Systematic Investment Plan. Before that a small and midcap stock or fund cannot be your first equity investment. Your first investment should be in a largecap or flexicap fund before stepping into mid and smallcap funds. As small and midcap stocks have very high risk associated, unless spread across many companies the potential downside can be high. 

Mutual funds address this very well in comparison to directly investing in these stocks, by spreading across a large number of companies across sectors. There are AMCs which have as high as 200 stocks across various sectors in their smallcap fund and rightly so to balance between returns and risk.

If you have invested in an SIP of a smallcap fund, though the recent investment may be negative, don’t miss the fact that your current investment will be bought cheap at a lower price and average your overall cost which is the advantage that comes with an SIP. So, continue your SIP investment and if possible, make additional purchases in a phased manner and not in a single shot.

Also Read: This is the reason why midcaps and smallcaps may consolidate in medium-term

Stress test of mutual funds and investment decisions

SEBI has mandated mutual fund houses to come out with stress tests for small and midcap funds every fifteen days with the first one which was declared on 15th March. Basically, these tests are to inform investors in a situation of stress, if redemption pressure is high, what would be the number of days taken to liquidate 50% of the portfolio and 25% of the portfolio. The number of days fund houses have declared as the time to liquidate 50% ranges from 12 days to 60 days and half of that for liquidation of 25%.

While this is a useful information, practically going by history we have hardly seen instances of investors liquidating 25% of the portfolio and that too not in the evolved phase post 2010. Size of funds have zoomed now with the largest smallcap fund Nippon Smallcap Fund holding an AUM of above 46000 cr with a much larger number of investors compared to earlier. Also, investors today are matured with better understanding about a correction and the potential for future growth, so that knee jerk redemptions would be relatively much lesser.

In mutual fund parlance, the 101st company to 250th company by market cap is a midcap and the 101st company by marketcap is 74000 cr by size. Smallcaps are companies downwards of 250 by marketcap. The 251st company by marketcap is 25000 cr by size. So clearly many of the midcap and smallcap stocks are not that small in marketcap as most would presume, and it’s only the stocks which are relatively too small in market cap which may face liquidity challenges.

Metrics to be watched in decision making

Given this backdrop of reality, stress test results cannot be the sole reason for anyone to choose a fund but along with that it’s a combination of factors like long term performance of the fund, agility to market conditions, portfolio risk, portfolio diversification, expense ratio etc which are essential to choose the funds. For example - a fund which takes a lower number of days for liquidation but is poor in performance is not a combination to go for.

So new investors and existing investors need to be cognizant about these factors and respond to the current scenario of the small and midcap universe accordingly. Prudence needs to be employed to make a decision and not mere fear without proper understanding, which can go grossly wrong for your wealth creation exercise.

V.Krishna Dassan, Director, Dhanavruksha Financial Services Pvt. Ltd.


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Published: 03 Apr 2024, 01:45 PM IST
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