Why Small Cap Equity Mutual Funds are must for wealth creation

Small cap stocks, i.e. stocks below the top 250 stocks by market capitalization, offer investors exponential growth opportunities. Since these stocks are under-researched and under-owned by the by institutional investors, there is considerable scope of price discovery in this market segment and small cap equity mutual fund schemes managed by good fund managers can generate considerable alpha relative to the broader market.

Small caps are the wealth creators

While large cap and midcap stocks can give good returns to investors in the long term, the multi-bagger stocks, i.e. stocks which multiply investor’s money (gives more than 100% returns), are all mostly from the small cap segment.

In the table below we are showing the number of stocks from different market cap segments which gave more than 100% returns in the last 5 years. You can see that the big wealth multipliers (5X to 10+X returns) are mostly from the small cap segment.

Why small cap stocks / funds have potential to outperform large cap stocks / funds?

Large cap stocks are concentrated in only a few industry sectors. Large cap stocks have limited presence outside Financial Services, Energy, IT, Automobiles and Metals. These 5 sectors account for nearly 85% weight in the Nifty 50 Index. Nifty stocks have virtually no presence in sectors like fertilizers, media and entertainment, services, industrial manufacturing, chemicals, healthcare services, textiles, paper etc. Sectors like chemicals, packaging, sugar and tea, ceramics and sanitary ware, hotels, logistics and construction can be played better through small cap stocks. These sectors are likely beneficiaries of a number of policy reforms enacted by the Government and have a great potential in the consumption driven India growth story.

Increasing institutional investor confidence in small caps

Historically, institutional investors had limited investments in the small cap segment. However, involvement of institutional investors (both foreign and domestic) in small caps has increased considerably over the last 8 years. FII investment in small caps has grown 42%, while mutual fund investment in this segment has grown 77% in the last 8 years. This shows increasing institutional investor confidence. Though we think that, institutional flows in the future will continue to be directed mostly into large cap, increasing institutional investor presence in small cap will lead to faster price discovery in this segment.

Why invest in small cap now?

2018 was a very difficult year for small cap stocks. The Nifty Small Cap 100 index fell 30% over the year and many small cap equity mutual funds gave negative returns. It is natural that many investors may feel nervous about investing in small cap.

Small cap stocks are always more volatile than large and midcap stocks. They tend to fall more in market corrections, but they also bounce back stronger from the lows, as historical data shows. The chart below shows the effect of market correction on large cap, midcap and small cap stocks in wake of taper tantrum, i.e. when the US Federal reserve announced tapering of their quantitative easing program launched at the peak of the financial crisis (please see the chart on the left). The chart on the right shows the recovery driven by crude oil price correction, 2014 Lok Sabha elections and other factors. Even though small caps fell more during the correction, their recovery was the strongest in intensity (compared to large and midcap) in the ensuing rally.

Let us look at another market correction, this time driven by the Chinese economic slowdown in 2015. Again small caps corrected more sharply than large cap and midcap and bounced back with the strongest intensity.

Corrections have historically provided great investment opportunities in the small cap segment and investors have made very high returns by investing near bottoms.

Though Nifty Small Cap 100 index has recovered nearly 19% from its 52 week low, it is still nearly 30% lower than its all time high (made in January 2018). The examples discussed above shows that 25 – 30% correction in small cap provides a base for a strong recovery. Based on the historical precedence, current small cap prices may provide an excellent investment opportunity for wealth creation in the long term.

Principal Small Cap Fund NFO

Principal Mutual Fund is shortly launching Principal Small Cap Fund, an equity mutual fund scheme which will invest 65% of its assets in small cap stocks. The subscription to the NFO will be open from 22nd April 2019 to 6th May 2019.

The fund will be helmed by veteran fund manager PVK Mohan with Siddarth Mohta as the associate fund manager. PVK Mohan has a great track record as fund manager and several schemes managed by him have generated excellent returns for investors in the past. Many small cap stocks selected by Principal Mutual Fund for various schemes have created substantial wealth for investors in the past. Principal Small Cap Fund will have the STEP and auto-trigger facilities (to know more about these facilities please visit Principal Mutual Fund website or ask your financial advisor)

Since small cap stocks tend to be under-researched, strong research capabilities are very important in identifying quality small cap stocks with high return potential. Principal Mutual Fund equity investment team has over 100 man years of experience. The AMC uses their proprietary investment software. Principal Mutual Fund uses liquidity, management quality and growth outlook as parameters to filter stocks. The stock selection of Principal Small Cap Fund will be based on GARP (Growth at a reasonable price) and tactical value picks. Principal Mutual Fund’s strong track record gives us the confidence about their small cap NFO.

Conclusion

In this blog post, we discussed why you need to have to small caps in your mutual fund portfolio for wealth creation. Small caps offer investors broader scope of larger alpha generation through price discovery (valuation re-rating) and faster EPS growth – today’s small caps can become tomorrow’s mid and large caps, enabling investors to create wealth. The price correction in the small cap segment in the past 15 months may provide a great investment opportunity, as historical precedence shows, for investors to get high returns. In this backdrop, Principal Mutual Fund is launching its small cap equity scheme in the coming days. The fund manager of the scheme and the AMC has excellent track record. Investors should consult with their financial advisors about small cap funds and the upcoming NFO.