The Mutual Fund Show: The Right Way To Invest In Small-Cap Schemes

Shalini Dhawan: So, I think it is kind of clearly defined now and investors will know SEBI has clear classification what would be called a small-cap scheme, basically needs to have about 65% of its money in small-cap stocks. And therefore, the question that comes up is that what is a small-cap stock?

Here again, there is kind of a clearly defined universe. So, the Association of Mutual funds of India does have a listing which basically speaks about, the market capitalisation of different stocks and if you take the 251st stock, let's say on exchange the 251 to the 500 is what we would call as the small-cap universe.

Typically, market capitalisation would be around say Rs 10,000 crores for some stock which is around the 250 first level and then you will go down to somewhere in the 500 stock would be a market cap of around Rs 5000 or 6000 crores So, that is the kind of size of the stock or the company that you are looking at when you are making an investment into a small-cap scheme.

Santosh Joseph: I think the two reasons for it, number one, the universe for small-cap stocks is barely dig out than what do you look for in a large-cap and mid cap. For example, by the explanation that just Shalini shared, the top 100 are large cap, the next 100 are mid cap, whereas when it comes to small cap, this is much larger list, number one.

Number two, because of the liquidity that these stocks have, which is actually less liquidity compared to mid-cap and small cap, depending on the size of the fund and depending on the opportunity that there is at hand, the need to have a slightly longer list of stocks in the small-cap becomes an essential part of the portfolio and even the exposure that they have is going to be at some level, a derivative of the total assets under management in the scheme. So, at one level you have more number of stocks at another level you have a liquidity factor to play for.

The third important aspect is that because of the larger number of stocks available and derivative of the size of the fund, you will have to play a slightly larger number of stocks in the small-cap portfolio basket.

Shalini Dhawan: Yes, I believe recent performance would have some bit of an impact when investors are looking at what kinds of schemes to invest in. And if you see the year-to-date performance of small-cap schemes, the range of the category they have been around 7% and but some of you been given double digit returns like less than 11-12% absolute.

Now, when you compare that to your large-cap schemes which are in the 2-3% kind of range, then obviously small-caps look attractive so there will be a bit of a recency bias. I would also add another item that probably investors may be considering is the fact that small-caps are now actually trading at the long-term valuation, very close to their long-term valuation as compared to large-cap schemes or if you look at mid-cap schemes.

They are still a little bit away from or they are a little bit more expensive if you compare their long-term valuations from a forward perspective. So that could be another reason.

Santosh Joseph: I think that at the distribution level, the point that we were looking forward to, is that both mid-cap and small-cap index will lag the large-cap for the broader index for some time. So, while small-caps did stage a recovery and flow started catching up, in spite of that we saw there was a valuation gap in terms of the all-time highs of the mid-cap index and the small-cap index.

So, you had a green shoot of performance kicking in since maybe Feb-March. You add to that that the valuation was comfortable and attractive, especially over the last year or so we were in a sideways market. It was the perfect recipe for small and mid-caps to take off both in terms of equity flows in small-cap and even the return.

So, sometimes you go through the short periods where returns will attract more flows and more flows will actually take the returns higher because it's small-cap and this shortage of liquidity there are only so many finite very good small-caps and therefore that will drive the prices even higher and therefore lead to greater performance.

Shalini Dhawan: So, I would probably attribute it to a couple of things, like we discussed, the small-cap universe is huge in that sense by definition, but there would be a lot of expertise here between fund management, invest management, and the team in terms of trying to understand stock selection, sector selection and so on and how does the overall India macro story fit in, what kind of sectors and stocks that would a small-cap fund manager actually look at.

I mean, just to give you an example, there could be a case. This is just some data that we were reading or evaluating. There could be a case where one outperformance scheme actually gave a miss to a certain stock in the financial services sector and that could be the reason for its outperformance.

On the other hand, the other underperformance scheme could actually have added more weightage to certain stocks and this could be financial services, or it could be energy, or it could be any other sector that we are talking about. So, I think it is quite important for you to know how the fund is managed overall, what is expertise, what is the fund manager history, I am sure a lot of that counts.

Santosh Joseph: To begin with, I think they were offering value at one point. There was a broader market at one level of valuation, large-caps at another level of valuation mid and small-caps were available relatively cheap within the broader market. So that's the first paradigm.

Second is about the stance of the portfolio. Now with these small-caps and we have noticed that thanks to what we went through the entire 2022 calendar year, it was normal for a portfolio manager to go into the conservative mode of conserving capital or avoiding further drawdown on the portfolio. Now the third part as you know, since you have a wide array and a longer list of stocks, the people who are concentrated can go to the challenge of errors of omission and commission and miss out on some good stocks and buy something which didn't perform.

Well, the guys who did perform if you look at them, they played the small-cap stance and the strategy to the hilt, which is they bought as many stocks as possible with slightly differing waves and they played the small-cap or weighted on some of the stocks and sectors that they like.

Now you look at the year-to-date or even a particular month, let's say April and May, which will be particularly good months, notice that the market itself saw a lot of activity in the mid and small-cap space where for a second the large-cap which controlled all of 2022, most of us know that for the whole of the 2022 calendar year, 8 to 10 stocks control the market, whereas now you have many small, mid-cap stocks participating in the market activity. That's why you saw the year-to-date and the couple of months haven’t outperformed because you had a massive participation by mid and small caps.

Shalini Dhawan: I think for fund selection rolling returns is a good idea, not necessarily for small caps, but I think for equity practice. It's good to have rolling returns; they allow a temporary bust of outperformance or underperformance or get rolled out in that sense.

So long-term rolling returns are a good way to look at it. They also capture different business cycles. So, if you are taking 5-7-10 years rolling returns, they would have even taken the entire Covid and all the Ukraine war kind of geopolitical events that happened. So, rolling returns would be one way.

Another item to look at, as I mentioned previously, is the fund manager’s experience, fund manager’s history. We also do look at risk-return ratios. These also help investors understand if the scheme fund manager has taken undue level of risk in delivering that return to you.

And of course, last but not the least is the expense ratio and you know peer group comparisons, on how you know the return stack up versus expense ratios and of course, consistency will also come by when you look rolling returns. 

Santosh Joseph: So, before I answer, let me give you a very interesting perspective about small caps. Now let's take a slightly larger timeframe like a 10-year period, when you take a standard 10-year period and when you take a small-cap performance, the best large-cap performance will be equal to the bottom small-cap performance.

I will repeat, the best of the best large-caps funds’ performance will more or less match the bottom rung small-cap performance, which means the top performer in the small-cap will be 2x, maybe even 3x of that performance.

So, let's take the last week's data, the best large-cap on a 10-year basis will give you between 15% to 16%. The worst small-caps in a 10-year business have given you the worst fund mind you, 15 to 16%. Now the best small-cap has gone on to make over 20% return on a 10-year period. Now that itself is true that small-caps are an integral part of the portfolio. Well, it comes with the sense of what we call lumpiness in returns or volatility.

Now once you understand the 10-year, story is clear, the short-term is where you are worried about what you start now, allocating the right process and the right percentage into the portfolio. But if you are someone who's staggering or doing an SIP, as the small-cap equivalent to your portfolio, you have got nothing to buy, you should be happy.

On the other hand, if you are someone getting in at one time, be careful with the valuations. I think for a seasoned investor must have figured out that you buy small-caps when nobody's looking at them and the one-year return is probably negative. Right now, when you look at one-year return and three-year return and five-year return, the story is slightly different. So, you know you are at the crux of another big turnaround in terms of small and mid-caps.

So, I don't think we have to make it more complicated than it is, that its simple markups are an integral part of the portfolio based on an individual's risk appetite. You decide whether 10% or 30% of the portfolio. Nobody goes to 30%, everyone knows the pros and the cons of it, and we usually go into multi-cap structure for your overall portfolio.

Shalini Dhawan: So, I think I have mentioned it, my compliance, not able to answer that in specific terms. But like I mentioned, I think above all to possibly go to some names which have longer term, consistent track record.

Investors would need to kind of do their homework around this. There are quite a few names, which I really like just mentioned, like a ten-year track record. So, some of those names, and of course, within that we can watch out for schemes which have higher fund manager’s history, experience and of course return data and look at risk data.

Santosh Joseph: Yes, before that, let me tell you, I will make this exercise easy because everybody really wants one or two funds when we can all invest and make money. But in small caps, you actually have better chances of making money because that universe is more important than the brand or the scheme that you pick.

Like I explained to you that the best small-cap will outperform the large cap, I have multiple margin. Now here diversification in a mutual fund scheme happens only in small cap. It happens a little bit in mid-cap and probably never happens much in large-cap because this is a common. So, even if you bought the three or four schemes depending on the size of your portfolio, you are truly diversified because each guy's got different stocks, and some will not have it and some will have it, taken even the reason you know tangentially different.

If you look at the top 10 smallest caps, it's not going to be same as we watch a large-cap or a million large caps. So therefore, the first thing is if you like three or four schemes that you are confused by all the three, don't buy the needle in the haystack, buy the haystack you will benefit, number one.

Number two, I will also be a little wary about the size of the fund. I like it to have a longer maturity in terms of at least a 5 to 10-year track record. But if I truly find the size of the fund at Rs 1000 to Rs 3000 or maybe even Rs 5000 crores, I am more or less going to be veering towards a smaller fund because in small cap, the percentage exposure you take really matters a lot. I mean will it normally go with a slightly smaller side.

Now also remember the guys who had performed well over the last five and 10 years may not necessarily be the performers over the next five or 10 years. So, if you notice all these three points that I made, will make redundancy of any recommendation that I give you that buy XYZ or don't. But otherwise, you know thanks to Nippon, HDFC, Tata and Franklin being familiar names and having a good track record of great investment processes is great you know, better jump into some interesting schemes.

Shalini Dhawan: So again, this will be a little contextual depending on which tax bracket the investor is into, does the tax law make a big difference. Many times, contingency funds specifically are actually like a long buy and hold kind of money put away and therefore, I think in some cases, the strategy would probably still remain liquid funds.

But it could also move to, if you are looking at gold planning specifically and where people are looking at, let's say six months, one year horizon for emergency corpuses, we also look at arbitrage from that perspective, given the tax bracket, so that could be another way. Otherwise, broadly, I don't think tax should be that big an element I think we probably should be more conservative about it.

Santosh Joseph: You know, we are actually at crossroads, and because we had a pause last week with our central bank. The U.S. may also go in for a pause in a few hours from now, and in a few hours from now and ECB meet actually didn’t hike and actually narrowing the gap because the gap between the ECB or the American markets is 150 basis have been dropped 200 basis points and China is going for a rate cut, and so therefore you are at a crossroads with different economies and now saying I will not use a blanket approach. I will use what works for my economics.

The Fed Chairman very clearly said that there is going to be a lag effect of the previous hikes that have already happened. Now in India for four months in a row, we have CPI inflation show signs of cooling off. So therefore, I think either we are at the peak of the peak interest rate cycle, or maybe we are looking for some more key indicators to say that we are somewhere around that net debt level.

I think if you were to talk about contingency or emergency, my practical experience over the last many years is taught me that it's really contingent keeping your bank account. Forget about FD, forget about liquid funds available anywhere. It's that whether it's Rs 50,000 or Rs two lakh or five lakh, whatever the contingency for each individual person that relates to, please keep it in the most accessible format that you like.

Over and above that, you have to start looking at the applicability or the need for the fund and therefore you notice that liquid and the money market and the short term or the ultra-short term comes into play because then you want to ensure that the money that you have will be more or less parked into the duration that the fund offers.

Now, let me also add another important point here that sometimes even in fixed income people chase returns, if ultra-short is doing well, they want to go there and if the liquid is lower, they don't want to park over there. That's a huge mistake that you should avoid because you should know that there are risks even in fixed income between long duration, short duration and liquid and money market.

I really go in for strategies that will be aligned to the need of the funds that you have. As far as the longer-term debt is concerned, I think it makes sense to be between the two and a half to three-year maturities because if you're looking at coming off the peak interest rates, you may have some bit of luxury to lock in money at a decent yield and also benefit from capital and as rates go south.