Had you invested Rs 1,000 in the BSE Mid Cap on March 9, 2009, the value of your investment would be Rs 2,814 (April 30, 2010). If you put the same amount in the BSE Small Cap, it would have amounted to Rs 3,212. While in case of the Sensex, the value would be around Rs 2,512.
But to present you with only those statistics is unfair. You have to look at the entire picture to get an idea about investing in smaller market-cap stocks. If you looked solely at the crash that just preceded this bull run, you would have not touched them with a bargepole. Between January 8, 2008 and March 9, 2009, the BSE Mid Cap and BSE Small Cap lost 68 per cent and 74 per cent, respectively. The Sensex managed to hold up at -55 per cent.
So what does this tell us? Mid - and small-cap stocks have the potential to deliver scorching returns that make their large cap cousins look terribly boring. But when the bulls get thrashed, large caps are definitely a safe house, at least compared to the smaller fare in the market. Does that mean you should avoid mid- and small-cap funds? Not at all. In fact, we would dare to suggest that every equity portfolio must have at least some exposure to such stocks. These companies have high growth potential and it is in this space that you get the future large caps. In other words, if you want to latch on to some multi-baggers, it is here that you should go hunting.
When investing in mid- and small-cap stocks, the investor has to tread carefully because the mortality risk is high in small companies. Any problem with the external environment could cause these companies to freeze in their tracks. On the flip side, there will be few that have the DNA to transform themselves through a crisis to emerge as leaders. The key is spotting such gems that have the potential to make it really big. And having the best cost or being a thought leader is not enough, execution is the key. That is why management plays a crucial role in smaller companies.
So while we advocate an allocation to mid- and small-cap stocks, our advice would be to stick to funds which will enable you to get such an exposure. Don't try going for it on your own. Within funds too, we suggest you go for the tried and tested fare, such as the ones we have recommended.
Though we broadly refer to a Mid- & Small-Cap Category, there are hardly any pure mid-cap or small-cap funds. Currently, there are only 8 funds that have more than 50 per cent of their portfolio in small-cap stocks. Magnum Emerging Businesses currently has around 68 per cent of its portfolio in small-cap stocks while Sahara Star Value has 76 per cent of its portfolio in small caps.
At the other end of the spectrum are funds like Principal Dividend Yield and HDFC Capital Builder that have just 4 per cent of their portfolios in small caps.
If we look at mid-cap allocation, there are 22 funds which currently have more than 50 per cent of their portfolio allocated to mid caps. But since each fund house has its own definition of what constitutes a mid or small cap, the weighted average market capitalisation of portfolios under this category of funds ranges from Rs 1,100 crore to Rs 22,700 crore.
Mid- & Small-Cap Category
How we arrived at this universe of 62 funds
1. From the entire universe of equity funds, thematic and sector funds were excluded; such as Infrastructure, Banking, FMCG, Pharma, Infotech, Power, Auto and Media & Entertainment. Funds with a global exposure were also bypassed along with equity linked savings schemes (ELSS).
2. The balance equity funds were further categorised on the basis of their market capitalisation exposure.
3. According to their market capitalisation exposure, they were classified as Large Cap, Large & Mid Cap, Mid & Small Cap, and Multi Cap. As per our definition, stocks accounting for the top 70 per cent of the market capitalisation of the BSE are classified as large cap. The next 20 per cent are mid cap and the remaining 10 per cent are small cap.
4. The funds that fell into the Mid- & Small-Cap category were those that had an exposure of less than 40 per cent of their equity portfolio to large cap stocks. To arrive at this figure, the complete portfolios of March and September were considered over a 3-year time frame.
5. The final list of funds under the Mid- & Small-Cap Category was a diverse group of 62.
6. The final recommendations are on the basis of their combined risk and return rating score over 3- and 5-year periods.
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