A big haul
Let us assume you had invested Rs 1 lakh in a small cap fund five years ago. By now, you could have added another Rs 2.5 lakh to your corpus, and your investment could have grown to Rs 3.5 lakh at a compounded annual growth rate (CAGR) of 29 per cent. Yes, that is the average return delivered by the small cap funds during a blistering five years between July 14, 2012, and July 14, 2017. Due to their turbocharged growth, these funds have not only beaten their benchmarks but also outshone most of their large-cap and multi-cap peers, over the short term and the long term. The mid-caps followed close on the heels at 24 per cent; the multi-cap funds lagged at 18 per cent, but all of them were way above the 13 per cent delivered by the broader market - the BSE Sensex. Had you invested Rs 1 lakh there during this period, it would have grown to Rs 1.8 lakh only (see Table: Small Cap Versus Other Players).
Small-cap stocks could be lucrative if one has the risk appetite as these companies, with relatively small market capitalisation, tend to be more volatile in the short term. On the other hand, these could be the little acorns with great growth potential that often results in exciting returns. Also, in the world of large caps, there are only about 100 top companies while small-to-mid-cap funds can choose from 500 companies.
"India is fortunate to have a well-developed equity market that encourages small and mid-size companies and entrepreneurs to list their firms in the public markets," says Mahesh Patil, Co-Chief Investment Officer, Birla Sun Life AMC. According to him, the small and mid-cap segment is a stock picker's paradise as it has an inherent advantage - a wider basket of stocks to choose from - allowing both stock and sector diversifications.
TOP PLAYERS AND THEIR PORTFOLIO PICKS
One of the oldest funds in the small- and mid-cap category, Birla Sun Life Small and Midcap Fund held about 40- 45 stocks by June end, a good example of the diversification mentioned above. It has come up with 14 per cent CAGR over the past 10 years and also delivered big returns periodically (see Table: How They Are Performing). The performance, says Patil, can be attributed to its bottom-up stock-picking strategy and GARP (growth at a reasonable price) methodology, which means the portfolio companies have seen significantly better earnings growth and a good return on equity than indicated by their benchmark indices while valuations are in line with the market or bench mark.
As for the choice of stocks, the solar industry is one of its top picks as the fund manager favours the renewable energy sector. The Federal Bank finds a place in the portfolio as Patil prefers private banks, select corporate lenders and retail non-banking financial companies with better capital ratios, growth outlook and profitability. Industrial and capital goods are also among the top sectors with exposure to stocks such as KEC International and J. Kumar Infraprojects. This could be a rewarding sector as public capex in areas such as railways, ports, urban infrastructure and affordable housing is gathering pace and construction projects, too, have seen a pickup in order flow, says Patil. In a bid to manage the risks, the fund avoids firms with poor corporate governance, excludes leveraged companies with high capex intensity and companies with poor operating cash flow.
The Reliance Small Cap Fund has a strong run as well, returning 39 per cent over the past one year. "While its performance is in line with the strong markets, especially in the mid-cap and small-cap space, its ability to select good stocks and identify winners and trends early enough has worked for the fund," says Samir Rachh, Fund Manager at Reliance Mutual Fund. "Some of the top sectors include building materials, industrial and engineering, which are expected to benefit from the government's focus on infrastructure and housing," he adds.
Then there are chemical stocks, which Rachh believes will gain from India's increasing competitiveness over China. Consumer goods will be another area to benefit from growing financial inclusion.
The fund's current holdings range from Navin Fluorine, Deepak Nitrite, Seya Industries, Atul, West Coast Paper and Orient Cement to GIC Housing Finance, Karur Vysya Bank, LG Balakrishnan & Bros, VIP Industries, Vindhya Telelinks, Kalpataru Power Transmission and more. It has been cautious in some cyclical sectors like metals and power because of business headwinds. And it avoids stocks where the companies do not focus on management quality, cash flow and return on capital employed.
Some of the small-cap and mid-cap funds are also known as emerging opportunities or emerging businesses funds as they invest into small companies which have the potential to turn into large-cap companies. L&T Emerging Businesses Fund, which invests more than 50 per cent of its corpus in small-cap stocks, is one such fund and it has emerged a clear winner, fetching 47 per cent between July 14, 2016, and July 14, 2017.
As for strategy, the fund has picked a few multibaggers. For instance, its top stock, Avanti Feeds, has gone up from Rs 600 to Rs 1,600 over the past one year. Then there is Rane Holdings, another top pick, which has tripled from Rs 600 on July 26, 2016, to Rs 1,700 on July 20, 2017. Other stocks such as Swaraj India, Tube Investments of India and Max India have also done exceedingly well. Notably, most of these stocks trade in the higher price-to-earnings band, which means more than 35x earnings. The fund's higher allocations to sectors like construction, chemicals, financial services and engineering have boosted its performance.
The DSP BlackRock Micro Cap Fund has also performed consistently, returning 20 per cent CAGR over the 10-year period and about 30 per cent over the past threeyear and five-year periods. Fund Manager Vinit Sambre puts it to finding superior companies in each sector. As of now, the fund is overweight in sectors like consumer discretionary as Sambre believes that the consumption trend will peak along with rising income levels, growing aspirations and favourable demographics. He is also bullish on speciality chemicals/agrochemicals as the opportunity size is quite big and some Indian companies have carved a niche versus global players. Again, the fund is overweight on engineering companies as they seem to be operating at sub-optimum capacity utilisation and would see operating leverage benefits as utilisation improves.
"The fund is underweight on IT and pharma. Traditional IT services are witnessing low growth while the US Food and Drug Administration's issues with the Indian companies and the price fall of generic drugs in the US market are affecting the pharma companies' growth prospects in the near term," says Sambre.
RISKS VERSUS REWARDS
Data shows many of these funds have done well, but one cannot invest in them based on past few years' performance. With the markets trading at an all time high, valuations of small-cap and mid-cap stocks are also trading higher than historical averages. But opportunities will shrink as valuations become expensive. Sambre's fund, for instance, is now going slow, adding only the names that fit its investment philosophy. Not too long ago, the fund house stopped fresh inflows into the fund owing to limited opportunities at current valuation.
"However, Indian economy is on the cusp of a turnaround, and there are still some companies in this space, which can create value for investors in the long run," says Rachh of Reliance Mutual Fund. According to him, there is a strong case for this segment with a three-year view as earnings will accelerate from now on, but before that, one could expect a healthy correction to allow earnings to catch up.
When it comes to valuations, one should understand that the small- and mid-cap indices have a different sector composition compared to large-cap indices. "Comparing the price/earnings or P/Es of these indices with broadermarket indices like the Nifty or the Sensex and making a judgement on valuation differential could be misleading," says Patil of Birla Sun Life. The risk-return trade-off will always be there, but considering the superior growth rates, they can deliver better returns than the large caps over the medium-to-long term, he adds.
Historically, too, small-cap funds have fared better than their large- and mid-cap peers, but investments in these funds may witness a bumpy ride for several reasons. For one, when recession hits or the market corrects, small companies, with less access to funds that could tide them over, suffer most and the price swings become bigger. Second, the bid-ask spread - the difference between a buyer's offer and a seller's ask price - is often wider in these cases and trading in small caps becomes expensive. Therefore, small-cap funds are ideal for systematic investment plans (SIP). In fact, these funds are best suited for investors with a high risk-reward appetite, says Patil. The investment horizon for such investors should be three to five years to reap the benefits of different market cycles, he adds.
