Should you invest in small caps?

Small cap mutual funds category attracts investors' interest from time to time. Investors usually prefer to stay away from small caps in volatile markets, but get interested in this category in bull markets. Small cap funds category has been one of the best performing equity mutual fund categories in the last one year (source: Advisorkhoj Research). However, the market situation has turned very volatile over last few days. In this blog post, we will discuss about small cap funds.

What are small cap stocks and funds?

According to SEBI, companies which are 251^st or smaller in terms of market capitalization are classified as small cap stocks. Small cap funds need to invest at least 65% of their assets in small cap stocks as per SEBI's mandate for this category of funds.

Will small caps continue their outperformance?

In the last one year, small cap stocks outperformed the market. The benchmark Nifty Small Cap 250 TRI gave 58.3% return1 in the last one year (ending 31^st January), beating both Nifty 50 TRI (22.9% return¹) and the broader market index, Nifty 500 TRI (28.2% return¹). However, with the escalation of the Russia and Ukraine crisis over the last few weeks, small caps have been underperforming² the Nifty. Crude oil prices are surging in the international markets and global equity markets turned volatile after Russia invaded Ukraine. The United States is expected to announce stringent economic sanctions on Russia. As such, we will see high volatility in global financial markets. Historical data from past volatile markets show that small caps usually underperform in highly volatile market situations.

Can small caps outperform in the medium to long term?

The current geopolitical situation is highly volatile; it is impossible to predict how stock and commodities markets will react, till we see de-escalation in the Ukrainian situation. The growth prospects for Indian equities in the medium to long term is promising, as the economy recovers from the longer term impacts of the COVID-19 pandemic. Historical data shows that small cap stocks can outperform large caps in the long term (see the chart below³).

Why small caps can outperform large caps in the long term?

• Small cap companies are usually less capital intensive with the potential to generate superior Return on Equity (ROEs). Companies with higher ROEs can generate superior returns for investors in the long term.


• Small cap stocks are also tend to be under-researched compared to large cap stocks. Fund managers can identify stocks trading at considerable discounts to their intrinsic valuations. Such stocks can generate considerable alphas for small cap funds.


• There are 250 small stocks in the Nifty 500 index versus only 100 large cap stocks. Small caps provide a much broader opportunity set for investors. There are a number of industry sectors where large caps do not have any presence. One can invest in these sectors through small caps.


• Mid and small cap stocks tend to outperform in periods of demand revival. In the post COVID scenario of economic recovery small caps can outperform.

Active versus passive exposure to small caps

Historical data shows that percentage of small cap schemes outperforming their respective benchmark indices is much higher compared to midcap and large cap schemes. The small cap segment has many more stocks (250 stocks in Nifty 500) compared to midcap (150 stocks) and large cap (100 stocks). Though stock selection is important for all equity fund categories, bottom up stock picking plays a much more important role in small caps compared to the other two segments. Historically, multi-bagger stocks have usually come from the small cap segment. Fund managers who are able to identify such stocks early, can deliver superior returns (alphas) to investors. As such, small cap exposure is better through actively managed schemes.

Ideal stock concentration in small cap fund

Small cap stocks have a larger percentage of promoter ownership compared to large cap or even midcap stocks. The percentage of free floating shares is consequently lower in small caps. This can cause liquidity issues in extreme market conditions. Therefore, concentration risk is important in small cap funds. Ideal single stock concentration in a small cap fund should not exceed 5 – 6% of the portfolio.

How to select small cap funds?

Bottom up stock picking has a larger impact of returns on small cap funds. Performance data of the small cap funds category shows large variations in alphas created by different schemes. Different fund managers have different stock picking strategies. You should invest in small cap schemes, which have fund managers with strong long term track records. You should look at minimum three years performance, when comparing performance of different small cap funds.

How much should you invest in small caps?

Your allocation to small caps will depend on your risk appetite and investment horizon. Small caps are more volatile than large and midcaps. Financial planners recommend that your small cap allocations should not exceed 20% of your equity portfolio. You should consult with your financial advisor and plan accordingly.

Who should invest in small cap funds?

• Investors who are looking for capital appreciation over long investment horizons.


• Investors with high to very high risk appetites. These funds can be very volatile in the short term


• Investors with minimum 5 year investment tenures


• Small cap funds are suitable for SIP investors, since you can take advantage of volatility through Rupee Cost Averaging. You can also take advantage of deep corrections to invest in lump sum.


• Investors should consult with their financial advisors if small cap funds are suitable for their investment needs.

Footnotes:

• Source: National Stock Exchange, Advisorkhoj Research, as on 31^st January 2022. Disclaimer: Past performance may or may not be sustained in the future.


• In the last one week (as on 23^rd February 2022), Nifty Small Cap 250 TRI fell by 5.3%, while Nifty 50 TRI fell by 1.4%. Disclaimer: Past performance may or may not be sustained in the future.


• Source: National Stock Exchange, Advisorkhoj Research, as on 31^st January 2022. Returns for periods exceeding one year are annualized (CAGR). Disclaimer: Past performance may or may not be sustained in the future.