Good time to enter mid- and small-cap space

'Allocate 30% to 35% of your equity portfolio to mid-cap funds and 10% to 15% to small-cap funds.'
Sanjay Kumar Singh and Joydeep Ghosh report.
Illustration: Uttam Ghosh/Rediff.com

Investors in mid- and small-cap stocks and funds have had a torrid time.

And it's primarily because of the high valuations that these stocks reached in 2017, and the subsequent fall.

Year-to-date, the S&P BSE Midcap Index is down 10.19 per cent while the BSE Small-Cap Index is down 14.26 per cent.

Some stocks within these segments have seen higher correction than the benchmark indices.

However, to use the clichéd phrase, there seems to be 'cautious optimism' from some fund managers.

And it is largely because of the outperformance of the large-cap stocks.

Says Jyotivardhan Jaipuria, founder and managing director, Valentis Advisors: "Following the sharp outperformance of large caps, relative valuations of mid-caps versus large-caps are now in line with historical averages."

"With absolute valuations still slightly expensive," Jaipuria added, "we would advise investors to gradually use market corrections to build their portfolio in small- and mid-cap stocks with a two-three-year holding horizon."

According to him, we are on the cusp of a recovery in the earnings cycle, a phase where mid-caps see strong absolute as well as relative performance.

Historically, two consecutive years of negative mid-cap returns are a low probability event, which bodes well for the performance of mid-caps next year.

The initial signs of good news for mid-caps and small-caps came when prominent fund houses such as DSP Investment Managers, which had suspended fresh investments in its Micro-cap Fund (now DSP Small-cap fund), started allowing investments again.

However, it is only through systematic investment plans (SIPs) and systematic transfer plans (STPs) currently.

In December 2017, even L&T Mutual Fund had restricted inflows in excess of Rs 200,000 per transaction per day per investor in its L&T Emerging Business Fund. Now, this cap has been removed.

The key reason fund houses had imposed restrictions on inflows was high valuations.

"The number of stocks that one could buy at reasonable valuations was shrinking. There were many companies that we liked in terms of their business prospects, but could not invest in owing to their high valuations," says Vinit Sambre, head-equities, DSP Investment Managers.

The fund house, he says, felt that it needed to give investors some indication of the valuation risk in the small-cap segment, and hence decided to restrict flows.

Now with valuations tempering, fund houses have begun to remove restrictions on inflows.

"After a significant correction in the small- and mid-cap space in the past few months, valuations of companies have become more attractive," says Soumendra Nath Lahiri, chief investment officer, L&T Investment Management.

Good time to enter?

Fund managers believe that this is a reasonably good time to enter the mid-and small-cap space.

The current year has been volatile. This turbulence is expected to continue, owing to the currency crisis in emerging markets, and the spate of elections in India (state elections followed by the general elections next year).

While the volatility may seem ominous to investors, it spells opportunity for fund managers.

Says Lahiri: "Although popular indices such as the Sensex and the Nifty have scaled new highs recently, mid-caps and small-caps continue to remain sluggish. This divergence is throwing up interesting opportunities for bottom-up stock pickers like us."

Fund managers plan to use the ongoing volatility to increase their stakes in quality companies, with a long-term perspective.

Moreover, all investors need to have a long-term allocation to mid-cap and small-cap funds.

"The long-term rationale for investing in these funds arises from the promising growth prospects of companies in these segments," says Sambre.

"Many good companies in this space believe they can double their revenues in three-four years, which means they will grow their top line and earnings at a compounded annual growth rate (CAGR) of 15 to 20 per cent," Sambre adds.

Over the long term, he says, investors' returns tend to track earnings growth.

With the large-cap space being tracked heavily, alpha generation by active fund managers has been shrinking there for a few years now.

On the other hand, fund managers and their research teams still have opportunities in the mid-cap and small-cap space to discover new stocks, or those where there is a mismatch between price and valuation.

"The dispersion between the performance of the best and the worst companies is high in this space. If stock selection is good, there is better opportunity to create alpha here," says Sambre.

Avoid lump sum investments

Despite the recent correction, valuations within the mid-cap and small-cap segments remain expensive.

"Avoid making large lump sum investments in mid-cap and small-cap funds right now. Look at your category allocation. If you are under-allocated to these categories, and if your risk profile permits, invest in these segments via the SIP route," says Kaustubh Belapurkar, director-manager research, Morningstar Investment Adviser India.

The ongoing market turbulence could cause stocks in these segments to correct further.

The SIP route will allow investors to buy fund units at lower costs.

Belapurkar suggests investing in these funds with at least a seven-year horizon.

Investors should also avoid loading their portfolios too much with mid-cap and small-cap funds.

"Allocate 30 to 35 per cent of your equity portfolio to mid-cap funds and 10 to 15 per cent to small-cap funds," says Mumbai-based financial planner Arnav Pandya.

Investors should not panic and exit if these segments correct further, he says.

Pandya suggests examining a fund's portfolio before investing in it.

"It should be well diversified and should not have excessive concentration in a particular sector or theme," he says.

Belapurkar advises selecting funds that have given sound risk-adjusted returns over the long term.

"Go with a fund manager who has delivered consistent rather than lumpy performance," he adds.