It's the right time to invest in small-cap and mid-cap funds

Small-cap and mid-cap stocks have a knack of stealing the show every time the stock market rebounds after a long lull. The Bombay Stock Exchange (BSE) Sensex has risen 18% this year. In comparison, the BSE Mid-Cap index and the BSE Small-Cap index are up 34% and 44%, respectively. This has also boosted the performance of mid-cap and small-cap funds, which have returned 43% on an average in the one year to May 30 compared to 20% returns delivered by large-cap funds and 30% by multi-cap funds.

"When stock markets do well, mid-cap and small-cap stocks give better returns than others. But when markets do badly, they fall more," says Mrinal Singh, fund manager, ICICI Prudential Mid Cap Fund.

For instance, in 2007, BSE midcap and small-cap indices returned 61% and 77%, respectively, compared to 43% rise in the Sensex. The fall, when it came the next year, was also far greater.

This is because smaller companies are hit harder in difficult economic conditions. Also, in bull markets, even a small investment can push up a smaller stock by a much greater degree. Feroze Azeez, director, investment products, Anand Rathi, says small-cap and mid-cap funds have delivered superior performance as a result of the marginal incremental risk they take.

"The other factor driving midcap and small-cap stocks is the enhanced liquidity after the elections. Generally, liquidity drives mid-cap stocks more easily than it moves large-cap stocks," he says. This is because of the low market float of smaller companies. Market float is the number of shares available for trading.

"Hence, liquidity-driven rallies are front-ended by mid-cap stocks," says Azeez.

Both mid-cap and small-cap companies show pronounced cyclicality. Their earnings fall much more in a down cycle and rise much faster than that of the larger companies when the cycle turns, says Janakiraman R, portfolio manager, Franklin India Smaller Companies Fund.

This leads to a sharp difference in valuations of large and small companies. "In a down cycle, smallcaps could trade at a significant discount of up to 30% to large-caps," says Janakiraman. Hence, when there is expectation of economic recovery, the faster growth leads to improved sentiment and re-rating of smaller companies. As a result, the valuation gap narrows, which is what we are witnessing now.

STRATEGIES THAT PAID OFF

Stock selection -

The best performing fund in the category on the basis on one-year returns as on May 30 is Birla Sun Life Pure Value Fund. It returned 78% during the period. The fund invests in stocks that are trading below long-term averages, either in terms of PE/PBV ratios or assets. PE, or, price-to-earnings, ratio shows a stock's level relative to the company's earnings while PBV or price to book value indicates where the stock stands relative to the value of assets on the company's books.

Mahesh Patil, Co-CIO, Birla Sun Life AMC, says the fund's ability to deliver good returns is purely a function of selecting stocks priced lower than their value. Also, the fund's low exposure to stocks in IT and FMCG sectors worked, as these were fairly valued then. The top five holdings on April 30 were Jyoti Structures, Jain Irrigation, Federal Bank, Muthoot Finance and Axis Bank.

Jyoti Structures, for instance, found place in the portfolio due to its low valuation (trading at three-four times earnings when bought), which was due to high debt in a high interest rate environment. It doubled in the one-year period ended May 30. Similarly, the fund holds a large number of mid-cap banks considering that these are better positioned to take advantage of the turnaround in the economy, more so banks which are trading significantly below their long-term averages.

"Many mid-sized banks have managed asset quality better than the bigger banks and are trading below book value, are well capitalised and so should do well, especially in an improving macro environment," says Patil.

Right timing -

Another fund in the category, ICICI Prudential Mid Cap Fund, has returned about 60% in the one-year ended May 30, way above the category average of 43%. The CNX Mid Cap index returned 32% during the period. According to Mrinal Singh, fund manager, ICICI Prudential Mid Cap Fund, a lot of credit goes to the timing of some of these investments. For instance, when the markets were down in June-August 2013, the fund saw an opportunity in domestic cyclical stocks and bought construction and mid-cap cement companies, besides mid-cap banks. It was a contrarian view but we thought that such low valuations were not justified, says Singh of ICICI Prudential.

Another fund from the ICICI stable, ICICI Value Discovery, is a flexicap fund whose mid-cap and smallcap exposure hovers between 50% and 75%.

Betting on recovery-

Another fund in the category, Franklin India Smaller Companies Fund, has returned 51% in the last one year. The performance, says Janakiraman, can be attributed to the call taken in September last year that 2014 could see moderate recovery in economic growth and, hence, increased exposure to cyclical stocks.

IS SOME STEAM STILL LEFT?
On an aggregate portfolio level, mid-cap and small-cap stocks have risen quite a bit, which makes one wonder whether these still offer value. Azeez of Aanand Rathi says the fund manager of a mid-cap fund will take into account the high valuations and move out of stocks that have returned fair results and invest in stocks where some amount of value is still left. That's why the rate of churn in a mid-cap fund is twice that in a large-cap fund, he says. Further, the PE ratio of mid-cap funds is currently 13-17 times one-year trailing earnings while the PBV ratio of most funds is in the range of 1.5 to 2.5. Hence, valuations are not alarmingly high, he says.

Also, the fact is that liquidity, which is driving stocks, is likely to sustain, considering that it is based on fundamentals, that is, hope that the economy will do well. Also, no investor category is currently over-invested in stocks. After having said that, easy stock-picking is behind us as future gains are highly uncertain because of slightly stretched valuations. Hence, choosing a fund wisely is more imperative now than before.

ICICI Prudential's Singh recommends investing in a fund that has a low turnover ratio (less than 0.5) and is among the top two quartiles on the basis of sharpe ratio. The ratio measures risk-adjusted returns. Investors should also look at the fund's performance in various market cycles and vis a vis the benchmark. Unlike large-cap funds, which get momentum from sector selection, mid-cap funds thrive on the basis of stock selection. Hence, while choosing a fund, it is critical to see how dependable the fund manager is.

How much money one should invest depends on your investment objective and asset allocation. According to Janakiraman, a young person, aged 45, could invest up to one-fourth funds in mid-caps and small-caps.