Exploring Small-Cap & Mid-Cap Funds
India has now exited the technical recession phase. The greatest beneficiaries of such a reversal in the fortune of the economy are small-cap and mid-cap companies. They are high beta sections of the economy, which means when the economy accelerates, they are the ones who show a superior growth rate. The article takes an in-depth look at the trend in this space
Equity markets have had a dream run globally in the last one year and the Indian equity market is no exception. In the last one year ending May 7, 2021, the frontline equity index Nifty 50 has moved up around 60 per cent. The broader market has generated even better returns. For example, Nifty Mid-Cap index has moved up by 87 per cent whereas Small-Cap index has more than doubled and gained by 115 per cent in the same period.
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 also the equity market had seen such a vertical move. The rolling one-year return of equity indices shows that the last one year remains one of the best for the equity markets in terms of returns. Mid-cap and small-cap indices have almost doubled during this time.
The impact of such rise in indices was reflected in the performance of equity-dedicated funds too. In normal years, for instance, in years 2018 and 2019, the highest return generated by equity dedicated mutual fund was around 25 per cent. Nevertheless, in the last one year, the lowest return generated by any equity mutual fund was around 25 per cent. This pretty much explains the strong momentum in the equity returns last year. However, the momentum was so strong last year that it turned out be the worst performing fund.
The graph of return in percentage of different categories in the last one year shows the average return generated by different equity categories. There are three categories that generated return in excess of 100 per cent in the last one year and another three in excess of 70 per cent. One of the reasons for such spectacular return is the V-shaped recovery in the economy that we witnessed last year. After registering de-growth of little more than 24 per cent in the first quarter of FY21 and more than 7 per cent in QFY21, the Indian economy finally came out of recession in the third quarter of FY21. India’s gross domestic product (GDP) for the third quarter of FY21 ended December 2020 grew at 0.4 per cent.
India has now exited the technical recession phase. The greatest beneficiaries of such a reversal in the fortune of the economy are small-cap and mid-cap companies. 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 negative territory and recovered the fastest when the economy turned the corner.
The second wave of the corona virus that seems to be more dangerous and infectious has already swept the nation and is putting the nascent economy recovery in jeopardy. The sudden and steep surge in the number of virus cases since the month of April, where daily cases have even touched more than 4 lakhs and daily deaths in excess of 4,000, will dent economic growth going forward. The entire nation is once again going through partial lockdown if not complete lockdown that we saw the last time, which has once again slowed down economic activity. So does it warrant a churning of your portfolio and book some profit from mid-cap and small-cap funds and wait for the situation to normalise before making a new bet. To make an informed decision the situation needs to be analysed from a 360 degree perspective. The first aspect that we will analyse is the valuation of the mid-cap and small-cap stocks.
Valuations
In the last one year ending April 2021, mid-cap and small-cap indices have outperformed the Nifty in nine out of 12 months and on other three occasions they underperformed. It was only in the month of October 2020 when both the indices underperformed Nifty simultaneously. The graph of relative performance of small-cap and mid-cap indices against Nifty shows the last one year’s monthly outperformance of mid-cap and small-cap indices against Nifty.
Such a continuous outperformance by the broader market has made their valuation also rich, especially if measured on price to trailing 12-month earnings’ basis. So, purely comparing PE of mid-cap and small-cap indices against the historical averages, it looks stretched. Nevertheless, if we look at a more stable valuation metric such as price to book ratio, the valuation of the broader market looks again a higher side. Nonetheless, it needs to be seen from the liquidity perspective and lower interest rate scenario. The environment of easy liquidity has resulted in asset price inflation across the board and only limited to equity.
Hence, we tried to compare the relative valuation of the broader market against the frontline market rather than absolute valuation. Again we took only price to book value ratio to gauge if the valuations are stretched. The graph of relative price to book value of broader market against Nifty shows the relative valuation of Nifty Mid-Cap and Nifty Small-Cap indices against Nifty since year 2010 along with the long-term average. What it shows is that both the mid-cap index and small-cap index are currently trading at valuations higher than the last 10-year average.
Nonetheless, it is the small-cap index where such valuation is more pronounced. It has crossed the previous high that it reached in the first month of year 2018. Small-cap as defined by the regulator constitutes all companies that have market-cap beyond the top 250. There are more than 2,500 such companies whose shares are actively traded. Looking at valuations for small-caps at index level may not be appropriate. This space is too vast and so a good fund manager can always look at opportunities at a bottom-up level.
The mid-cap index valuation though is currently above its long-term average; it is not stretched especially if we evaluate on forward price to earnings (PE) ratio. According to a report by a leading broking firm, in the last five years mid-cap companies on an average were trading at forward PE of 19.2 times compared to 18.1 times they are currently trading at. Moreover, if we compare this against Nifty, it has traded at average discount of 8 per cent compared to the current 10 per cent. Therefore, valuation-wise we do not see the broader market very much stretched despite such a vertical rise in the mid-cap and small-cap stocks. There may be few pockets of excess built; however, fund managers are expected to apply their wisdom while building their portfolio and investors while selecting funds.
More than 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. Investments in such funds are not meant for the fainthearted and 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 the year 2008, some of the mid-cap and small-cap dedicated funds saw their NAVs eroding by more than 70 per cent in a year. Even as late as in 2018, we saw many broader market-dedicated funds losing their value by 50 per cent. Hence, investment in these funds requires proper planning and you cannot time entry and exit from these funds.
Plan Your Investment
There are four things that you need to know for better planning of investments through mutual funds. First is your investment goal, second is the time horizon of your investment, third is the risk appetite and last is the amount that you can commit. Your investment goal, time horizon and risk appetite will primarily
determine your selection of investment. For example, if you do not have higher appetite for risk and the purpose for which you are investing is unavoidable such as your child’s education than you cannot invest in broader market-dedicated funds. Nevertheless, if are investing for up-gradation of your four-wheeler you may take a riskier bet.
Nevertheless, investing in broader market-dedicated funds always means a longer investment time horizon. So if your investment horizon is higher than five years but less than 10 years, then you can go for large and mid-cap funds. However, if the time horizon is more than 10 years, then you can choose mid-cap or small-cap funds or both, depending upon your risk appetite and investment goal. If the risk appetite is high then small-cap fund is advisable while in the case of low risk-taking ability, mid-cap fund is better suited for the investor.
Investing in Broader Market-Dedicated Funds
One of the best ways to invest in such funds is through a systematic investment plan (SIP). 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 drawdown 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.
Consider, for example, that you have started your investment journey in the month of January 2012 and invested Rs5,000 in three different funds belonging to three different categories. In the month of January 2020, sensing that frontline indices were trading at lifetime high, you stopped your SIP and exited your investment. The returns are as following:
Nonetheless, if you would have been patient and remained invested throughout the phase of downturn and subsequent upside, the return would have been much better.
One of the reasons higher levels of indices should not perturb you and force you to remain on the sidelines is that this may cost you dear. 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. The obvious implication of these findings is that it is exceedingly hazardous to try to time markets. Staying invested is the name of the game, be it in equities as an asset class or the funds you select to invest in. The report further says that less than 5 per cent of the months account for all of the outperformance for Indian actively managed diversified equity funds.
Conclusion
The intense resurgence of the corona virus in India definitely carries the risk of disrupting the prevailing macroeconomic trends. Nonetheless, the recent numbers has been encouraging where new cases are coming down. If we see beyond a month we see the situation more under control. Moreover, if you are investing for long term, these incidents should not derail you from your investment plan. You can exit from small-cap funds only if you find them beyond your risk tolerance level and do not fit into your asset allocation plan. Purely from a valuation perspective also we see that mid-cap stocks are still not over-stretched. Moreover, fund managers managing such funds might have already used the leeway given them to invest part of the corpus in large-cap stocks and might make necessary adjustments to withstand any exaggerated volatility. Investing in mid-cap and small-cap funds requires a longer time horizon and patience to ride out the volatility. Those who can withstand this volatility can expect to earn superior risk-adjusted returns over the long term.