Want to Invest in Small caps? Manage the Risk and Reward Well

October 16, 2023 Mutual Fund

For those investing in Indian equities, the last couple of years have been wonderful. Exuding confidence in India’s growth story backed by several reforms, markets have generated significant wealth for investors. The mid and small-caps, in particular, have delivered stellar returns.

Not wanting to miss the bus, an increasing number of individuals have participated in this rally. As of September 2023, the demat count touched 12.97 crore — the highest in 13 years – as per the data revealed by two depositories, NSDL and CDSL.

Similarly, Mutual fund retail folios also touched an all-time high of 15.71 crores (with the retail ones in equity, hybrid, and solution-oriented schemes comprising 12.55 crore) according to the AMFI data.

Graph 1: Inflow into Large-cap, Mid-cap and Small-cap Funds

#Segment-wise data reported by AMFI from April 2019 onwards
*Data as of September 2023
(Source: AMFI, data collated by PersonalFN Research) 

In the case of mutual funds, as seen in the graph above, it is mainly the mid and small-cap funds that have witnessed huge inflows since the COVID-19 pandemic.

Table: Performance of the Key Indices since the COVID-19 Pandemic

Data as of October 12, 2023
(Source: www.bseindia.com, data collated by PersonalFN Research) 

Clearly, there is FOMO (Fear of Missing Out), as an increasing number of people are taking risks and participating in equities hoping to earn better returns.

However, one ought to be careful and take calculated risks. Currently, the following are the imminent risks for the equity markets…

• Ongoing geopolitical tensions (Israel-Gaza war, Russia-Ukraine war, tensions between India and China, India and Pakistan, China and the United States, China and Taiwan, and North Korea-South Korea among others)
• Geoeconomic fragmentation
• Higher international oil prices
• Weak Indian rupee
• Concerns that India’s Current Account Deficit (CAD) may widen
• Possibility of inflation shooting up again due to supply chain pressures
• Policy interest rates remaining high
• Higher borrowing costs
• Higher bond yields
• Weak global demand
• And chances of economic slowdown later this year (or early 2024)

Against the backdrop of the above, volatility in the financial market is likely to intensify.

While small-cap (and mid-caps) stocks have the potential to generate high alpha and create significant wealth, refrain from getting carried away by irrational exuberance.

Here are the risks to watch out for when investing in small-caps:

You see, in a bull run, it is not uncommon to see small-caps outperforming the mid and large-cap segment by a remarkable margin.

But when market sentiments turn pessimistic, the downside risk is higher in the case of small-caps and mid-caps, compared to the large-caps.

In other words, investing in smaller companies is inherently high risk — it can swing from thrilling highs to dangerous lows, akin to a roller coaster ride. This highlights that the small-cap investment is not for everyone, surely not for the fainthearted.

Further, one cannot expect all bets to turn out well always. The chances of disappointment in small caps are much higher compared to bigger businesses.

The key traits of small-cap companies are:

1. Less liquid than mid and large-caps:Low liquidity and market caps lead to the risk of exit. Thus, avoid small-caps with low liquidity as they could face the biggest knock if fundamentals do not support, them and market sentiments turn sour.Hence, even when you invest in a small-cap fund ensure that it prioritises liquidity and market capitalisation. The average liquidity per day should be at least Rs 2 crore. Furthermore, the market capitalisation should be around Rs 400 crore. These parameters shall ensure that the days taken to liquidate a stock, particularly if it’s in the top-10 holding, are the least.
2. Weak Cash Flows:Just looking at earnings growth is not enough, because there may be some stocks where profits only appear on paper.Thus, from a due diligence point of view, it is necessary to check if the cash flows from operations are positive. If there is a huge gap between cash flow from operations and earnings, it may be a red flag and will require deeper analysis.It would be worthwhile investing in a small-cap fund that judiciously looks into this aspect during the portfolio construction activity with its research capabilities as it navigates the small-cap universe.
3. High LeverageIf a company is highly leveraged, i.e., has a higher debt-to-equity ratio, then it may be a sign that the growth may not be sustainable. Such companies may witness weak earnings growth and even risk to survival during uncertain economic conditions and a rising interest rate environment, and consequently, their stock prices may suffer.
4. High Promoter PledgingHigher pledging of stocks by promoters is another negative sign, as such stocks tend to witness higher volatility in case of negative market events. Be cautious if the promoter pledge percentage exceeds 15-20% or is on a rising trend.
5. Poor Corporate GovernanceAlong with quantitative parameters, it is also sensible to check qualitative aspects of the business. Avoid companies with poor work ethics, corporate governance lapses, low regard for stakeholder interests, and lack of transparency in operations, among other such factors. Only companies with quality management teams can offer comfort while you expect to create wealth.

So, instead of chasing momentum-driven bets and expecting probability to work in your favour, focus on qualitative aspects when investing in small-caps. This due diligence and selective approach may enable you to be a successful investor.

How are valuations placed in the small-cap segment?

The S&P BSE Sensex is near the peak and the Indian equities are trading at a premium compared to the global peers. The Morgan Stanley Capital International (MSCI) India Index Price-to-Equity (P/E/) ratio is currently over 25x, while the MSCI Emerging Markets Index and MSCI World Index trail P/Es are at around 14x and 19x (as per the latest factsheets).

Even on a 12-month forward P/E, India is commanding a premium vis-a-vis emerging markets and the world. To know the investment strategy to follow near the market peak, watch this video:

Having said that, there are some pockets of value in small-caps despite the run-up. Yes, you read that right. The Small-cap Index PE is trading below its 5-year median. The Small-cap Index PE is also trading below the long-term average. The recent correction in the Indian equity market since the lifetime peak (of 64,414.84 points on the S&P BSE Sensex made in mid-September 2023) has reduced the valuation premium.

Graphs 2A and 2B: Small-cap Index PE and Small-cap Index-to-Sensex Ratio

Data as of October 12, 2023
Past performance is not an indicator of the future.
(Source: NSE, ACE MF, data collated by PersonalFN Research) 

Also, the Smallcap Index-to-Sensex ratio, which is around 0.58, offers some comfort or margin of safety. In other words, there exist value-buying opportunities in the small-cap space.

Given that India is a bright spot in the global economy, the long-term prospects are bright. Many of the smaller-sized companies are likely to grow and become the mid and large-caps of tomorrow. Simply, put they would create for investors.

The point is, if you discover the hidden gems from the small-cap (and mid-cap) space following a bottom-up approach with due emphasis on the fundamentals today, you could make appealing returns that could help accomplish your envisioned financial goals.

Many small-cap companies today are engaged in niche, innovative and sunrise businesses, such as green energy, new-age technology, drones, AI, geospatial systems, genomics, semiconductors, clean mobility, food processing, biotechnology, logistics, and so on that have the potential to grow.

Recognising this, Foreign Portfolio Investors and domestic investors also are largely positive on the small-cap space.

The Approach to Invest in Small-caps

To invest in small-caps, preferably consider small-cap funds that follow robust investment process and systems, pays close attention to liquidity, market capitalisation, and hold an optimally diversified portfolio with conviction.

An actively managed small-cap fund should not perform like a Small-cap Index. It must be true to its label.

Also, a small-cap fund ought to be aware of its capacity to prevent its large size from becoming a hindrance to performance. Stay away from small-cap funds that manage a large AUM, hold dismal weight in small-cap stocks (showing a lack of conviction), and perform like index funds.

To select a small-cap fund avoid giving too much weight to past returns, as they are not indicative of how the fund/scheme would fare in future. To check for consistency in clocking returns check how the fund/scheme has performed across market cycles.

To know how the scheme would fare in the future, recognise the portfolio characteristics(the top-10 holdings, top-5 sector exposure, how concentrated/diversified is the portfolio, the market capitalisation bias, the style of investing followed – value, growth, or blend, the portfolio turnover, etc.) as well as the overall efficiency of the mutual fund house in managing investors’ hard-earned money (i.e., the proportion of AUM actually performing — which shall reveal whether the fund house is a mere asset gatherer or a prudent asset manager).

Along with returns, it is also important that the small-cap fund (or any other mutual fund scheme for that matter) manages the risks well because along with returns there is risk.

“Successful investing is about managing risk, not avoiding it,” said Benjamin Graham, the father of value investing. He also opines that the essence of investment management is the management of risks, not the management of returns.

Want to know which are the best Small-cap Mutual Funds to invest in? Click here.

To sum-up…

When you are investing in equities, don’t expect to earn you supernormal returns always. There have been years when equities have rewarded investors with stellar returns and, at times, disappointed investors (like in the years 2015, 2018, and 2022). Hence, keep your return expectations from equities rational.

Invest sensibly and be a thoughtful investor.

Happy Investing!

This article first appeared on PersonalFN here