Small-Caps, Mid-Caps: Too Hot to Handle?

What factors drive the exceptional rally in small-cap and mid-cap stocks?

Broadly, there are two reasons why small caps have been able to hold their ground.

The primary reason is that for the last four to six years, the domestic market has been driven by individual investors - they are SIP investors. And a good part of investor money is flowing into small-cap funds. So, if money is flowing into small-cap funds, it has to necessarily get invested there.

That apart, many small-cap companies have been able to improve their performance. They have scaled up and grown.

So, both investor enthusiasm, largely led by domestic investors, and rising earnings are driving this rally. Even when foreign investors have pulled out, it has been predominantly from large caps or larger mid caps. This does not hurt small caps as much.

The resilience of small-cap funds, derived from this steady investor participation, is very significant.

How sustainable is the rally in the current economic and market environment?

While it may not be sustainable, markets are always like this. You'll have intermittent phases when they collapse or correct sharply. We haven't seen a meaningful collapse so far, but in the last four or five years, there have been intermittent corrections.

If small-cap companies keep receiving money as they are now, some valuations may cross their justified limits. That's when one should start worrying.

That said, the small-cap universe is very large. If 100 companies falter, all portfolios won't collapse.

In contrast, in large caps, if five companies falter, the entire market can crumble. So, I'm hopeful. It may not turn out to be as bad as people expect, especially considering the steady flow of SIP money from individual investors.

Suggested read: Investors riding the small-cap tiger's back

What are the biggest risks investors should be aware of, and how can they mitigate them?

Small-cap companies are risky for several reasons.

Firstly, these companies are small and often cannot withstand the cyclicality of the market. For instance, a company may face high interest rates, changes in regulations or shifts in market dynamics. For instance, an export-oriented company will be affected by currency fluctuations. Small companies are more vulnerable and, in some cases, can even go out of business.

Secondly, many small-cap companies are currently richly valued. They have grown quickly. For example, a company with Rs 100 crore in revenue may grow it to 200 crores, then to 400 crores and even 800 crores. But beyond that, will it scale to 1600 crores?

That leap may not happen. When growth slows down, high valuations will lead to disappointment. A business that doubles its revenue in five years may struggle to maintain that pace as it grows larger. Scalability becomes a challenge, and businesses that cannot sustain their growth face natural risks.

However, the risk framework for small-cap funds is relatively attractive, due to regulations, they have to invest at least 65 per cent in small caps. Whereas, the remaining 35 per cent can be invested anywhere i.e. even in non-small-cap stocks. This makes small-cap funds worthwhile and helps investors derive substantial benefits while mitigating risks to some extent.

Not only that, I think small-cap funds hold greater promise than large-cap or even larger mid-cap funds.

Simply because the universe of small-cap investments is very large.

When you invest in a large-cap fund, the universe is limited to the top 100 companies. For mid-cap funds, the next 150 companies are considered i.e. the 101st to 250th company. But small caps cover an expansive universe beyond that.

Additionally, if you look at large-cap portfolios across funds, there's often significant overlap - sometimes 80 per cent of the portfolios are similar. The same applies to mid-cap funds. However, small-cap funds are very diverse. Fund managers have greater scope to apply their judgment, thinking and rigour.

Many successful small-cap funds now hold over 200 stocks, which was unimaginable in the past. As small caps grow and diversify further, the case for small-cap funds becomes even stronger.

That said, investors should moderate their expectations. This rally won't last forever. There will be steep corrections, and investors should be prepared for them.

Suggested read: A percentage shot: investing in small caps

How should investors select funds that best suit their needs?

It can be difficult, but here's a simplified framework:

• Choose funds that have consistently beaten their benchmark over three- and five-year periods.
  
• Narrow your choices to highly rated funds—those rated four or five stars by Value Research, for instance.
  
• Within those, select two mid-cap and two small-cap funds from different fund houses to ensure diversification.

This approach ensures that you avoid overlapping portfolios and achieve better diversification.

Suggested read: How to choose a mutual fund

How much of an investor's portfolio should ideally be allocated to small- and mid-cap funds?

There's no fixed rule, but here's a practical guideline:

• Any money you need in the next two to four years should not be in equity at all - especially not in small-cap funds.
  
• Equity investments, particularly in small caps, should only be made with money you won't need for the foreseeable future.

For experienced investors - those who've been investing for five to ten years and are accustomed to market volatility - it's fine to allocate 60-70 per cent of their equity portfolio to small and mid-caps.

However, beginners should avoid small caps entirely for at least their first five years of investing. Start with broader categories like flexi-cap or multi-cap funds, which include small-cap exposure in a more balanced package.

Suggested read: Should I allocate over half of my portfolio to small and mid-cap funds?

Viewer's question

I have been investing in MFs for a long time. My style is aggressive, and I don't panic if the market falls. I didn't withdraw during the Covid-19 drop. With a 20-year investment horizon, what will be the pitfalls if I invest only in mid- and small-cap? - Satish Bandal

If you're investing regularly and have a 20-year horizon, the risks are limited.

However, keep in mind that COVID-19 was a very brief market downturn. A better test of patience would be the 2008 financial crisis, during which small and mid-cap stocks fell by over 60 per cent. Recovery took much longer: 18 months to three years.

You also need to evaluate your real-life situation:

• When will you retire?
  
• When will your children go to college?
  
• When will you need large sums of money?

If you've provided for these and have a sufficient margin of safety, you can take higher risks.

That said, risk tolerance changes with circumstances. Even risk-tolerant investors should avoid putting money they'll need soon into volatile investments like small caps.

Also read: Real equity investing

This article was originally published on December 06, 2024.