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Small is beautiful, even now

The recent crash in smaller companies' stocks has been traumatic for momentum chasers, but smarter investors have done very well out of small cap funds

Small is beautiful, even now

There's a course of shock therapy that equity and equity fund investors have to go through every few years. The stocks of small cap companies zoom up sharply for a time, and then they crash down, again much more sharply than anything else. Sometimes this happens as an amplified version of what's happening to the stocks of larger companies, and sometimes by itself when the rest of the market is doing something else. The first part brings great joy and happiness to investors--especially to those who have forgotten the last such cycle, while the second part brings shock, and hopefully, some learning about the risks inherent in small cap investing.

After a boom that lasted two years, we now seem to be entering a phase when small cap stocks--and the funds that invest in them--are heading down decisively. This was entirely to be expected, and as I'll explain in a moment--actually works to the advantage of investors in small cap funds. However, there seem to be plenty of investors who are in shock and ready to head for the exits.

To answer this question, investors must consider what they expect from equity investing and whether they are willing to put up with the risk and the volatility that is an inevitable part of the same package that also contains great returns. Investment advisors and analysts often ask investors to evaluate what kind of risks they are willing to take in order to have a chance of getting the kind of returns that equity is capable of. It's an open secret that in answering this question, most investors lie to themselves, even if unwillingly.

When an investment is doing well, it's natural to be full of bravado and be sure that you will take any volatility in your stride because you understand the nature of equity etc etc. Equity investing seems like the easiest thing and the world, and those who talk of risk and volatility appear to be nervous ninnies. However, when the markets start declining and the value of your investment starts going down every day, then the answer to that question about risk-taking changes, as it should.

So what should investors do? Should they quit and run (perhaps switching their investment to large cap funds), or should they stick it out? For some investors, if they feel they can't take the volatility, the answer has to be that they should not invest in small-cap funds. However, the right way to approach the whole thing is slightly different. The first principle is also the oldest one, which is diversification. Unless you have found that you enjoy the volatility, small cap exposure not be more than 20 to 30 per cent of one's total equity assets.

However, the high returns that good small cap funds generate are valuable. The way to exploit these properly is not the momentum chasing of the recent past but steady SIP investing over long periods of time. Those who understand the maths of SIP investing know that volatility is their friend and the frequent drop in NAVs helps to generate higher returns in the long run. Over the last five years, small cap funds SIP returns have typically outpaced their own point-to-point returns by about 5 to 10 per cent per annum. This is true not just of the better funds, but down the line as well. Over this period, Value Research's highest rated small cap fund (Franklin Smaller Companies) had lumpsum (one time investment) returns of 21.5 per cent p.a. while its SIP returns were 28 per cent. The interesting thing is that even our worst-rated fund (HSBC Midcap) had lumpsum returns of 10.6 per cent p.a. and SIP returns of 21 per cent p.a.!

And that is the real secret of small cap investing, as it is of all equity investing. Stop chasing momentum and stop worrying about volatility. Choose a fund with a decent track record--doesn't have to be even close to the best--and then sustain it for years on end. You'll do very well out of it.