Are Small-Cap & Mid-Cap Funds Still In The Race?

History suggests that small-cap and mid-cap companies tend to grow faster than the large-cap universe in an economic recovery scenario. Hence, we can expect companies from this category to register robust earnings’ growth as we go forward, further supported by a lower base. The article explains this particular phenomenon and provides guidelines to investors

The broader equity market in India has witnessed a vertical rise in the last 18 months. In August 2021 we saw this rise in small-cap and mid-cap stocks coming to a screeching halt after gaining 48 per cent and 23 per cent for the year, respectively. The reason for such a fall in these categories of stocks was largely driven by the introduction of new surveillance rules by India’s oldest stock exchange, the BSE. This was introduced to maintain market integrity and curb excessive price moves. It caused panic among investors and there was sell-off in these categories of stocks. Although at the index level there was not much movement and BSE Mid-Cap and Small-Cap indices saw a fall of between 2-5 per cent after the announcement, many stocks saw a fall of more than 20 per cent.

Nevertheless, soon a clarification was issued, supporting the price. This led to underperformance of the broader market compared to the large-cap-dedicated stocks by a margin of 5 per cent. This was probably the first time in the year we saw them underperforming on a monthly basis. The chart below shows the performance of BSE 100 representing large-cap, BSE Mid-Cap and BSE Small-Cap for the last one year. It clearly shows the dip in August.

What is also visible from the above graph is that since Septem- ber 2021 once again the price of mid-cap and small-cap stocks is gaining. The same performance was also visible for funds dedicated to these categories. They too saw their performance declining in August by 2-5 per cent only to regain in the following months. What is good to note is that the average performance of the funds has been better than their respective benchmarks. For example, year-till-date on an average the mid-cap and small-cap-dedicated funds have generated returns of 47.35 per cent and 64.4 per cent, respectively. Their bench- mark in the same period has given return of 39.18 per cent and 61.11 per cent, respectively.

What this episode highlights is that even the regulator and exchanges are not very comfortable with such a huge rise in the share prices of the broader market in such a short span of time. This is not the first time we are witnessing such a rise in the equity market in such a short span of time. The last time we saw such a spectacular rise in the equity market was after the great financial crisis of 2008 and subsequent recovery in 2009. During that time the equity market had seen such a vertical move. The mid-cap and small-cap indices as well as funds dedicated to these categories have almost doubled during this time. Nevertheless, exactly after 18 months of vertical rise they started showing signs of fatigue. Will history repeat itself? In the following paragraphs we will take a 360 degree view to understand if it is the right time to book partial profits.

So Far So Good
One of the reasons for such a sharp rise in the performance of the small-cap and mid-cap stocks was strong economic recovery. India’s GDP contracted 24.4 per cent in the quarter ending June 2020, followed by 7.3 per cent contraction in the subsequent quarter. However, it moved north in the third quarter with a marginal 0.4 per cent growth and recorded a growth of 1.6 per cent in the last quarter of FY21. Finally we saw the economy contracting by 7.3 per cent for the entire FY21. However, for the first quarter of FY22, India’s GDP grew at a record pace of 20.1 per cent. History suggests that small-cap and mid-cap companies tend to grow faster than the large-cap universe in an economic recovery scenario. Hence, we can expect companies from this category to register robust earnings’ growth as we go forward, further supported by a lower base.

They are high-beta sections of the economy, which means when the economy accelerates, they are the ones who show a superior growth rate. Similarly, when the economy goes through a downturn, they are the ones who suffer most. This is the reason why we saw the share price of mid-caps and small-caps falling most when economic growth was in the negative territory and recovered the fastest when the economy turned the corner. The latest macroeconomic data demonstrates the Indian economy is on an upswing. Investor and industry optimism, combined with government spending, could lead to India recording 8.5-10 per cent nominal growth in FY22. High frequency data suggests that we are already above the pre-pandemic level. Google Mobility report depicts that economic activity has recovered and is above March 2020.

Different institutions, organisations and rating agencies have estimated different rates for India’s GDP growth. The estimated GDP rate ranges from 6.5-9.9 per cent, with an average growth rate of 8.3 per cent. While HDFC keeps it at 6.5 per cent, Barclays pegs it at 9.9 per cent. SBI, ICRA, Deutsche Bank, India Rating and CARE estimate it at 7.3-7.5 per cent, 7.7 per cent, 8 per cent, 8.26 per cent and 8-9 per cent, respectively. According to Chetan Ahya, Asia Economist at Morgan Stanley, for the next three years India will deliver an average growth of about 7 per cent, which would be, sort of, effectively the highest amongst all major countries in the world.

Growth and Valuation
A higher GDP growth number has a positive rub-off impact on the corporate sector, which is recovering strongly. The debt-to-equity ratio is trending downward for the top 600 non-financial companies to 0.7 times of the peak. Profit growth for Q1FY22 was 51 per cent more than that of Q1FY20. The result for Q1FY22 shows that most companies have paid off debt at, again, a record pace, and corporate lending has reduced. Even the results so far for the second quarter of FY22 have shown good deleveraging by India Inc. The result season for the second quarter is yet not over but going by the last quarter i.e. Q1FY22 numbers we saw a good earnings’ revision.

After the completion of June quarter results and upward earnings revision, the PE ratio of Nifty Mid-Cap index saw a fall. The earnings revision in the Nifty companies was gradual and less than companies from the mid-cap index. The same has happened with Nifty Small-Cap index. The premium of the Nifty Mid-Cap over Nifty is now close to the average or median since April 2017. At current levels, Nifty Mid-Cap index is at 32.04 times based on trailing 12 months earnings (TTM) while Nifty Small-Cap index is cheaper at 28.98 times. Nifty Mid-Cap was at 42.61 times TTM PE at the beginning of this year i.e. January 1, 2021 but Nifty was a bit cheaper at 38.95 times while Nifty Small-Cap was at 42.69 times. Conversely, the valuation of Nifty Small-Cap is at 11 per cent premium to Nifty at the current levels from a premium of 7.15 per cent in January. The following graphs show the valuation of the key equity market indices based on forward earnings’ estimates.

The graphs clearly indicate that the valuation has come down from its recent peak. However, it is above one standard deviation. Going ahead, earnings’ support will be critical to justify the steep valuation of the markets. The mid-cap firms that analysts of Reliance Securities are tracking will report 26 per cent year-on-year growth in revenue, while sequentially revenue is likely to remain flat in the second quarter of FY22. Earnings before interest, taxes, depreciation and amortization margin is expected to contract by 50 basis points year-on-year due to higher input costs. Net profit of the mid-cap firms is expected to grow 34 per cent year-on-year but it may decline 1 per cent sequentially. According to the domestic brokerage firm Motilal Oswal Financial Services, the overall results are margin- ally above expectations. This is on the back of multiple metrics during the second quarter of the financial year 2021-22. Besides, it is also expected that H2FY22 earnings’ will remain robust and constructive.

MF Investment: Beyond Valuation
Investing in mutual fund is different from investing in direct equity and hence there are other aspects that need to be considered while entering or exiting from mid-cap and small-cap-dedicated equity funds. First of all, investing in these funds is already placed at the higher end of the risk-return spectrum and hence not meant for those investors who cannot stomach higher volatility. These funds are highly volatile and have larger draw-downs. They can go from hero to zero in no time. For example, in 2008, some of the mid-cap and small-cap- dedicated funds saw their NAVs eroding by more than 70 per cent in a year.

Consider the fact that Franklin India Smaller Companies Fund, HSBC Small-Cap Equity Fund and Kotak Small-Cap Fund saw their value NAV dropping by more than 70 per cent from their peak during 2008-09. The mid-cap-dedicated funds such as Taurus Discovery Fund were down by more than 80 per cent and other funds such as SBI Magnum Mid-Cap Fund were down by 75 per cent. Even as late as in 2018, we saw many broader market-dedicated funds losing their value by 45-50 per cent in a span of 24 months. Hence, investment in these funds requires longer investment horizon and commitment towards these funds should be planned in a better way. You cannot time your entry and exit from these funds.

Investing in Mid-Cap and Small-Cap Funds
On an average, mid-cap and small-cap-dedicated funds in the last 10 years have generated annualised return of anywhere between 20-25 per cent. Therefore, the risk-reward ratio has been in favour of investors willing to take risks. Large-cap funds over the same tenure have generated a CAGR of about 15 per cent. Going ahead, should investors expect similar returns from the broader market? If the growth of underlying companies over the last decade is taken into context, the future may hold the answer to that. Over the long term, these funds tend to deliver returns that are more or less in line with nominal GDP growth rate plus dividend yield. Going by what economists are predicting, India’s nominal GDP growth rate is expected to in teens for the next few years and hence similar should be the return expectation for these categories of funds. 

Looking at the current performance of funds, which is more than 80 per cent for small-cap funds and more than 65 per cent for the last one year, many investors tend to go overboard and add more than two or three funds from each category. Al- though, this is good from a diversification perspective, we believe not more than two funds from each category should form part of your portfolio, else there is always the risk of duplication of sectors and even stocks. Before adding a new MF scheme, check the top three sectors and the top 10 holdings of the new fund to see if your existing schemes already have similar exposure.

One of the best ways to invest in such funds is through a systematic investment plan (SIP), especially when the equity market is trading at all-time high. This is because investment through SIP helps you to manage volatility better than lump sum investment. Since mid-cap and small-cap funds tend to show more volatility and draw-down than the large-cap funds it makes sense to invest through SIP. If you are investing for a long term the downturn in between actually helps you to gain more as you tend to accumulate more units when the market is down. There is very minimal difference in returns if you try to time the market based on the frontline index level.

According to research by Morningstar, between March 2011 and February 2021, Indian stocks owed their outperformance over cash to just eight months—less than 6.7 per cent of the months in the sample. If you held stocks for all 112 months apart from those eight critical months when the equity market yielded extraordinary returns, your investment would not have beaten even cash. There are not many funds in this category that have long history. In the following table we share a glimpse of the funds dedicated to small-cap and mid-cap stocks that have a history more than five years.

The way to evaluate funds for investment is to go for funds that have lower risk measured from maximum draw-down and yearly volatility, and higher annualised returns in the longer run.

Conclusion
It will be naïve to assume that the last one year’s fund returns will be repeated the next year also. Now, investors should tread with caution. Broader market-dedicated funds tend to perform better than the frontline-dedicated funds but also carry risk, which is further accentuated at the higher level. Going by the macroeconomic condition and the last 18 months’ returns generated by these funds, we believe that only those investors with longer investment horizon and higher risk appetite should go for these funds in a staggered manner.