Midcap mutual funds versus small cap mutual funds: an ever going debate

There is a lot of material online, including on our website, discussing the merits and demerits of investing in large cap versus small and midcap stocks / mutual funds. Most blogs and articles that I have come across club small and midcap stocks / funds together when comparing them with large cap stocks / funds. While there are a number of similarities in characteristics of small and midcap stocks / funds relative to large cap stocks / funds, investors should understand that, small and midcap are two distinct market capitalization segments. The chart below shows the growth of Rs 1 Lakh investment in BSE – 100 (index of large cap stocks) versus BSE Midcap (index of midcap stocks) and BSESmall Cap (index of small cap stocks), over the last 3 years.

Source: Bombay Stock Exchange

You can see that, BSE Midcap and Small Cap indices outperformed BSE – 100 over the last 3 years. While the overall performances of BSE Midcap and Small Cap indices were quite similar in the last three year periods, there were times when BSE Small Cap outperformed BSE Midcap and vice versa. Before we delve further into midcap versus small cap discussion, let us understand, what we mean by large cap, mid cap and small cap stocks.

Large Cap:

Large cap companies are typically companies which have a market capitalization of over Rs 20,000 Crores. Market capitalization of a company is calculated by multiplying the current stock price of the company with the total number of shares outstanding. Large cap companies are large and well established companies with strong market shares. These companies are generally considered to be safer investments compared to mid cap and small cap companies. Mutual fund schemes which invest the majority portion of their portfolio in large cap companies are called large cap funds.

Midcap:

Mid cap companies are typically companies which have a market capitalization ranging from Rs 5,000 Crores to Rs 20,000 Crores. Mid cap companies tend to be less well known, less researched and are thought to be more risky than large cap companies. Mutual fund schemes which invest the majority portion of their portfolio in mid cap companies are called mid cap funds. Midcap funds tend to be more volatile than large cap funds. Midcap funds can also be less liquid than large cap funds in extreme market conditions.

Small Cap:

The market capitalizations of small cap companies are less than Rs 5,000 Crores. These companies are smaller than midcap companies and thought to be riskier than even midcap companies. Mutual fund schemes which invest the majority portion of their portfolio in small cap companies are called small cap funds. Small cap funds tend to be more volatile and less liquid than mid cap funds.

Performance of Small Cap versus Midcap versus Large Cap Funds

Large cap and small cap stocks fall in the extreme ends of the risk / return spectrum, while midcap stocks lie in between the two segments. The chart below shows the average category returns of small and midcap funds (also in relation to large cap funds) over the trailing 1, 3 and 5 year periods.

Source: Advisorkhoj Mutual Fund Category Monitor

You can see that, small cap funds outperformed midcap funds in the last 1, 3 and 5 years. You can also observe that, the outperformance of midcap versus large cap was much larger, than its underperformance versus small cap in the same period. The difference in performance of these three fund categories are consistent with their risk / return profiles. The risk and return profile of midcap stocks / funds are closer to small cap stocks than large cap stocks / funds. Small cap funds outperformed midcap funds by 4 – 5% on a CAGR basis in the last one to three years, which is not insignificant. Therefore, it is important to understand the distinct characteristics of these asset categories, so that you can make the correct investment decisions for your portfolio.

We have already discussed the difference in market capitalizations of these two asset categories (midcap and small cap). Let us understand the characteristics of these companies.

Midcap Companies

Midcap companies are the ones who have been able to establish themselves in the industry and achieved scale. They usually have a few thousand Crores of revenues but they are much smaller in order of magnitude compared to large cap companies. For example a mid cap information technology (IT) company’s revenue base can be $ 500 to 700 million dollars, while that of a large cap company can be over $10 billion. The smaller size of midcap companies make them more risky than large cap companies (from an investment perspective), but they are less risky than small cap companies. The growth potential of midcap companies is more than that of large cap companies. Midcap companies can become large companies in the future, generating huge returns for shareholders. However, investors should also know that, the market cap distribution is pyramidal in nature and only a few midcap companies will become large cap companies.

Midcap companies also tend to run up a lot relative to their balance sheet strength in bull markets. A severe recession can put the balance sheets of some midcap companies, especially highly leveraged companies (high debt equity ratios) under a lot of stress. Midcap stocks need to be thoroughly researched and a bottom-up approach to investing is required in this market segment. It is not easy to identify multi-bagger midcap stocks and retail investors who do not have necessary stock selection expertise should go through the mutual fund route. One must also have a sufficiently long investment horizon, at least 4 to 5 years, for these stocks to realize their potential and generate handsome returns for investors.

Small Cap Companies

Small cap companies occupy the lowest end of the market capitalization spectrum. They are seen by some investors as “get rich quickly stocks” and by some as “toxic waste”. We want Advisorkhoj readers, not to succumb to perceptions and understand the risk / return characteristics of these stocks / funds before they make investment decisions. Small cap companies are relatively newer companies, in the early stage of their development, compared to midcap companies (and by extension, large cap companies). These stocks are not very well known and since these companies operate in niches, their revenue and earnings growth potential is not very well understood by the average investors. However, since these companies tend to be under-researched they can be significantly under-valued and over a period of time can turn into multi-bagger stocks for investors when their potential is discovered by the market. It takes a lot of expertise to uncover great potential in the small cap space, which the average investor usually lacks. Like the midcap segment, mutual fund route is ideal for retail investors who want to invest in small cap stocks.

Retail investors (both in stocks and mutual funds) should realize that, we are minority shareholders. Unlike large cap stocks, where institutional investors have a substantial stake and therefore influence on corporate governance, corporate governance and interest of minority shareholders in small cap companies is in the hands of the promoters. It is extremely important that you invest in companies, where the management takes care of the minority shareholders. Small cap companies have smaller balance sheets compared to midcap companies; an economic shock can cause severe financial distress for small cap companies. That said we have also seen small cap companies with strong business models which are less capital intensive and have nimble footed managements, emerge stronger from recessions by grabbing market share from their competitors. When investing in small cap companies, it is important for investors to understand the business model and management quality, something which good mutual fund managers are equipped to do.

Small cap stocks are often seen by some investors as instruments to make huge profits in a short period of time. However, investors are better served by having a long investment horizon when investing in small cap stocks (and funds). Some small cap stocks have given 1000% returns in the last 10 years; while the same cannot be expected from a small cap fund which has diversified portfolio of stocks, over a long investment horizon, small cap funds have created wealth for investors.

Liquidity Concerns

Though we have said that, investors should have a long investment horizon for midcap and small cap stocks / funds, liquidity should be an important consideration for midcap and small cap investors. The free float market capitalization percentage of midcap stocks in India is quite small due to large promoter shareholding in these companies; the free float market capitalization percentage of small cap stocks is even smaller. Free float shares are actively traded shares in the market; retail investors whether directly or indirectly (through mutual funds) buy free float shares. Free float shares is a portion of the total number of shares outstanding of a company. In a midcap or small cap company, the promoters will retain most of the shares because they want management control and only a relatively small number of shares are traded in stock exchanges.

The problem with a small free float is that, if investors want to sell their shares, they may not find buyers in the market for all their shares. If you do not get buyers for all the shares that you want to sell, you will have to wait for a few days or even weeks to offload all the shares that you want to sell. During this period the share price may fall and this will affect the return on your investment; in stock trading parlance, this is known as impact cost. Small free float will usually be not a problem for average retail shareholders, but it can be a problem for small and midcap mutual funds, when there is high redemption pressure. This situation usually occurs during bear markets (some readers may recall that, we saw this situation in 2008) and investors should keep this in mind. While both small and midcap stocks / funds may be affected by liquidity scarcity, the problem can be more acute for small cap stocks. That is why you will see that, some small cap mutual fund schemes restrict funds inflow, especially lump sum investments, when their AUM grows beyond a certain size.

Conclusion

When investing in small and midcap stocks / funds, you should check the liquidity profile of your entire portfolio. Large cap stocks are the most liquid, followed by midcap and then small cap stocks. A well-constructed mutual fund portfolio comprising of large cap, midcap and small cap funds will have sufficient liquidity to meet your needs and also enable you to ride out liquidity crisis, so that you can get good returns when market recovers. Good financial planning practices suggest that, you should invest in a mix of large cap, midcap and small cap funds to meet your long term investment needs. In this post, we discussed differences between small and midcap stocks. You should consult with your financial advisor, if midcap or small cap funds or both are suitable for your investment portfolio.