Factors to consider while investing in small-caps and mid-caps in India

Authored by Darshan Engineer, Portfolio Manager at Karma Capital

Listed companies across all equity markets are generally classified into three categories - Large-Caps, Our country has a large pool of over 5,000 companies that are listed on the Indian exchanges. As per the classification made by SEBI, the top 100 companies by average market cap over the last six months are categorised as large-cap companies whereas companies that ranked between 101 and 250 are termed as Mid-Cap companies. The rest of them fall under the category of Small-Cap companies. It has been observed that over the long term, small and mid-cap indices have generally delivered better returns compared to their respective large-cap indices.    

Source: Karma Capital Advisors, Bloomberg, ACE Equity. Data as of December 2021.  

This is because small as well as mid-cap companies generally offer more diversity and represent emerging sectors such as chemicals, textiles, industrial goods, media & entertainment, travel, and hospitality, among others. In India, they are characterised by a strong growth outlook and tend to garner more profits than large-caps that are rather densely concentrated in a few sectors such as banking, financial services & insurance (BFSI), information technology & FMCG, and offer growth at a slower pace.   

In the recent past, markets have corrected significantly from the top in order to account for the various macro uncertainties and increase in the cost of capital. As is always the case, the small and mid-cap companies have corrected more than the large-caps. Even if they do correct some more from current levels, their valuations become more attractive after accounting for lower future estimates. Even the best small and mid-cap companies have to undergo a corrective phase in their stock prices. However, it sets the stage for the next bull market in small and mid-cap companies in India when looked at from a three to five-year perspective.  

Factors to be considered while evaluating companies 

The potential of higher alpha in small and mid-cap companies comes with its own set of challenges, some of which are highlighted below:  

Under-researched and less liquid  

As highlighted in the charts below, small and mid-caps are mostly under-researched. The number of analysts covering a particular stock reduces as we move down the market-cap curve. Similarly, Indian small and mid-caps tend to be less liquid with volumes and value-traded dry up as we move down the curve. Entering and exiting them can result in huge impact costs, which reduces the overall return of a portfolio.    

The regular churn of a portfolio is needed – absolute return mindset and active management of portfolio  

Not all companies transition to large-cap over time. Many of them enjoy a good run for a few years, after which, they stagnate. In terms of stock price, it leads to a period of absolute price correction or being range-bound for a long period of time. Hence, active management with a regular churn of the portfolio is important and much-needed in the case of small as well as mid-cap companies. Having an absolute return mindset is essential while investing in small and mid-cap companies. It benefits an active investor in several ways: (1) avoids drag on portfolio returns (2) avoids opportunity cost.  

Entry and exit valuations are very important at the time of buying & selling  

Generally, it is seen that small and mid-cap companies would be trading at a discount to the large-caps in the same sector. As an example, leaders in the cement industry would be trading at much higher valuation multiples compared to the smaller companies in the same sector.  

In the case of sectors with no large-cap companies, many times, the sector itself may be trading at cheap valuations. Certain external events lead to an inflection point for that sector, leading to a better growth outlook and earnings profile, which in turn, attracts more investors along with the re-rating of the sector itself. Chemicals is a classic example of this, where in the last 10 years, the sector saw significant re-rating driven by a better understanding and more institutional ownership. Sometimes, the listing of more companies in the same sector leads to a period of re-rating for the entire sector, especially for the small/mid-cap companies already listed.

Just as companies re-rate during the period of strong earnings in growth, they also de-rate fast when the earnings outlook deteriorates. The higher the valuation, the greater the damage can be to the stock price in such periods. Thus, it is not sensible to buy small and mid-cap companies at any valuation. The margin of safety is the highest when small and mid-cap companies are available at cheap valuations during the time of entry.

Corporate governance, ESG & frauds 

ESG is becoming an increasingly important metric for the evaluation of companies across the globe. Small and mid-cap companies in India generally tend to score less on ESG metrics, some of which may be for genuine reasons, such as lack of knowledge or lack of management bandwidth. However, for us, the most important aspect in the case of small and mid-cap companies relates to corporate governance. Companies that are not minority-shareholder friendly or commit outright fraud eventually destroy value. Forensic analysis and going through the history of promoters as well as their past actions can help avoid such pitfalls.

Liquidity and economic cycle   

Governments around the world take steps from time to time to boost economic growth or ward off recession and slowdowns. These economic considerations in turn drive central banks to modify their stance on liquidity conditions. Normally, benign liquidity conditions, marked by low-interest rates or a rate-cut cycle, lead to higher flows to small & mid-caps, which leads to re-rating of their valuation multiples, and vice-versa.

Regulations

Regulations can have an impact on small and mid-caps as seen in the past. SEBI came out with its definition of small and mid-caps in February 2018. Similarly, there was a change in the definition of multi-cap funds in September 2020. All such rules caused significant churn in the MF portfolios by all AMCs to comply with the rules. Similarly, other regulations such as LTCG, surveillance mechanisms, trading rules around ASM, GSM, changes in FPI rules & taxation, etc. have caused pressure on small and mid-cap stocks for non-fundamental reasons.

Institutional ownership  

Like cyclicality in market-cap performance, institutional ownership patterns also make a difference to small and mid-caps. Institutional ownership in small as well as mid-caps increases when the lows at the beginning of bull markets reach a peak and then comes down during bear markets to a new low as they are faced with redemptions and forced to trim their holdings across market caps but more so, in the small & mid-caps due to lesser liquidity as well as higher drawdowns, as explained earlier. Actions taken by institutional shareholders make a big positive or negative impact on stock prices of small as well as mid-caps, depending upon the situation.