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Large-cap Logic Remains Strong

Large-caps have lost the most of late because of FII pull-outs, but that doesn't change the fundamentals of investing in them...

If you were to look at the short-term performance of various category of equity mutual funds on ValueResearchOnline.com right now, you could be forgiven for assuming that there was a mistake. The normal pattern that is followed when the markets decline stands completely reversed. Large-cap funds have the worst performance, large and mid-caps come next, and mid- and small caps have the best (or rather, least worst performance). To be precise, Large-caps have declined by 17.7 per cent over the last six months, Large- and mid-caps by 15.9 per cent, Multi-caps by 15.6 per cent, and Mid- and small-caps by just 11.9 per cent.

This is precisely the reverse of what is normal in market declines and stands the logic of large-cap investments on its head. The whole point of investing in large-cap stocks (and equity mutual funds that invest in these stocks) is that large-caps are more stable as business as well as stocks. As businesses, they tend to have have a lot more momentum, in the sense that it would take a relatively long time for any reversal of fortunes to take place. Large-cap companies tend to have a much larger floating stock and simply have a much larger set of investors who are invested in them. This makes them widely tracked and analysed, which makes it less likely that any news or fact of importance stays hidden. The larger floating stocks also means that if you were to try to sell such a scrip even in bad times, it would be much easier and there would be a lower impact cost compared to smaller companies. All these are rules of thumb and while there are certainly exceptions they are true as a whole.

This stability means that any fund analyst and investment advisor would recommend that equity mutual funds that invest in such companies be a core component of an investor's portfolio. I would normally say that well above 50 per cent of an investor's equity fund holdings should be in such funds; for an investor who needs to take a conservative approach, there's no harm in this going up to even 100 per cent. The logic is that when the markets decline, such funds will decline less.

So what gives? Why has the current pall of gloom on the stock markets descended much more darkly upon large caps? The answer is the same simple accusation that is the Indian investor's pet complaint: The FIIs did it. Except that in this case it appears to be true and usual suspects really are the villains. You see, FIIs by and large limit themselves to the larger cap companies. Most of them have hard lower limits on the market cap of the companies they invest in. This effectively means that in general, the larger a company, the more likely it is to have a higher FII shareholding.

Which is great in normal times, but mean trouble in times of general FII sell-offs. Over the last few months, as FIIs have sold off India in waves, large-cap stocks have suffered disproportionately. And obviously, along with these stocks equity mutual funds that focus on these stocks have also suffered. What does this mean for the investor? The troubles which are making FIIs skittish could actually continue for years, with the money flowing in and out as panics rise and subside. Does this mean that the Indian investor should reverse the common sense about large-caps and conclude that they are the riskier asset?

Not quite. This logic applies only in the very short-term. In the long run, the basic qualities for which large-caps are more suitable are more relevant. Just because one group of investors are pulling out money doesn't mean that the fundamentals of investing have been reversed. Large-caps are safer, more predictable, better understood and generally immune to problems that plague smaller stocks. The last six months are not going to change that.