Quality within small-caps: Unveiling an alternative approach to generate alpha for Smart investors in the small-cap mutual fund arena!

Small-Cap multibaggers: A Love Affair

The world of investing has always been fascinated by the charm of small-cap stocks. The thrill of discovering hidden gems that could potentially become multibaggers has captivated individual investors. According to DSP Mutual Fund's data, small-cap stocks have indeed delivered impressive returns, with a significant number of them turning into multibaggers in the last five years. The data reveals a staggering 71 small-cap stocks offering returns greater than 5x, and 175 stocks providing multibagger returns in the range of 3x-4x.

The Double-Edged Sword: High Returns vs. Higher Risks

However, with the allure of high returns comes the lurking shadow of higher risks. The dark side of small-cap stocks is unveiled in DSP's NFO presentation, revealing that 21 per cent of small-cap stocks have witnessed negative long-term returns over the last five years. This statistic serves as a stark reminder that the potential for gains in the small-cap segment is accompanied by an elevated level of risk.

Navigating the Small-Cap Seas: A Glimpse Into the Numbers

To understand the dynamics of the small-cap arena, let's delve into some key figures. Among the 4813 stocks classified as small-cap, accounting for market caps from 250th place onwards, they contribute to 15 per cent of the total market cap. However, the average institutional holding is merely 8%, highlighting the relatively lower interest from institutional investors in this space. Liquidity is another challenge, with the average three-month average daily volume traded (3MADVT) standing at a modest 0.9k, significantly lower than its larger counterparts in the Large-Cap and Mid-Cap categories.

The Conundrum for Investors: High Potential, Higher Risks, and Lower Liquidity

In essence, small-cap stocks present a tantalizing potential for wealth generation, but investors must tread carefully due to the associated risks, lower liquidity, and the vast universe of options. So, what's the solution for investors seeking to navigate this complex terrain?

Enter the Index Fund: DSP Nifty SmallCap250 Quality 50

DSP Mutual Fund has introduced an index fund tailored for such scenarios, offering investors exposure to the Nifty SmallCap 250 Quality 50 index. This index fund, available for subscription until December 19, 2023, aims to track the performance of 50 carefully selected stocks from the Nifty SmallCap 250 universe.

Strategic Timing: Riding the Small-Cap Wave

The launch of this index fund seems well-timed, capitalizing on the heightened investor interest in small-cap funds. AMFI reports that net inflows into small-cap funds this year have surpassed Rs 37,000 crore, indicating a growing appetite for these riskier yet potentially rewarding investments.

Decoding the Nifty SmallCap250 Quality 50 Index

What sets this index apart is its meticulous selection process. The Nifty SmallCap250 Quality 50 index picks 50 stocks from the Nifty SmallCap 250 based on three crucial parameters: return on equity (ROE), financial leverage (debt/equity ratio), and earnings growth variability over the last five years. Notably, in the financial service sector, the debt-to-equity quality score is disregarded. The index is reviewed semi-annually in June and December, ensuring its constituents align with the evolving market dynamics.

Quality Trumps Size: A Comparative Analysis

To illustrate the advantages of a quality-tilted index, let's compare it with its traditional market-cap biased counterpart. The traditional index's top holding is Suzlon Energy (3.1 per cent), while the quality-tilted index places the largest bet on Central Depository Services India (5.2 per cent). Among the top 10 holdings, only two are common to both indices, emphasizing the stark contrast in their compositions.

Performance Pays: Quality Triumphs Over Time

Now, here's the clincher – why choose quality? The Nifty SmallCap 250 Quality 50 Total Return Index has outperformed its parent index, the Nifty SmallCap 250 Total Return Index, since its inception. Delivering an impressive 19.3 per cent CAGR, the quality index has trumped the 15.7 per cent CAGR of its broader counterpart. In 12 out of 19 calendar years, the Nifty SmallCap 250 Quality 50 Total Return Index has outperformed, showcasing its resilience in both bull and bear markets. The probability of better returns increases and negative returns decrease with a longer tenure for the Quality Index compared to the Broader Index.

In Conclusion: Navigating the Small-Cap Landscape

As the small-cap wave continues to surge, investors now have a new instrument to ride the tide while minimizing the inherent risks.

Disclaimer: The article is for informational purposes only and not investment advice.