Time To Buy Small-Cap & Mid-Cap Funds
The last few years have been difficult for most of the mutual fund investors. Their investments in mutual fund schemes through Systematic Investment Plan (SIP) have generated lesser returns compared to very safe, fixed deposits in banks. Baring IT and International category of funds, every other category have generated returns in single digit. The worst hits were those investors who had invested in small-cap, infrastructure and PSU dedicated funds. These funds on an average have generated negative return in the last 3 years. This return also includes the spectacular performance of year 2017 when some of the funds in mid and small-cap category generated returns northward of 50 per cent.
The story is not different for lump sum investors in the last 3 years. Mid-cap dedicated funds on an average, generated an annualised return of 7.77 per cent while, small-cap generated 4.69 per cent in the same period. Nevertheless, the situation might be changing for good now for these beleaguered categories, especially the mid-cap and small-cap categories. Since the start of the December (till January 6), the broader indices represented by BSE Small-cap and BSE Mid-cap has outperformed the large-cap index represented by BSE 100. The best return is generated by Small-cap index, which is almost up by 5 per cent in the last one month, as compared to flat return by large-cap index.
The million dollar question is whether this is going to be sustainable or is it going to be another false signal, especially after looking at the current geo-political tension that has a potential to derail the current rally.
We believe the current rally has a longevity. There are strong reasons to believe that this will continue.
Worst of economic growth is behind now
The Indian economy is going through one of the worst phase currently. The GDP growth numbers for the second quarter ended September 19 at 4.5 per cent is 26 quarter low. Nevertheless, economists believe that the worst is behind us. Year 2020 could be a year of cyclical recovery for the economy. This will be aided by the global growth, easier domestic financial conditions, positive fiscal impulse, uplift in sentiment, and an easing of supply bottlenecks. These factors will lead to pick up in the corporate profit growth assisted by better operating leverage, lower interest burden and lower tax burden. Most of these factors till now were acting as headwind for the corporate but will now act as a tailwind.
The change in the situation is clearly visible in some of the recent high frequency data. The Nikkei Manufacturing Purchasing Managers’ Index (PMI) has increased to 52.7 in December 2019, the highest since May 2019. Goods and Services Tax (GST) collections were above Rs 1 lakh crore for the second consecutive month in December. Even the auto companies such as Maruti Suzuki have reported a rise in domestic car sales. Moreover, data compiled by Centre for Monitoring Indian Economy (CMIE) on CapEx shows that the new investment announcements have posted a positive growth in December quarter, the first since June 2018.
Mid-cap and small-cap companies will be the chief beneficiary of such reversal in the economic growth. Large-cap companies that are generally market leader of their sector has many levers to play during the economic downturn and hence, are less impacted by slowing economy. However, in case of small and mid-cap companies, they face the most at the time of deceleration in the economy. However, when the economy turns the corner and growth rate increases, we see that mid and small-cap companies are benefitted most.
The below chart shows the performance of mid-cap and small-cap funds against the quarterly GDP growth rate. For the fund performance, we have taken the median return of the funds in the respective category. The fund returns are daily returns that are compounded while the GDP growth rates are quarterly. We see that as the economy recovers, the returns generated by the funds also improves but not in the same proportion or time. For example, between the second quarter of FY14 and Q2FY15, the economy grew at an average rate of 7.2 per cent. During the same period, funds based on broader indices doubled more than before. The average return of the mid-cap and small-cap dedicated funds, was to the tune of 76 per cent and 88 per cent, respectively. These funds have a higher beta with respect to GDP growth. Therefore, in the current downturn, they are the one who have suffered most. In the last two years, the growth rate of the Indian economy has come down from 8.1 per cent recorded for the fourth quarter of FY18 to 4.5 per cent during Q2FY19. Mid-cap dedicated funds on an average were still down by 2 per cent till November 2019 while the small-cap funds are down by 13 per cent in the same period.
Stock market being the lead indicator tends to perform before the economy recovers and hence, the outperformance of the last one month of the broader market indices and the funds dedicated to that should be looked with this perspective. If the economy is on a recovery path, we may see these funds generating far better returns going ahead. Besides, there are other reasons to believe that these funds are going to outperform, going ahead.
Recovery from drawdown
Various studies show that the current bear market cycle for small and mid-cap indices on the BSE and NSE had started in January 2018 and lasted for 21 months and 23 months, respectively. During these months, the BSE Mid-cap and BSE Small-cap indices crashed 29.5 per cent and 40 per cent, respectively, from their all-time high levels seen in January 2018, to make a bottom in August 2019 (11,950 and 14,975, respectively).
The same is true in the case of mid-cap and small-cap funds, while, the worst is behind us. The graph below shows that in case of small-cap funds, we have reached the bottom somewhere in the month of August only and in case of mid-cap funds in the month of October. It also shows that we are in the recovery phase.
The current downturn in the mid-cap and small-cap funds is already one of the longest and deepest especially, for small-cap funds. Even during the sub-prime crisis and one of the worst recent falls in the stock market world over including India, the pain of the fall was not so long. Both the mid-cap and small-cap funds fell for 137 days and started recovering from there on and took 177 days and 146 days, respectively to reach its previous peak.
In the current downturn, in case of small-cap funds, we have gone down for 390 days, which is highest ever in the last 11 years. In case of mid-cap dedicated funds, we were into downturn for 185 days, which remains the second highest.
The table below shows the top 10 drawdowns and their statistics. The table shows when the fall started, when it reached its bottom (Trough) and again, when it reached its previous peak. Next, it shows the maximum fall, total time taken to reach the fall and the time taken to recover back.
Mid-Cap & Small-Cap have not underperformed for so long to Large Cap
According to a research by broking firm, Edelweiss, Small-cap and Mid-cap index has never underperformed the large-cap index for more than a year. Whenever they underperformed for so long, they generated stupendous returns in the following year. For example, after the poor show of 2013, the mid-cap index rallied 54.7 per cent in 2014, which was better than Sensex’s 29.9 per cent surge. The same was repeated in the calendar years 2009 and 2012.
The above chart shows the difference in the relative performance of small cap index and mid cap index against the large cap. We have taken two year of annualised returns to calculate difference in returns of the indices. Therefore, although we took the index data from 2008, first return came at the start of 2010.
The graph clearly shows that the current underperformance of the broader market against the large cap is probably longest and deepest in the current downturn. Hence, it make sense to invest in these categories now.
Right Time to Increase Your Exposure to Broader Market
In the world of finance, one of the most dangerous words used is ‘this time is different’. It has been argued that more money has been lost because of these 4 words than at the point of a gun. We have seen at the start of January 201+7, when the Indian stock market started its ascent, more so, in the mid-cap and small-cap stocks, new theories started to appear that supported the astronomical valuation of stocks of broader market. One of them being, the large inflows into the Indian equity market especially from the institutional players such as mutual funds that would help in sustaining their higher valuation. Adding to this, the structural changes that Indian economy is going through will help mid-cap companies to improve their efficiency, which will further improve the performance of these companies and higher valuation. These theories led to a huge jump in the share prices of small-cap and mid cap companies in a small span of time. This even got reflected in the different fund’s NAV and AUM dedicated to these stocks.The rise was so sharp that many funds have to stop accepting further investment in the funds.
That was an extreme and what is happening now is also an extreme, however, in opposite directions/the opposite direction. The continuous fall in the prices of these stocks has made them untouchable for many investors. Nevertheless, for the reasons explained above, it is a perfect time to start investing in funds dedicated to broader market indices selectively.
Therefore, it makes sense to look at mid-cap and small-cap dedicated funds with an investment perspective. You should consider this space if you have a long-term investment horizon of say more than 5 years. You can start an SIP now and in the periods that this category does badly sometime in future, consider lump sum investments to reap higher returns in the upturn. These categories of funds tend to generate better returns in the long-run. The attractive valuation in the small-cap space makes a compelling case to include this category of funds in your portfolio at this stage. These funds should not form more than 5-10 per cent of your total portfolio. So you can have 5-10 per cent in small-cap funds as well as another 5-10 per cent in mid-cap funds. Plan a strategy on how you want to include these funds in the portfolio!