Investment Potential In Small- & Mid-Cap Funds

I had invested in Small- and Mid-Cap equity funds in October 2010 but have lost some of my principal. I have also invested in some large-cap funds. I now wish to switch to funds which will generate high returns, and plan to redeem my investments in 2021. Please recommend alternative equity funds for me.

- Naresh Swamy

Small-Cap and Mid-Cap stocks have had a rollercoaster ride over the past few years. Since the last peak in November 2010, they are currently trading at a discount to their Large-Cap counterparts. In the last three years, the CNX Midcap Index generated a return of -7.6 per cent and underperformed the Nifty, which generated a positive return of 0.74 per cent. During the same period, some Small- and Mid-Cap funds generated returns as high as six per cent, while some underperformed the CNX Midcap Index and declined by nearly 20 per cent (based on CAGR).

Nevertheless, Small- and Mid-Cap stocks do have the potential to outperform Large-Cap stocks, as shown in the chart. But there is a price to pay for these high returns, as Small and Mid-Cap stocks are more volatile than Large-Cap stocks, especially in the short-term. As the table illustrates, this phenomenon is especially true in falling markets. For example, when the global markets crashed in 2008, the Nifty fell by 52 per cent, while the CNX Midcap Index fell by 59 per cent. The same phenomenon occurred in 2011.

As your time horizon is relatively long, you could invest a small portion of your corpus in Small- and Mid-Cap funds to enhance your potential returns. These funds generally invest in companies in the early stages of their business cycles. Hence, Small- and Mid-Cap companies may have higher growth rates than Large-Cap companies, which are already mature. However, Small- and Mid-Cap stocks are relatively more volatile than Large-Caps, as they are less traded in the market. Large-Cap stocks are generally quite liquid as they are frequently traded. At any given time, the volumes of Small and Mid-Caps in the market are lower than the volumes of Large-Caps.

Furthermore, unlike blue chips, smaller companies are more susceptible to shocks in the business environment. This is because Small- and Mid-Caps generally have fewer resources than mature Large-Caps. This characteristic also makes the former more vulnerable to business cycles. These are usually the worst hit in a downturn, as they also act as ancillaries to Large-Cap companies. Over the last few quarters, they have suffered because of the weak economic environment and high interest rates.

Currently, Small and Mid-Caps are trading at relatively more attractive valuations than Large-Cap stocks. On October 22, the Nifty was trading at a P/E of 18x – slightly below its long-term average of 18.3x. In contrast, the CNX Midcap Index was trading at a P/E of 13.7x. The long-term average P/E of the Midcap Index is 15.9x. The Nifty is very close to the record high of 6312, which was achieved in November 2010. In contrast, the CNX Midcap Index is currently trading at a discount of 24 per cent to its all-time high. In November 2010, the index hit an all-time high of 9783 but was only trading at 7453 on October 22.

Over time, Small- and Mid-Cap companies may eventually graduate to Large-Caps and benefit from ‘re-rating’ – this will generate higher returns for investors in Small and Mid-Cap funds. You may benefit from capital appreciation as the values of Small and Mid-Cap stocks get unlocked. Currently, the valuations of most Small and Mid-Cap stocks are still at the 2009 levels. These stocks may recover more quickly than Large-Caps when India’s economy recovers.

You could redeem your investments in the Small- and Mid-Cap funds you currently hold, as they have generated negative returns over the past three years. You may choose to switch to funds like ICICI Prudential Discovery Fund and IDFC Premier Equity. These are among the best performers in their categories and have consistently generated high risk-adjusted returns. They have also outperformed the CNX Mid-Cap Index.

However, as a general rule, you should not invest more than 20 per cent of your overall portfolio in Small and Mid-Cap funds. Invest the bulk of your equity portfolio in relatively safer Large-Cap funds. These generally invest in ‘blue chip’ stocks of well-established companies with strong financials and steady growth prospects. Generally, they are more consistent than Small- and Mid-Cap funds and have lower downside risks. The returns of Small and Mid-Cap funds may fluctuate more than the returns of Large-Cap funds, especially when the markets are turbulent.

Follow the ‘core and satellite’ approach. Large-Cap funds should form the bulk of your portfolio (‘core’), while a small portion can be invested in Small- and Mid-Cap funds for higher returns (‘satellite’). Your allocation to Small and Mid-Cap funds should be governed by your risk tolerance – a financial advisor can help you determine this. Furthermore, you could use SIPs to invest in equity funds, as the markets are likely to be volatile in the run-up to the elections. Through this approach, you will be able to reduce the downside risk of your overall portfolio while maximising your returns.