Strong investor flow lift-off puts mutual fund small-caps into orbit

Retail investors now own a bigger slice of small-cap companies than a couple of years earlier, attributable to their growing conviction in mutual fund (MF) schemes focused on this space.

Data from Capitaline shows MFs’ average holding in the National Stock Exchange Nifty Smallcap 250 rising to 8.67 per cent, from 7.67 per cent in the past two financial years, with the number of companies with over 20 per cent MF holdings, rising from 15 to 24.

At the end of May, the top five small-cap firms with the highest MF holdings were Carborundum Universal, Blue Star, Cyient, Gujarat State Petronet, and Cholamandalam Finance.

At the end of March 2023, MFs owned 27 per cent of Carborundum Universal, up from 25 per cent at the end of March 2021.

Similarly, their ownership in Blue Star rose from 20 per cent to 24 per cent during the two-year period.

In 2021-22 and 2022-23, MF investors poured a net of Rs 32,220 crore into active small-cap funds, with inflows rising steadily month-on-month.

The growth continued thus far this financial year (2023-24), with investors injecting a record Rs 3,280 crore in May.

As a result, the total assets under management (AUM) of active small-cap schemes surged 79 per cent in two years to Rs 1.5 trillion at the end of May 2023.

MF executives and distributors ascribe the growing traction for small-cap funds to the category’s emergence as the top performer over the long term and investors perceiving the space as comparatively better valued than mid- and large-caps.

On average, small-cap funds have delivered a 21.3 per cent annualised return in the 10 years, compared to 13.4 per cent in the case of large-cap funds, according to Value Research data.

However, there are concerns over fund managers finding it challenging to deploy funds to the right companies at the right valuations if inflows continue to rise in small-cap schemes.

Owing to this problem, SBI MF suspended lump sum investments in its small-cap fund and capped systematic investment plan investments at Rs 25,000.

As of now, four schemes are managing over Rs 10,000 crore and 10 schemes have over Rs 5,000 in AUM.

“Although there aren't any reasons to worry right now, there are some risks associated with the growing size of the small-cap MF space. Investors may face issues when large-scale redemptions happen in panic.

"The problem of size is restricted to certain schemes, and hence, at the overall category level, we don’t see any reason to worry," says Arun Kumar, head-research, FundsIndia.

The price-to-earnings ratio of the Nifty Smallcap 100 has gone up to 18.7x, from 17.5x at the end of March, owing to a rally in small-cap stocks.

This is lower than the valuations for the Nifty50 or the Nifty Midcap 100 index.

In the past three calendar months, including June, the index has gone up over 5 per cent in each of the months.

Fund managers say although pockets of value are shrinking in the space, they have been able to find the right stocks through the ‘bottom-up’ approach.

“We have been able to deploy funds because the universe is large.

"Opportunities are there if you take the bottom-up approach.

"In the near term, we are somewhat cautious due to rising valuations.

"The key is to have the right stock selection framework and avoid making mistakes.

"More than earnings, what’s important is the balance sheet and cash flow of the company, along with the integrity of the promoter,” says Pankaj Tibrewal, senior executive vice-president (V-P), Kotak MF.

In the bottom-up approach, the fund manager places greater emphasis on specific characteristics and the micro aesthetics of individual stocks than on macro factors.

“Deploying these augmented flows does not seem to be a major concern in the current market, given that valuations appear reasonable despite the recent upswing.

"Moreover, corporate earnings growth is reasonably good, and with inflation easing, there is potential for positive surprises in profit margins in the year ahead,” says Resham Jain, V-P, investments, DSP MF.

Experts say although the valuations are not high enough to go negative on the small-cap space, investors should exercise caution and ensure their portfolio has the right market-capitalisation balance.