Large cap Midcap or Value Fund: Where should you invest now

The bullishness in stock market post the Balakot airstrike started ebbing out since polling for 2019 Lok Sabha elections began in the middle of April 2019. In the last 1 week or so, we saw erosion of nearly Rs 5 lakh Crore of market capitalization with the Nifty falling 500 points. Many indicators point to volatility continuing till May 23, 2019, when the election results will be announced. Whether the market will bounce back or go through a deeper correction will depend on the election results. The volatility in the market shows that it is no longer confident about BJP / NDA getting absolute majority in Lok Sabha. It is extremely difficult to guess where the chips will fall on May 23^rd 2019 because this is one of the most fiercely fought elections in last several decades. In this blog post, we will discuss what you should do if market conditions continue to remain volatile. Please note that this post is mainly from the perspective of equity investments – we will discuss fixed income investments in a later post.

Election is not the only factor

Many mutual fund investors I have spoken with are associating the market volatility with BJP’s prospects of forming the next Government. While elections are an important factor in the stock market behavior, it is important to understand that there are several other very important factors too. From a global perspective, US economic slowdown is a major fear. Contrary to the fears, the US macro data in April 2019 was encouraging, but economic slowdown fear will persist. Another worrisome factor is the intensifying US / China trade war – this may have an impact on INR / USD exchange rate. The Trump administration’s decision to end waiver to import crude oil from Iran without US sanctions may have an impact on our import bill, fiscal deficit and exchange rate.

In the debt market, there were several high profile credit downgrades in the last few months, beginning with ILFS, Essel Group, Dewan Housing, Reliance ADAG and now Yes Bank. There may be more in the future and might impact the stock market as well. Finally, there are concerns about our fiscal deficit with reports of tax revenues, both direct and indirect (GST), lower by more than Rs 1 lakh crore versus target. The point of this is that, irrespective of what happens on May 23^rd, these are some of the issues that the market has to grapple with. Investors should take into account all these factors, not just election results, when forming expectations in short to medium term. However, Indian economy and stock markets have faced difficult situations many times before and have always emerged stronger. Equity will continue to be best performing asset class in the long term.

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Large Cap versus Midcap Funds

Midcap outperformance from 2014 – 2017 created the perception that they will always outperform large cap, despite the unreasonably large valuation premium for midcap versus large cap – we were saying this repeatedly in our blog. The 2018 correction in mid and small cap mutual funds was a brutal lesson for naive investors who believed that good times will last forever. In the last 1 year, Nifty Midcap 100 index fell 15%, while Nifty Small Cap 100 index fell 25%. However, has this correction in midcap and small cap resulted in good investment opportunities in those segments?

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We have spoken to a number of fund managers in the last few and most of them are of the views that post the price correction, there are attractive investment opportunities in the midcap and small cap space. We in Advisorkhoj are of the opinion that investors should have allocations to midcap and small cap funds in their investment portfolio because these funds can create considerable alphas.

Read more about: Investing in large cap funds versus midcap equity mutual funds

One question that some investors ask is whether midcaps and small caps have bottomed out and will outperform large caps henceforward? The 52 month low of midcap and small cap was reached sometime in October 2018, and was revisited in the immediate in the aftermath of the Pulwama attack on our security forces in February 2019, when fears of escalation in India and Pakistan tension reached a peak. From the February lows, midcaps and small caps made a handsome recovery with the Nifty Midcap 100 and Nifty Small Cap 100 indices rising 14% and 20% respectively before polling began for 2019 Lok Sabha elections. This suggests a recovery in these stocks.

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However since the polling began, the Nifty Midcap 100 and Nifty Small Cap 100 indices fell by 7% and 8% respectively, while the Nifty – 50 fell by 4% (as on close of trading session May 9). There is nothing surprising about midcap and small cap underperforming large cap in volatile market. The price behavior simply reiterates how different market segments react in volatile markets. Midcap and small caps naturally, are more volatile than large cap. Investors should invest in midcap and large according to their risk appetites. If you do not have high risk appetite and at the same time, want high returns then, Multi-Cap Funds are the best investments for you.

Value Funds

If you are regular reader of our blog, then you may know that in our view multi-cap strategy, which balanced risk and returns, is best suited for long term retail investors. In this strategy, fund managers invest across different market cap segments i.e. large cap, midcap and small cap – they have the flexibility to determine the allocations to these segments without having to abide by any restrictive mandate.

Did you know how to get more returns from your mutual fund investments?

As per SEBI’s mutual fund classification, Multi-cap Funds have a flexible market cap mandate. However, there is another category of funds, which also have multi-cap mandate but follow value investment strategy – these are known as value funds.

Value funds invest in high quality stocks which are trading at a discount to the fair market valuation or their intrinsic value. Value fund managers look for factor of safety in their investments or in other words, look for stocks which are trading at deep discounts to their fair market valuations. This strategy limits downside risk in volatile market and gives superior returns when market rebounds.

In Advisorkhoj, we looked at past data and have seen that, value funds give good returns in volatile markets and in the medium term as well. The market has been volatile for the past 15 – 18 months, and value stocks have outperformed over various short to medium term time-scales. The chart below shows the returns of MSCI India Value Index versus MSCI India Index over various time-scales (ending April 30^th 2019).

Source: MSCI

Conclusion

In this blog post, we discussed several risk factors in equity markets, not just those related to political risks, but also global and local economic risk factors. Past elections have shown that, political risks have a short term impact but in the longer term, it is all about earnings growth. Earnings growth is continuing to show signs of recovery in Q4 FY 2018-19. This makes us bullish about Indian equity in the long term. However, in the short to medium term, the risk factors discussed in this post remain, irrespective of election results. Value funds may be good investment options, if volatility persists for some time even after election results are declared. The correction in midcap / small cap and even in select large cap counters may provide excellent value investing opportunities. Investors should consult with their financial advisors, if value funds are suitable for their investment needs in current market conditions.