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Is the mid- and small-cap rally a bubble or a sustainable rally?
First and foremost, the honest answer is that I don't know. And assuming that I knew about it, I don't think we can really predict it. Whether it is in a bubble territory or not is entirely a function of a lot of investor behaviour. If the market starts going up again, it'll look as if it was not in bubble territory. If a lot of investors pull out money, it'll look like it was in bubble territory. We only get to know of it in hindsight - only after it has happened.
The fact is that small- and mid-sized companies do better over time, but they carry substantial risks. That's because small companies can wither away in an economic down-cycle. They are small and cannot withstand very turbulent economic weather. So, small companies are generally vulnerable.
Now, the point is, will you actually lose money? When you look at very long-term returns - 10-20 years - I find that, while small-cap companies are risky, the promise of smaller companies is that when they turn big, they are extremely rewarding. And that is the charm of small caps.
Now, this is a very risky category. Let me just tell you the reasons. The number of small-cap companies listed in the Indian market is 4,586 as of today, which somewhat trade. Of this, 3,471 companies have traded every day or at least 90 per cent of the days in the past one year. This means that these are the number of active companies, and of these, mutual funds invest in only 609 companies. So, imagine a universe of 3,400 companies and mutual funds investing in only 609 companies. The remaining 2,800 companies - that is where you'll have many companies that will disappear. There will be many companies that do not exist, but they still trade. You might be buying the stock of a company that might be worthless.
So, I think mutual funds really deliver a very high value in this segment. If you have to invest in large companies, then you have choices. You can invest in any of the bigger companies yourself. Dropping a few companies from the top 50 companies of the Nifty, which may have a bleak outlook, is relatively easier. But here, of the 3,400 companies, the mutual funds have narrowed the universe to 600 companies, and then you are diversified. You are investing in a more secure way. If you look at some of the small-cap funds, they are spread over 250-300 stocks. It's a very difficult portfolio. I know for a fact that some funds are managed internally by three or four fund managers because it is beyond one fund manager to keep an eye on so many stocks.
If you are venturing on your own into small caps and investing for the short run, then they can be very risky. If you are investing at one go, and you invested your short-term money, you might be in trouble. But if you're doing SIP (Systematic Investment Plan) - if it's 15-25 per cent of your money - and you're investing with another 5-10 years in mind, and in this correction of 15-25 per cent, if you did not lose your sleep, then carry on. It's not in the bubble territory, and even if it is, we'll only know it after it happens, not before.
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Should long-term investors hold small and mid-cap stocks instead of taking profits?
Yes. If you accidentally drifted into small caps and this is your first investment, get rid of it. If you're losing your sleep, get rid of it. But if you've invested for the long run, and it has gone down, and you are not losing your sleep, and it's a part of your overall portfolio, make sure that you're investing during these lean times because investments made during these periods will turn out to be the most profitable ones.
Are large caps a better choice given mid- and small-caps' high valuations?
I don't know, because large caps are also not very cheap. If you look at the cheapest stock in the Nifty and the most expensive stock in the Nifty, I would say that a good number of them, the ones on the higher side, don't look cheap either. Also, if you look at it in terms of volatility - because large caps are owned by foreigners (the FIIs) - we've seen that in a crumbling market, they fall more. They fall much worse than small caps. Of course, the risk in small caps is completely different. Some of these companies in the small-cap universe, beyond what mutual funds invest in - and including many companies where mutual funds do invest - some of these companies will simply disappear. They will wither away without any fanfare.
In the large-cap universe, nothing like that happens. But you're unlikely to find a multibagger in large caps. I would say that you should have a mix of mid-cap, large-cap, and small-cap stocks in your portfolio, so you don't lose your sleep. That's why flexi-cap, multi-cap, value funds, and ELSS (Equity Linked Savings Schemes) are the mainstream categories through which most investors should invest a substantial part of their money.
Suggested read: Keep calm and...
What are the key risks associated with investing in mid- and small-cap stocks?
All the risks - the business risks. Every business comes with its own risks: economic cyclicality, competition, regulatory frameworks, etc. And you know, when GST happened, it was applicable to every business, and every business had to comply. It could have been disruptive.
Besides that, small caps have other issues, such as liquidity. They are companies with small equity capital, a good part of which is held by promoters. The remaining part, if some investors sell, is more volatile and more vulnerable, and there could be a liquidity crisis. If there's a good company, many people want it, and there's a finite supply. So, everybody buys it, and then there is no liquidity. A little bit of buying, and the price shoots up.
So, small-cap stocks can be extremely volatile both on the buy and sell side, and you may not be able to buy as much as you want to. This is why mutual funds are more vulnerable in their small-cap stock holdings. Mutual funds have to buy something that is worthwhile for them, you know - Rs 100-500 crore - in a large fund for it to be meaningful. But when they try to buy, if they are somehow able to buy it, if they choose to sell, then these stocks collapse. If two or three of them collapse, a small piece of bad news can have a disproportionate impact on these small caps.
And, of course, as I said, all the other business risks are involved, but liquidity and promoters' actions are risks. What happens is when a company achieves scale, other parties get involved. The company is able to professionalise. Smaller companies might still be vulnerable to the owner, and that is a risk. This can be dealt with, though, if there's a great owner who can work on a succession plan and transfer the business to a professional team. If that happens, nothing like it. This is the opportunity, but it's also the vulnerability.
What should investors do if they own mid- and small-cap stocks?
My suggestion would be to stop looking at your portfolio values. Don't visit Value Research Online to check them every day. If you need the money after 10 years, but you get nervous, upset, and disappointed, and you're checking every day, that's a problem. Avoid that - do something else. Looking at the decline on a day-to-day basis distracts you from the big picture.
In the next 10 years, there'll be one or two more occasions when there will be a big fall. These are the periods when you should make sure you are investing and continuing with your investment plan. More importantly, if you can actually accumulate more to invest, you will be buying cheaper.
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How does one review the performance of a mutual fund, how often does one need to do that, and how long should one wait before taking action for an underperforming fund? - Sunil
It's pretty straightforward. There are many things you can look at. I would say that you should develop a very simple framework so that you can easily compare your investments. You're investing in a mutual fund where you are trusting your money to somebody, and they are managing your money for a fee, which is the expense ratio. You better be rewarded for it.
Set up your portfolio at Value Research Online; go to the performance section, and there, you can put a benchmark to compare your performance based on complex cash flows. It can get very difficult to compare. You'll be doing your SIP in one fund for the last five years and another for the last three years, and in between, you might have taken some money out. This makes comparisons hard. Value Research Portfolio Manager will compare your investment against the BSE 500. If you see that you would have beaten it with that index, that's a good sign.
If you are beating the index over any of the one-year, three-year, or five-year periods, that's a good sign. If you're not beating the index over any of these periods, that's a reason to worry. It's a reason to sell.
As for how often you should review your funds, do it every year - not earlier than that. You don't necessarily need to sell just because your fund has underperformed by a small margin. If the index has given 6 per cent in one period and your fund gave 5.75 per cent, don't sell. You should give it some margin of error.
But when you see underperformance as meaningful and substantial, then, by all means, change it.
Also read: How to choose a mutual fund
This article was originally published on February 21, 2025.
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