The Mutual Fund Show: Is It The Right Time To Buy Small And Mid Caps?

Anupam Tiwari: You need to see this question in a proper context. We are going through a difficult time where growth rate expectations are coming down but generally history tells us that if you invest in bad times, your expected return goes up. Specially in case of small caps because de-rating and re-rating happens very fast. The question is that whether this is the bad time, or we are here to see the worst, I am not sure. But this is time where you start allocating money to small caps. If you look at last one and half years, especially starting 2018 calendar year and even till today, the underperformance of small caps has been much more severe than large and mid caps. If I tell you in broader terms that the valuation gap or froth which is still available in large cap and mid cap has gone in small cap. So, I will not say everything is cheap here. But it looks attractive and one should start looking at it. One has to a see small cap not as a broader category because if you look at 10-year history as a category, small caps have never delivered as compared to mid caps and large caps. But if you dissect that category into top quartile of performance and bottom quartile of performance, then the return differential is very stark. One has to be choosy. Small cap space is very important in terms of good stock picking. From that perspective, things are starting to look attractive.

Tiwari: Generally, we advise investors to have very long-term horizon for small caps because inherently it is a very volatile asset class and it takes time for small cap companies to scale up, grow and show great results and create wealth for investors. You can manage this risk of further slowdown by deferring your investments through SIP, STPs or doing it in an instalment manner. They are putting some milestone and investors have to have five years-plus time horizon to make a decent return in small cap space. It is not a two-three year story.

Tiwari: At a broader level, SIP is a good option given the current situation and the context that we are seeing. But the decision about doing an SIP or a lump sum depends a lot on how investors are positioned in terms of their cash flows and ability to withstand volatility. The better decision maker is the investor himself. At a broader level, SIP is a better option.

Tiwari: For my personal money, I will not. Whenever I have money, I invest. So, I don’t get into all these technicalities. Because when you are investing in equity, generally I invest for 10-15 years or till my retirement. So, this 3-5 percent movement doesn’t matter. If you are taking a two-three year view, then all these things matter. Generally, I will not suggest somebody to take a two-year view for small cap. It is too short a period.

Tiwari: My personal investing continues and at a personal level I am increasing my small caps. If I look at context that we are in and just think of next five to 10 years, and you ask why we have not made money in small caps in the last 10-15 years. Couple of problems which crop up are the quality of management or promoter or corporate governance, the execution capability, availability of capital, strength of balance sheets. These are primary reasons for us to not make money in small caps. Everything is getting sorted one by one. Lot of private equity money is coming into smaller companies. Lot of good excellent talent is coming. Lot of companies are giving very good wealth creation options for employees. So, we are slowly solving all those problems. It is a slow process and not a fast process. Going ahead, we will have a lot of good opportunities in small cap which you will not have in mid cap and large cap. These are smaller and newer businesses — they are unique businesses. They are not available for you to own in large and mid cap. That’s a very compelling argument for me to be in these spaces and keep increasing my allocation to these spaces. If I look at next seven to 10 years, the kind of evolution that Indian economy is going to see, not just in monetary terms or GDP growth or saving rate, but the whole economy will go through a transformation where new businesses will come which are more efficient in terms of capital and operating efficiency and they are better off and of global standard. So, that will give us a good opportunity as an investor. In last two-years’ listings, we have seen that lot of niche businesses are getting listed and they are unique. They are not present in the mid cap and large cap space. That is an opportunity which may come in. when we look at small caps in a historical context, as a broader level when you look at small cap index, the problem is all good small cap stocks move into mid caps and all bad mid cap stocks come back to small cap. So, you are looking at something which is devoid of retaining good thing and getting filled by inferior stock of companies. So, one should not make a generic assumption based on broader market index and then take a very specific stock and business call and then take a decision.

Tiwari: Yes, If you look at the history of mutual fund industry, and you look at the peer group in small cap and all the funds, you will find that there are many of them who have outperformed the index and have outperformed the broader market in a very decent manner. That has been proven that looking at pure index in a small cap is a frivolous argument.

Tiwari: There are two parts to it. One is that how should you decide allocation to multi cap or small cap or large cap. Is it purely based on the current context of the last one-two years of market performance or do you need to do slightly longer view? Secondly, what is the key decision making criteria, whether it is return performance or investors’ ability to withstand the volatility and what is his ability to take risk and his expected return. I think the second part is more important. Before deciding on multi cap or small cap—inherently these are two different categories—one has a very different risk-adjusted return profile compared to another. Small caps are inherently volatile, take a longer term compared to muIti cap to give you good returns. So, it has to be decided by an investor. Can he withstand that volatility? Does he have time to wait for five-seven years to generate those returns? Can he see his portfolio going down 15 percent and still be confident about his investment? At a market level and my level, it is very difficult to answer. It has to be answered by the investor as to what type of investment is he choosing. There are multiple products to select. Depending on his own risk appetite, his own risk-adjusted return expectation, he has to take his call on the kind of return he wants.

Dhruv Mehta: My reaction to that is that clearly in 2018 when you look at the beginning, there was a huge difference in terms of valuation between mid, small and large caps. Typically, mid and small cap generally trade at a 5-10 percent discount to the large caps. Last 10-15 years when I have looked at the market, I think it was the first time when the small caps went into the premium over large caps and by small caps, I am referring to companies between 300-500 in terms of ranking. So, I think that froth has been taken away with this sharp correction in mid, small cap. The mid and small caps today are trading at a discount to large caps but on an aggregate basis, and what I look at is the medium valuation rather than the average, because sometimes the average gets distorted by two-three large. So, when we look at this data over the last 10-15 years, what it shows is that mid and small caps have corrected, has come back to a discount in terms of valuation to the large caps. But the discount is in line with the historical averages. As a basket, I think the valuations are in terms with the historic levels. I don’t think as a basket the small cap as a whole is very cheap. But what you said in terms of stocks, there could have been a lot of stocks which have seen a substantial correction and therefore could be at mouthwatering valuations.

Mehta: Yes, but a small cap fund manager is not only going to buy three-five stocks; it’s the whole portfolio. When you look at the market and you are looking at a category as a whole, we need to assess whether the whole category will do well. In that context, I am a little apprehensive that the category itself will not do that well because if the large caps do correct, if that is the case and the mid caps are attractive but if large caps are expensive and they are expected to correct, then the nature of the market is that when large caps correct, mid caps cannot rise at least.

Mehta: As I see it, all the three are reasonably at parity therefore you need not take a call whether I should be overweight large, should I be under-weight. Whatever is the allocations within the equities just as somebody keeps an allocation between debt and equity, I think, it is prudent for all investors or all advisors to have an asset allocation among large, mid and small. It’s very simple, if you look at the Indian market, the large cap—the top 100 companies—broadly account for 75 percent of the total market cap. The mid cap would account for the next 15 percent and then you have the small cap. So are you in tune with that? Most retail investors, typically when you start investing in direct stocks, your portfolio gets lopsided skewed toward the mid and small cap. Therefore, all individual stock portfolios when the markets do bad, generally your individual portfolios do bad. When the markets do well, your portfolios do well. This is one other factor in terms of allocations, people need to look, have a strategy, my long-term goal, what should be my allocation, you are inherently bullish on the mid- and small-cap space. Then rather than mid and small being 25 percent of the portfolio which the market is, you should decide whether you should be 30-40 percent. Once that is decided, whatever allocations you need to make at all points of times, you should stick to that.