Time to look at small cap funds, again

Mumbai: Investors with stronger risk appetites could consider equity mutual fund schemes that bet on smallcap stocks as their underperformance vis-à-vis their larger peers and a low interest rate environment have boosted their prospects. Though many of these stocks have more their doubled from their March lows, fund managers said there is still room for upsides in 2021 and beyond. Wealth planners recommend investors to hold up to 20% of their equity portfolio in smallcaps.The performance of small-caps has lagged behind that of large-caps in the past three years. Since January 2018, the Nifty 50 has given a 29% absolute return, while the Nifty Smallcap 100 has lost 28%. Fund managers said this has made valuations cheaper compared to large-caps.“The small cap space has witnessed correction in the last couple of years and valuations are close to long term average. This correction has led to market cap divergence. A staggered investment for the long term is recommended,” said S Naren, CIO, ICICI Prudential MF.Over a three-year period, investors are yet to make returns in 7 out of 14 small cap funds. Only 1 fund has given more than 8% returns. So, what has changed for this category? Fund managers said valuations of large-caps stocks have expanded beyond comfortable levels, while the low interest rate scenario has boosted investor risk appetite.Fund managers also believe low interest rates create a conducive environment for small caps, as the cost of capital – a key driver of profitability-- for small cap quality companies comes down.Moreover, small caps have outperformed large caps in 7 out of 14 time periods by a significant margin after big corrections. The total market cap of small caps fell to 10.6% of total market capitalization down from its peak of 18% in 2017 and 16% in 2011, leaving room for appreciation.“There are more than 200 category leaders within stocks ranked 100-650 by market capitalization and these leaders have only got stronger over the last decade,” says Pankaj Tibrewal, Fund Manager, Kotak Mutual Fund. He points out that even in the pandemic many top corporates, leaders in their business have improved profit margins and gained market share, giving confidence to investors.The Nifty SmallCap 100 is up 97% from its March 23 lows against the 78% advance in the Sensex and Nifty.If the risk-on sentiment continues, investors will slowly move to many small companies that are under researched, but are still good opportunities. A study by Edelweiss Asset Management shows that the average number of analysts covering a large cap stock is 30 and midcaps 15. As compared to this, in the BSE Smallcap Index, 185 stocks are not covered by any analyst and 288 stocks are covered by less than 5 analysts.Returns from small cap funds have been volatile and investor interest is low especially when there is uncertainty on economic growth.“This category has the highest potential to generate alpha. Have a longer time frame and keep overall allocation not more than 20% of your equity portfolio,” said Vijay Kuppa, Founder, Orowealth. 79911347

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