Small-Caps Have Been Beaten Down. Ripe Time To Invest In Small-Cap Funds?
Jul 29, 2019

Author: Divya Grover

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The Indian stock market witnessed a significant sell-off ever since the Union Budget 2019 increased the surcharge on the tax paid by super rich. The hike in surcharge impacted many FPIs and they started withdrawing their money to avoid higher taxes. As a result, the S&P BSE Sensex - TRI declined 3.9% since July 5, 2019, while S&P BSE Small-cap - TRI declined sharper by 7.4%.

However, it is not just the change in taxation rules that caused small-caps to sink. Small-cap stocks started to plunge since the beginning of 2018 and the fall continues.

The SEBI introduced re-categorisation of mutual funds which saw the merging, renaming, and changes in fundamental attributes of numerous schemes. The changes took effect from March to May 2018 and many small and mid-cap stocks were sold in the process to realign the funds as per new norms.

Chart: Growth of S&P BSE Sensex – TRI vs S&P BSE Small-cap - TRI

RBI's quarterly projection for CPI inflation (y-o-y)
Base: Rs 10,000
Data as on July 26, 2019
​(Source: ACE MF)

A growing economy is conducive for the growth of small-caps and hence, subdued growth in the recent past coupled with slowing consumption and uneven monsoon further affected small businesses. Regardless, India Inc is hopeful of recovery and plans a turnaround in the next few quarters.

So do the beaten down stocks along with the expectations of turnaround make it a ripe time to invest in small-cap funds?

Small-caps have high return potential as compared to large-caps where the growth is limited. The high return potential of small-caps attracts many investors to invest in it. However, not everyone can withstand the volatility it is prone to. The downside risk of such stocks can be higher than its upside potential.

The risk involved in small-caps is higher due to 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.

Therefore, invest only if you have a high risk appetite and an investment horizon of 7 years or more. Small-cap funds can form the satellite part of your portfolio, while your core portfolio should consist of large and multi-cap funds. Rather than investing in a lump sum, opt for the systematic investment plan (SIP) route to limit the effects of market volatility. If you are a conservative investor, you can invest in multi-cap or mid/large-cap funds having exposure to small-caps.

[Read: Four Types of Mutual Fund for Aggressive Investors]

Even during times of market volatility, there are opportunities to select good quality value stocks with strong fundamentals that can prove to be a winner in the long-term. Therefore, check the investment strategy of the fund house before investing. Choose a fund house which consistently provides better risk-adjusted returns and known for picking good quality stocks at a reasonable price for your investment.

Despite volatility, there were fund houses that were able to generate good returns even when the benchmark index dropped sharply.

Table: Performance of small-cap funds

Absolute (%) CAGR (%)
Name 1-year 3-year 5-year
Average category returns of Small-cap schemes -11.8 4.9 11.4
S&P BSE Small-Cap - TRI -19.9 2.8 6.5
Data as on July 26, 2019
Direct plans considered
(Source: ACE MF)

Small-cap funds on an average generated a compounded annualised return of 11.4% outperforming the S&P BSE Small-cap TRI. In the 1-year and 3-year periods too, the average category returns were higher than the index. Thus, an actively managed small-cap fund can help you ride the wave of volatility.

[Read: Want To Invest In The Best Small-Cap Funds In 2019? Read This!]

The S&P BSE Small-cap index is currently trading at a PE of 33.5 as on July 26, 2019 and is lower than the average PE of May and June 2019. But a lower PE does not always mean that it is fairly priced. Only few companies that boast of strong fundamentals and quality management have the potential to grow big in the future.

One should not expect immediate recovery in the small-cap space. Determine how the fund fits in your overall path to achieve your financial goals. Be patient with your investment and do not make any decision due to panic caused by short-term volatility. Don't forget to review the performance of the fund periodically to track its performance vis-a-vis benchmark and peers.

Lastly, do not rely heavily on the star-ratings or the advice of your family/friends to select the funds. Personalise your financial plan with the assistance of a financial adviser.

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