Is this a good time to invest in small cap mutual funds

What are small cap mutual funds?

Small cap mutual funds are equity mutual fund schemes which invest at least 65% of their assets in small cap stocks. SEBI categorizes 251^st and smaller companies by market capitalization as small cap companies. Small cap companies are smaller than midcap and large cap companies in terms of market share, revenues and earnings per share. While small cap stocks tend to be more volatile than large and midcap stocks, but they have the potential of giving higher returns in the long term.

Small cap stocks can turn in multi-baggers

Small cap stocks in your portfolio can significantly boost long term portfolio returns and create wealth. Small cap stocks are mostly under-owned by institutional investors. Price discovery of such stocks tend to take much longer time than large cap and midcap stocks. This enables fund managers identify quality small cap stocks with high growth potential at very attractive prices. Over a period of time, if the stock performs well, it will attract the attention of institutional investors and valuation re-rating of these stocks will take place resulting in considerable wealth creation for investors.

In fact, most multi-bagger stocks (stocks which give several time returns e.g. 2X, 5X, 10X etc.) are small cap stocks. Out of 13 stocks which gained more than 100% on the Bombay Stock Exchange in the last 1 year, 8 were small cap stocks. However, identifying quality cap stocks requires considerable expertise and extensive research. The best way to invest in the small cap stocks is through mutual funds.

Why should you invest in small cap funds?

• Historically, quality small cap stocks have delivered stronger earnings growth than large cap stocks. Hence, price appreciation potential of such stocks is much higher


• Small cap stocks have low institutional ownership and tend to be under-researched. This provides fund managers attractive opportunities to generate high alphas


• Many industry sectors do not have large cap representation. While market size of such sectors may be smaller than large sectors, there are high market growth opportunities for such sectors and for the small cap companies in them


• Institutional (both FII and DII) ownership of small cap stocks is likely to grow further in the future. This will enable small cap fund managers deliver superior returns in the long term


• SEBI’s market cap mandates for large cap, large and midcap, multi-cap, midcap funds and hybrid funds provide considerable opportunities for fund managers to add small cap stocks in these schemes in the future to boost scheme alphas. This can have favourable price impact for small cap stocks and funds

Small cap funds have been the biggest wealth creators over long tenures

The tables below show the growth of Rs 10,000 monthly SIP in various fund categories and annualized returns (XIRR) over different investment tenures. Category average returns are considered. You can see that small cap funds have been the biggest wealth creators over long investment tenures. Investors need to have high risk appetites, have disciplined investment approach and long investment tenures (at least 5 years or longer) to get the best results in small cap funds.

Source: Advisorkhoj Research (as on 22^nd January 2020)

Source: Advisorkhoj Research (as on 22^nd January 2020)

Deep correction in last 2 years

Despite long term superior performance, small caps saw sharp correction over the last 2 years. The Nifty Small Cap 250 TRI fell more than 30% in 2018 and 2019 (please see the chart below). The 52 week low was made in August 2019 and the small cap index has recovered slightly over the last 4 months or so. Deep corrections like these often create attractive investment opportunities. Since the small-caps are still consolidating at lower levels of their price range, we think that this may be a good time to invest in small cap stocks.

Source: NSE

Strong bounce-backs from deep corrections in the past

In the past small cap stocks have bounced back strongly from deep corrections (please see the chart of Nifty Small Cap 250 TRI from 1^st January 2008 to 1^st January 2020 below). You will notice that the recoveries have not always been V-shaped; we also saw W-shaped recoveries. Investors must therefore, be patient with small cap funds and have long investment horizons.

Source: NSE

Disclaimer: Past performance may not be repeated in the future. Investors should make decisions according to their risk appetites

We have studied each bear market / deep correction (20% or more) in the small cap index (Nifty Small Cap 250 TRI) since 2008 and observed how much returns it was able to give from the respective market lows over the next 5 and 7 years. You can see there is good possibility of getting high returns from deep market corrections.

Source: NSE, Advisorkhoj Research

Disclaimer: Past performance may not be repeated in the future. Investors should make decisions according to their risk appetites

We spoke to Mr. George Heber Joseph, CEO & CIO of ITI Asset Management Ltd. about his views on small cap stocks valuations and whether these are attractive investment opportunities at this point in time. This is what he has to say “Small cap stocks have, in the last two years, borne the brunt of economic slowdown. They have seen downgrades in earnings and also P/E derating. As a result, they have significantly underperformed large cap stocks. Today, the valuation differential between small caps and large caps is very large and at levels similar to those seen in 2003, 2009 and 2013. We have seen that from those levels small caps have given handsome returns. We believe today the investment opportunity in small caps is very attractive” Read the full interview on Advisorkhoj website

Summary

Small cap mutual funds were very popular with investors from 2014 to 2018. Unfortunately, the market has been very volatile especially in the small cap segment for the last 2 years. Many investors may have suffered losses in their small cap funds in the last 2 years and may have even got negative SIP returns.

Many investors switched from small cap funds to large cap and some may be sitting on cash. In the past, small caps bounced back strongly from deep corrections. We think, the deep correction over the last 2 years has created attractive investment opportunities in small cap funds. Investors should not expect quick recovery and should be prepared to remain invested over long (minimum 5 years) tenures. We think that, SIP is the ideal mode of investing in small caps, but you can take advantage of the deep correction by tactically investing in lump sum as well. Investors should consult with their financial advisors, if small cap funds are suitable for them.

ITI Mutual Fund is launching ITI Small Cap Fund NFO starting January 27, 2020. The NFO closes on February 10, 2020.