Mitigate valuation risk in smallcap funds with limited exposure, long horizon
While returns over the past year have been high, these funds are prone to significant drawdowns during tough economic environments
Investors who had chosen smallcap funds some time ago are a happy lot today. Over the past year, smallcap equity funds have, on average, returned 54.7 per cent as of April 10, 2024. The steep rise has also led to mounting concerns, with the Securities and Exchange Board of India (Sebi) mandating stress tests on these funds. It raised questions about some fund houses selling these ‘high-risk’ funds to senior citizens. In March 2024, the category witnessed outflows (of ~94.2 crore) for the first time since September 2021.
A diverse mix
While some companies in the smallcap universe are market leaders in their respective businesses, many others have not yet gained critical mass and a solid balance sheet. “Contrary to general perception, many smallcaps have dominant market share in sectors such as cables, logistics, durables, forging, chemicals, auto ancillaries, and their growth longevity and quality of management are excellent,” says Ajay Khandelwal, fund manager, Motilal Oswal Asset Management Company.
Deepak Jain, president and head-sales, Edelweiss Mutual Fund says, “Many emerging sectors, which are likely to benefit from the overall growth in India, may currently be part of the smallcap universe.”
Room for growth
Many of these companies outperform when the economy is doing well. “The past two years’ EPS (earnings per share) CAGR (compound annual growth rate) of the Nifty Smallcap 250 Index is 21 per cent while the return CAGR is 27 per cent. The returns are being driven by strong earnings growth, improvement in return on equity (ROE) to historic highs, and leaner balance sheets.
Smallcaps may continue to deliver robust earnings as they will benefit from a stable economic environment, favourable demand-supply situation and benign raw material prices,” says Khandelwal.
Chandraprakash Padiyar, senior fund manager, Tata Mutual Fund, agrees. “With Make in India, Atmanirbhar Bharat, China+1, and Europe+1 being discussed in India regularly, the smallcap segment could have more legs over the long term,” he says.
Investor preference for smallcap schemes arises from the possibility of generating alpha. “Given the small size of businesses in this segment, growth in earnings during a capex-driven cyclical upturn tends to be strong — much higher than in the largecap or midcap universe. This may lead to higher-than-normal returns,” says Padiyar.
Risk of higher volatility
Smallcaps find it difficult to grow in tough times when interest rates are high and the economy is not expanding. That makes these stocks more volatile compared to their largecap counterparts.
“Current valuations are on the higher side compared to historical averages, hence one must be prepared for higher volatility,” says Jain.
Smallcap schemes can face large drawdowns. The Nifty Smallcap 250 Index lost 43.9 per cent in the year ended March 23, 2020 — the day the market hit a low during the Covid-19 pandemic. Over the same period, the Nifty 50 index fell less, 33.57 per cent.
“Owing to the segment’s nature — a wide range of companies, low research coverage, and the presence of both emerging and established businesses — the risks are higher than in largecap companies. In tough market conditions, the possibility of higher drawdowns exists, going by experience,” says Jain.
Monitor stress test results
Recent stress tests show these schemes have fairly liquid portfolios. “Some of the risks associated with small caps are now addressed as fund houses will provide additional disclosure regarding valuation, volatility, investor concentration, along with disclosures on stress testing results (time taken to liquidate 25-50 per cent of assets under management of these schemes),” says Khandelwal.
Enter with a long horizon
Invest in a smallcap scheme only if you have a long holding period. “Whenever returns move on the higher side, a new set of investors gets attracted to this segment, leading to much higher stock price movement. This inflates valuations. Hence, take a long-term bet on the smallcap universe and don’t churn too often,” says Padiyar.
Jain explains that as of December 2023, smallcaps constituted roughly 17 per cent of market capitalisation. Allocating more than this percentage, he says, might increase the risk, and vice versa.
Investors with low-risk appetite, like senior citizens, should avoid this category.