The caps don't really matter

Last week, there was a wave of alarm amongst some well-informed (over-informed?) mutual fund investors and analysts that a large number of stocks have been 'downgraded' from large-cap to mid-cap and mid-cap to small-cap. People were worried whether funds would have to make sharp and sudden changes to their portfolios, and if this would lead to poor investment performance. While such a reclassification had indeed taken place--and takes place every six months--the rest of the alarm was just a storm in a tea-cup.

To appreciate why, understanding a little background is necessary. Classifying stocks on the basis of their capitalisation is a fundamental and universal way of bringing order to the galaxy of stocks from which an investor has to choose. Capitalisation refers to the total value of all the shares of a company. Roughly speaking, it is proportional to the size of the company and terms like 'large cap', 'mid cap' and 'small cap' are generally used in the same sense as 'big company', 'medium-sized company' and 'small company' even though they are technically different measures.

Equity investors the world over use this as a classifying characteristic because companies of a certain size have some things in common regardless of what business they are in. I mean that, for example, a large construction company will have some characteristics more in common with a large software company than with a small construction company, especially from an investors' perspective.

Smaller companies are riskier because they are not as well-understood as bigger ones. There is generally less research attention paid to them, so the truth about their prospects is not widely known. A company could be good, bad or ugly but since the number of analysts who are studying it are few (or zero), no one knows the truth and this means high risk. Large companies are less likely to suffer from this inattention. Of course, there is a flip side to this as well. If you invest only in large, well-understood and over-analysed companies, you could do well with them and yet never really have a winner.

So let's get back to the so-called downgrade. Most diversified equity funds define their mandate in terms of the capitalisation scale of the companies they invest in. Till a couple of years ago, each fund was free to choose its own cut offs between the large, mid and small. However, last year, to help investors compare like with like, SEBI standardised these categories. To make the standardisation work, the regulator also specified the criteria by which companies were to be classified as large, mid or small cap. Since equity markets move up and down by rather large amounts, these criteria are relative. That is, the top 100 companies are classified as large, the next 150 companies are mid cap and the rest are small cap. Once every six months, these are recalculated.

The recalculation means that some companies move up or down to different categories. For example, in the latest round, REC Ltd, Adani Transmission, Kansai Nerolac, Muthoot Finance and Info Edge have been promoted from mid cap to large cap while Yes Bank, Vodafone Idea, New India Assurance, Cadila and Indiabulls Housing have been demoted.

Does this mean that large cap funds will immediately have to dump these four stocks and mid cap ones will have to start buying them in a frenzy? Nothing of the sort. For one, the SEBI criteria has room for maneuvre. For example, the regulator's large-cap criteria says that at least 80% of the investment must be in large-caps. The mid-cap criterial says that at least 65% must be in mid-caps. This leaves plenty of room for discretion and for distinguishing a fund from another. Just because a company has declined in value, it doesn't mean it has to be sold. In fact, that would be the worst knee-jerk reaction. It may well mean that the stock is now better value and more should be bought. The reverse is also true. If a mid cap stock rises in value becomes large-cap, it could mean that it's overvalued and its time to sell. So the 'upgrade/downgrade' terminology is completely irrelevant here and may well be misleading.

Generally speaking, reading too much into the portfolio moves of mutual funds is not helpful for investors. It's best to focus on the fitness for one's goals and the performance track record and leave it at that.