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Time to bet big on mid- and small-cap funds?

If you are wondering whether it's time to invest in mid- and small-cap funds, watch the latest Investors' Hangout with Dhirendra Kumar

Dhirendra, mid- and- small-cap funds are back in the news. Investors are starting to take notice of them. Do we see a revival happening here?
Dhirendra:
We could be. A variety of things happened in 2019. If you look at the taxation regime, it became concessional for small and mid-sized companies before large-cap companies. And in September, we also got the big announcement that corporate tax rates are down to 22 per cent. This led to companies earning more even if they continue to do just as well, as they were doing before.

What happened during the past few years is that we first saw the resurgence of small and mid caps. They grew faster and the market went crazy by giving them higher valuations. People started believing in the sustainability of the growth. However, it could only be true for some companies. It could not be true for all of them. And then, when we saw the cyclicality playing out, most companies fell. There were a lot of companies which were primarily the story and not the reality. So the reality started catching up and we had a lot of dud small caps which fell by the wayside.

And now suddenly, everybody is realizing that there is a set of small caps and mid caps which are attractive. They are real. They are credible stories and are worth banking on. But I would say that don't bank on them completely. These could be early days. And I think after this corporate tax rate cut, the tailwind is on the side of large companies as they can get bigger, they have more money and brand power. But yes, some mid and small caps have become attractive and so the interest has begun.

The inflows in mid- and small-cap funds also surged significantly in January vis-à-vis December. Does that mean this is just the perfect time to invest, or is it not?
Dhirendra:
Timing it perfectly is a big folly because it's very difficult to do that. An individual investor should look at what his allocation is; whether he is comfortable with it or not.

One should not forget the 2008 kind of scenario. It was a classic milestone in terms of experiencing the market. Large caps fell by 43 per cent and small caps fell by 75 per cent. And it's a grim reminder that you have to be prepared for such situations in the worst case scenario. Smaller companies are more vulnerable. The ability to withstand a crisis is far lower in a small company than a large one which will have resources to sustain itself through the difficult times and wriggle themselves out of the crisis.

But at the same time, successful small-cap companies which have been able to figure out something and have grown at a faster pace can be really rewarding. The charm of having a small cap is the promise of it turning into a mid-sized company or a large-sized company. And we have quite a few large companies as examples, which were erstwhile small caps or mid caps. Whenever that happens, you build wealth and that promise is very compelling. But I don't think investors should really get into the trap of timing it perfectly.

Just have a meaningful allocation depending on your experience. It could well be 40 or 50 per cent of your portfolio. But then you should be someone who understands how small and mid caps are. You should be a person who does not get uncomfortable with a 20 per cent decline and has all the focus to stick around even during the bad times. Don't lose focus on why you are investing and diversify across market segments. Emphasise your priority. Decide on how much large caps or small caps you want to have. And stick to it.

So for whom are these funds suitable? Can you list some parameters to check whether one should invest in a mid- or small-cap fund or not?
Dhirendra:
It's more of who should not invest in them. Anybody who is getting attracted to small caps just by looking at recent past performance should never invest in them because that is what led to the whole disappointment. And you'll be disappointed again, because you'll come with expectations. That should not be the starting point of your investment in small caps.

Also, you shouldn't be investing with a time frame of less than five to seven years. And be regular with your investment. Average your purchase cost over a period of time. Don't invest at one go. That will actually enhance your return. So you should be someone who has a reasonable time frame in mind.

Another parameter could be that you should be someone who has invested in and has experienced equity before, at least for two to three years. If you haven't, don't invest in a small-cap or a mid-cap fund.

If someone meets all these criteria that you just mentioned, how should one go about choosing a particular mutual fund scheme?
Dhirendra:
Use the same framework that we follow with other funds. But there are one or two things which one should be more conscious of. Very large small-cap funds have the odds against them. In small companies, the liquidity is low. So if the fund manager has to build a diversified portfolio of small-sized companies and has Rs 2,000 crore or more for it, I think he will have a tough time managing it.

Another thing to be more conscious of is the credibility and the track record of the fund manager. Not much is known in the case of small-sized companies. Their coverage is very low. You have to really get into the skin of the promoters of the company and the people who manage it. It requires far greater intensity in terms of knowing your universe. For every one company that the fund manager invests in, he will have to evaluate five companies or maybe more. So in that sense, it is hard work. It requires a fund manager with imagination, experience and ability to validate those people. So look at the fund manager's experience. That is crucial. If the fund manager has not been around for five years and more, don't invest in that fund. And don't attach great value to those performance numbers because it could be because of some other person who was managing it earlier, and is now not around.

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