Are Small-Cap Funds An Attractive Proposition Now?
May 21, 2019

Author: Rounaq Neroy

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(Image source: pixabay.com)

I'm a 45-year-old individual, investing in equity mutual fund since about a decade with the sole objective of wealth creation. My portfolio mainly consists of large-cap and multi-cap funds. But of late, I'm a bit tempted to invest in small-cap funds. I've been reading and hearing that small-caps have been beaten down. Will it be worthwhile to add a couple of small-cap funds to my portfolio?

                                                                                             -- S. Kutty

It is true that small-caps have been hammered since February 2018. And lately, in the last couple of months, small-caps have recovered backed by a 'hope rally'--as the exit polls predict a second term for the Modi-led-NDA government.

Chart: Small-caps were hammered last year. Should you consider investing now?


Base: Rs 10,000
Data as on May 20, 2019
(Source: ACE MF)

The return potential small-caps offer is immense, but at the same time, the risk involved is also very high compared to large and mid-caps.

This is because of small-cap companies possess the following traits:

  • Limited scale of operations;

  • Narrow product line;

  • Narrow distribution channel;  

  • Limited financial and managerial resources; and

  • Greater sensitivity to underlying dynamic economic conditions.

Any adverse economic conditions or any policy changes from the government of greater magnitude can have an undesirable impact on the business of small-cap companies, and in turn on their bottom-line.

On the other hand, when the economy is booming and business is on an upswing, small-cap companies do quite well in terms of revenue growth and profits; and sometimes even outpace the larger companies by a noteworthy margin.

So, small-caps have the tendency to go from thrilling highs to dangerous lows.

A small-cap mutual fund scheme, as defined by the capital market regulator, is required to invest a minimum of 65% of its total assets in equity & equity related instruments of small-cap companies.

Small-cap companies as defined by the capital market regulator are those companies that fall beyond the 250th stock in terms of full market capitalization.

Should you invest in a small-cap fund?

Investing in a small-cap fund is not for the faint-hearted. As an investor, you need to be wary of the high volatility and have an appetite for very high risk.

Only if your investment time horizon is over 10 years, while you endeavour to boost your long-term returns, you may consider investing some portion in a small-cap fund/s.

[Read: The Best Small-Cap Funds In 2019]

Table: How have small-cap funds fared?

Scheme Name Absolute (%) CAGR (%)
1 Year 3 Years 5 Years
Category Average Returns of Small-cap Schemes -11.7 11.1 16.4
Nifty Smallcap 250 - TRI -15.5 8.7 10.9
S&P BSE Small-Cap - TRI -16.3 10.3 11.8
Data as on May 20, 2019
Note: Direct Plans considered and the returns are on a point-to-point basis.
(Source: ACE MF)

In the small-cap fund category, there only a handful of schemes that have completed a 10-year track record. And only a couple of schemes are worth considering.

Over the last five years, small-cap funds on an average have generated a compounded annualized return of nearly 16%. However, some worthy schemes have outperformed the category average returns and the benchmark indices by a wide margin.

Do valuations in the small-cap space offer a margin of safety?

The trailing P/E of the S&P BSE SmallCap Index is around 92x. It has come down from its earlier highs, but that doesn't mean valuation-wise small-caps are cheap or even reasonable. A fact is, many constituents of the BSE SmallCap index are making losses. Only a handful of small-cap companies are able to manage financial stress, and those who pile up massive debt are rarely able to manage it when the going gets tough.

The year 2019 is not going to be easy; it could test the patience of several investors. An economic slowdown could weigh on the corporate earnings and consequentially on the performance of mutual fund schemes.

Therefore don't expect a recovery in the small-cap space immediately; even though have been hammered down. Expecting handsome returns in a year may lead to disappointment.

Having said that, if you invest in a well-managed small-cap fund/s that pick fundamentally robust companies at reasonable valuations (and have the potential of being tomorrow's large caps), over the long-term it can prove to be a rewarding experience.

Remember not to pick small-cap funds by:

Editor's Note:

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Happy Investing!

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