From Underdogs To Superstars: Small-Cap Investing Defies Expectations

Intelligent investing involves buying more than what you are paying for. Imagine the returns netted by investors who decades ago bought and held on to today’s giants such as Reliance Industries, TCS, Infosys, L & T and the likes? In just the last 10 years alone, these stocks have generated 14-20 per cent CAGR returns. Welcome to the world of investing. If you spotted these giants 20-30 years ago, your gains would have been manifold. 

In Small-Cap investing, investors choose small-sized companies with the potential to become tomorrow’s Mid-Caps and Large-Caps, thus giving you attractive long-term growth opportunities. A portfolio approach is required to taste success in small-cap investing given that these stocks are of smaller companies which carry more risk and thus are more volatile than mid-cap and large-cap stocks.

Why Small-Caps?
Small is beautiful but often overlooked in nature and otherwise. Even though small-cap companies have potentially successful business models, huge growth potential and unique innovative products and services, their small size means investors would rather look at bigger peers. Therein lies the opportunity to experience alpha (higher than benchmark return) for small-cap investing as such stocks are usually under-owned (public shareholding is lower versus mid-caps and large-caps) and also under-researched (400 stocks have no analyst coverage). Unfortunately, direct investing in small-caps has its own set of risks. 

One, many small-caps have high key man risk. Two, the financials of many small-caps are not as healthy as bigger firms, exposing them to bouts of financial troubles. The third reason is that the smaller size of many small-caps means that larger players can muscle them out in areas of core competency. Armed with extensive research and experienced fund managers, mutual funds are able to screen such companies and only invest in good and clean small-caps. For instance, across the MF landscape, small-cap stocks with a total invested market value of Rs 2.8 lakh crore have been chosen for investments by fund managers. This represents a small share of stocks against the Rs 24 lakh crore in equities.

Use the Mutual Fund Route
There are 24 actively managed small-cap funds in the MF industry. They are linked to over 1 crore investor accounts (folios) as per AMFI data. In terms of portfolio construction, small-cap funds invest minimum 65 per cent of their total assets in the universe of small-cap stocks which are selected based on extensive research and screening. For liquidity purposes, the schemes may invest the remaining portion of the portfolio in large-cap and mid-cap stocks.

Depending on mandate, well-run small-cap funds invest in compact or diversified portfolios that are chosen after screening them for corporate governance, sector opportunity, leverage and return ratios, earnings potential and valuations, etc. Stocks selected for investment are reviewed periodically by actively managed funds, which is more proactive than passive schemes that do rebalancing only at fixed intervals. In comparison to 40-70 per cent of large-cap and mid-cap funds, 80-90 per cent of the small-cap funds have beaten their respective indices on a five-year and ten-year basis. Low coverage of promising small-caps gives fund managers an edge in spotting good businesses early, after conducting due diligence. 

Also, small-caps may be highly cyclical and understanding the business cycle helps mutual fund managers to bet on the right small-caps at the right time. However, given the nature of the offering, small-cap fund portfolios do exhibit higher volatility than large-caps and midcaps. However, with a well-run small-cap fund, investors can experience high return potential as the fund buys and holds stocks with a long-term view. For instance, the five-year and ten-year category average return of small-cap funds is 16 per cent CAGR and 21 per cent CAGR, respectively.

Conclusion
Big things always start small and small-cap funds are no exception. Investors with good risk appetite and investment horizon of 7-10 years must consider investing in well-run small-cap funds that focus on identifying high-growth companies which are likely to transform into tomorrow’s market leaders, resulting in capital appreciation over time. Systematic investment plans or SIPs are the optimal way for investors to increase their position in small-cap funds given the ample opportunities to enter over long phases.

The writer is Managing Director, Affluenz Financial Services India Pvt Ltd. ■ Email : shiney@affluenz.co