Small And Mid-Cap Funds:Should You Invest In Them Now

The lucky charms of the investors—mid-cap and small-cap funds—have been bleeding since last five months. Since the start of the year, the broader indices such as S&P BSE Small-cap and BSE Mid-cap indices have fallen by 16.81% and 13.46%, respectively. This fall has eroded returns of many investors who had entered these categories recently after looking at their past robust return profiles. 

With the falling indices, the mid-cap and small-cap funds have also fallen over the last six months. These funds have witnessed a great fall during the last six months. The fall in these schemes has made investors anxious about these funds. The clouds of uncertainty have left investors wondering whether the mid-cap story is over or whether this is an opportunity for them to invest in these schemes. Being a mutual fund investor, one should first analyse the main reasons and factors behind this fall and then one should look at whether it makes sense to invest in these categories. 

There are various factors that have led to the fall in mid-cap funds’ NAVs. The basic reason is the major fall in the value of mid-cap companies. The fall in the NAVs is not an outcome of the fund managers’ bad decisions. In the recent past, with rising volatility, investors turned bit more panicky on account of the weak macro indicators, which have forced them to shift to the large-caps for stable returns. At the same time, the exit by the foreign investors from the mid-cap space also impacted the stock prices quite a lot. 

Apart from these aspects, on the fundamental front, after a multi-year upswing, the valuations in certain pockets of the mid-cap and small-cap space have become stretched, which makes these highly overvalued. Due to this run up, the mid-cap and small-cap stocks surpassed the valuations of the large-caps. In this challenging environment, the large pool of investors sold off their stocks at the slightest hint of uncertainty in business environment. 

Moreover, the recent changes in mutual fund categorisation norms by the SEBI have also led to some churn in the mid-cap stocks as the fund managers had to realign their portfolios to ensure that their funds are positioned within the market cap boundaries set by the market regulator for each category. 

If we look back, the mid-caps and small-caps have always beaten the large-caps in the last three years. From the year 2014 post elections, the improved policy decisions catapulted the market to new highs. The story continued till January 2018, after which the reintroduction of LTCG and DDT, coupled with weak global cues, triggered the market crash. In this situation, the small-cap and mid-cap stocks, which had the highest valuations, fell more than the large-cap stocks. 

To understand the situation, we analysed the valuation trend of the benchmark indices Nifty 50 and Nifty Mid-cap 50 for the last 10 years. We saw that, in the past three years, the mid-caps have been valued at a premium to large cap stocks. In the meantime, in the year of 2016, there was a short-lived correction, post which the bounce-back that the mid-cap index charted was huge and which was quickly compensated for by the brief falls before. Currently, the Nifty Mid-cap 50 index is trading on P/E 60x even post the correction in the last six months. The key reason behind this is the sharp price run-up, which had jacked-up the ratios to a higher level. 

Currently the gap between the valuation of large-cap and the mid-cap & small cap stocks is very high. The large-caps, mid-caps and small-caps indices are currently trading at a PE of 26x, 60x and 95x respectively. Compare this with their last ten-year average of 20x, 24x and 67x for the respective indices. The maximum difference in the valuation between long term average and current valuation lies in is mid-cap & small-cap indices. Hence, what we are currently witnessing is return to mean. 

Usually, the mid-caps tend to fall more than large-caps when the market correction happens, which has however not beenthe case over the past three years. The mid-caps have also not had an extended corrective phase and have seen limited volatility. This deviation is now being addressed in the correction since January 2018, where the mid-caps and small caps have finally dropped more than the large-caps on a sustained basis. 

With the correction in the mid-cap and small cap space, the mid-cap and small-cap funds have seen a dip in their returns. The mid-cap and small-cap funds saw their double-digit returns slipping into single digits on account of this correction. In the last three months, the mid-cap category has given returns of 0.8% on an average, whereas the small-cap category has offered a negative return of 3% during the same period. This is in sharp contrast with the positive returns of 6% on an average of the large-cap category. 

In the current market situation, mid-caps are seen to be correcting more in the near term. However, the robust earnings growth is a good sign which helps to create some buying opportunities in the mid-cap space for the fund managers. But for the investors in the current market situation, entering into mid-caps and expecting returns similar to the returns in the last couple of years would be untenable. Currently, the large-caps are better placed than the mid-caps and small-caps on the basis of valuations and earnings. 

Moreover, in the rising interest rate and inflationary scenario, the large-cap funds and stocks are better positioned to provide stable returns as compared to the mid-caps and small-caps. So, in the current market situation, any new investor should not go for the mid-cap and small-cap schemes, until and unless he is able to handle the volatility and losses and has the patience to hold the investment for a long term horizon. At the same time, investors who have already invested in such schemes should hold the schemes for the long term as the long term drivers of the mid-caps and small-caps still remain promising. 

For investors who are investing in this space through SIP, the current situation is very good for averaging their investments. If the allocation to the mid-cap and small-cap funds in one’s portfolio is more than 30%, one should look for the large-cap schemes to minimise the impact of the downtrend in the mid-caps and small-caps to rebalance the portfolio. 

In the end, investors should always remember that the mid-cap and small-cap funds are high risk investments. No significant correction in the last four years has made these funds yield more returns, but with the current correction, one just needs to remember to invest in these funds for the longer term.