Small-cap Mutual Funds

Lying at the lowest end of market capitalisation, Small cap stocks are generally viewed under the misconception of being hazardous or 'quick rich' stocks. However, both these labels are untrue. 

Small cap companies have smaller revenue and client bases, and usually include the start-ups or companies in the early stage of development. Small cap stocks are potentially big gainers as they are yet to be discovered within the sector and can show growth potential in large numbers once unfurled in the market. However, as these enterprises are small ventures, these should be researched properly. This is considering that a lot of small companies do not have the financial strength to survive bad times and some of them might be mismanaged businesses run by greedy promoters. Hence it is essential, especially in the case of small caps investments that one does a thorough research regarding the promoters' credentials, management strength and track record, and long and short term growth plans of the company before investing. 

Small caps are often stated to be a platform to make big returns in a short span of time. However, we would state that small caps can prove to be a very wise 'long term' investments especially if the chosen companies are good businesses and are well-managed. 

Small cap wonders Change in share prices over the past years.

If you had invested Rs 1 lakh in Crompton Greaves on 1 January 2002, your money would have grown to Rs 65 lakh by now. Back then, Crompton Greaves was a small capital goods company with a market capitalisation, or market cap, of Rs 115 crore and a stock price of Rs 1.80.

It has been one of the biggest wealth creators in the Indian stock market and given 52 per cent annualised return over the last 10 years. The company had a market cap of Rs 10,410.25 crore on 01 April  2015 while its stock was trading at Rs 166.10.

On 2 January 2002, Sesa Goa had a market cap of Rs 99 crore and its stock was at Rs 1.28. On on 01 April  2015, the stock was trading at Rs 190 and the company's market cap was Rs 56,358.84 crore.

Scores of once small companies have over the years grown big, giving investors a 30-50 per cent annual return over 10-15 years and creating fortunes for investors. However, more often than not, we find ourselves at the wrong side of the fence and regret our inability to spot such stocks on time.

But due to their size, small-cap companies are more prone to volatility in the equity market.

The number of small-cap stocks is large and finding a quality stock that can give high returns over a long period is tough even for equity analysts. One reason is that such stocks usually have a short history and are not tracked by many analysts and brokerage houses. Then there are risks such as low liquidity, governance concerns and competition from larger players.

If these factors scare you but you still want to gain from the upside potential of such stocks, small-cap mutual fund schemes are an ideal choice for you.

A typical small-cap fund invests over 50 per cent money in stocks of small companies. However, the fund manager can lower the exposure depending on market conditions. Mid-cap stocks form 25-35 per cent of the portfolio. A small portion, usually less than 10 per cent, is invested in large-cap stocks. Mutual fund schemes that invest a large part of their money in small-cap stocks also carry a higher risk.

RISK-RETURN TRADEOFF

It's a challenge for the fund manager to build a portfolio of quality small-cap stocks as the number of such companies listed on exchanges is huge. Also, many of them are little-known.

"The number of small companies listed on Indian stock exchanges may run into a few hundred. Out of this, 30-50 companies can be selected for investment. The challenge is that many of them may be under-researched by research/brokerage houses. One may have to rely extensively on primary research," says Dhiraj Sachdev, senior vice president and fund manager, equities, HSBC Asset Management India.

Another risk is low volumes, which makes these stocks illiquid. This means the fund manager may not be able to sell the shares as and when he wants. Small-cap funds are thus prone to liquidity risk.

Small-cap companies see sudden rise and fall in stock prices and this is reflected in the net asset values, or NAVs, of funds investing in such stocks. Due to small size, such companies are more prone to volatility.

Therefore, only investors with appetite for high risk should go for such funds. Besides, small-cap funds should form a small part of your portfolio.

Mutual funds investing in small-cap stocks can minimise the risk by diversifying across companies and sectors. Since mutual funds are managed by professional managers supported by teams of analysts and researchers, they are in a better position to select the right stocks, diversify across sectors and companies and react swiftly to changes in equity market conditions.

ARE YOU GAME?

Those who wish to invest in small-cap funds should do so only if they have a long investment horizon and tolerance for volatility. Small-cap stocks suffer the steepest falls in a bear market and rise the most in a bull market. An investor should stay put for at least three-five years to allow the fund to gain from at least one Bull Run.

A small-cap fund will generally witness more frequent changes in its portfolio than a large-cap fund. It's better to go for schemes with a low turnover ratio, which measures how much the portfolio has been churned. A higher ratio means a higher trading cost.

Only a small portion of one's investment should go into small-cap funds.

Buy funds with lower volatility, which is measured by standard deviation (SD) and beta. The higher the SD and the beta, the more volatile the fund is. A better way to judge the performance of the fund is to check its Sharpe Ratio, which measures the risk-adjusted return. The higher the Sharpe Ratio, the better is the fund's performance. R-squared is the proportion of the fund's portfolio that moves in line with the benchmark index.

You can check these ratios in fund factsheets released by fund houses every month. These factsheets are also available on websites of mutual funds.

There are many companies in the small-cap space that may become success stories in the future. Investing a small portion of your savings in the small-cap theme through mutual funds may give you a pleasant surprise.

Mid-cap Mutual Funds

Mid-caps lie between large cap stocks and small cap stocks. Mid cap stocks are those that generally have a market capitalisation within the range of Rs 50 bn and Rs 200 bn. These represent mid-sized companies that are relatively more risky than large cap as investment options yet, they are not considered as risky as small cap companies. They rank between the two extremes on all the important parameters like size, revenues, employee and client base. 

When one invests in mid-caps for the long term, he may be investing in companies that could become tomorrow's runaway success stories. Generally speaking, mid cap stocks as an investment can bring you higher returns in 3 to 5 years as opposed to their big brother large cap stocks that can bring you moderate (yet safer) returns during this timeframe. 

Investors have been looking at the wonderful promise of midcap gains and have gone into a frenzy of pouring money into these funds that specialise in them.

The past year has seen the Nifty (stock index of the National Stock Exchange) post impressive gains of 42.60%.

But, these returns pale when compared with the dazzling 107% of the CNX Midcap 200 (index of mid-cap stocks).

However, wrapped inside this promise is a dangerous threat? Their recent gains notwithstanding, mid-cap stocks are a far riskier bet than large caps.

What are mid-caps?

·         If the number of shares in a company is multiplied by its current price, the result is market capitalisation. Based on this, companies are classified as large-cap, mid-cap and small-cap.

·         Blue chips are the largest companies in their sectors; the ones with the largest market cap.

·         If you can identify tomorrow's blue chips today, you could make a pile of money.

·         That's because these stocks, with smaller market caps, are usually priced low, since investors have not yet discovered their potential.

·         In the mid-cap segment, you may find such companies.

·         In fact, big investors, like mutual funds and Foreign Institutional Investors, have started investing in mid-caps in the recent past, because the price of large caps has increased substantially.

·         That has led to a big rally in small and mid-caps, with their prices climbing upwards steadily.

·         The mid-cap segment of the stock market is, thus, being increasingly perceived as an attractive investment segment with high growth potential.

However, there are certain things you must know about mid-cap stocks before you invest in them directly or via a mid-cap mutual fund.

Why mid-caps are hot

High volatility

These stocks tend to be very volatile.

Volatility is the rate of change in the price of the shares over a given time. The greater the price fluctuation, the higher the volatility.

Historically, mid-cap stocks have displayed the tendency to rise more than large-caps in a booming market (like the one you are seeing now) and plunge to more depths when the markets dip.

While mid-caps may be going great guns at the moment, their historic record shows that they can fall like a pack of cards in bad times.

Should you invest in a mid-cap fund?

If you have already invested in a diversified equity fund (fund that invest in the shares of various companies of various sectors), then you should know that even they have notably increased their exposure to mid-cap stocks.

So you are actually getting the mid-cap benefit even in a normal diversified equity fund

But, if you are willing to take the risk, then you could consider a mid-cap fund.

But do note, each fund house defines a mid-cap stock in a different way. Since there is no standardised definition of a mid-cap stock, each mutual fund will have its own. So what one fund house may consider a mid-cap, another may not.

It is undeniable that the spectacular performance of the mid-cap stocks has been nothing less than breath-taking.

You can make money. In fact lots of money. But how much you invest in mid-caps depends on how much of risk you are willing to take.

Remember, all mid-caps are not tomorrow's large-caps.

Large Cap (Big Cap) Mutual Funds

There are a  very large number of mutual funds available in the market. Funds which invest a larger proportion of their corpus in companies with large market capitalization are called large cap funds.. Large cap is an abbreviation of the term "large market capitalization".

The criteria for large cap companies may vary. However, these are generally the ones with huge market capitalization. Large cap funds are known to offer stable and sustainable returns over a period of time, but might be outperformed by small and mid-cap funds, which have higher risk exposure.

One can look at the BSE-Sensex or BSE-100 Index as a reference point for large cap stocks. Market capitalisation for stocks in the BSE-100 Index, for instance, ranges from Rs. 200 bn to Rs. 3,500 bn.

These are stocks of usually large and well-established companies that have a strong market presence and are generally considered as safe investments. One important fact about large caps is that information regarding these companies is readily available in newspapers and magazines. Most of the large cap companies have good disclosures and therefore there is no dearth of information for an investor looking into them.

Large companies such as Infosys, TCS, and Wipro are classified as large cap stocks. These companies have been around in the industry long enough and have firmly established themselves as leading players. Their stocks are publicly traded and have large market capitalisations.