Is it a Good Idea to Invest in Small-Cap Stocks?

The small-cap mutual fund category piques the interest of investors from time to time. Investors generally avoid tiny caps in volatile markets but become interested in them during bull markets. In the past year, small-cap funds have been one of the top-performing equity mutual fund categories. However, in recent days, the market has become extremely volatile. We’ll talk about small-cap funds in this blog post.

What are small-cap stocks and funds?

Small-cap stocks are defined as firms with a market value of $251 million or less, according to SEBI. According to SEBI’s mandate for small-cap funds, they must invest at least 65% of their assets in small-cap equities.

Will small caps continue their outperformance?

Small-cap equities have outperformed the market over the last year. In the past year (ending 31st January), the benchmark Nifty Small Cap 250 TRI returned 58.3 percent1, outperforming both the Nifty 50 TRI (22.9%) and the larger market index, the Nifty 500 TRI (28.2% return1). Small caps, on the other hand, have underperformed2 the Nifty in recent weeks as the Russia-Ukraine situation has escalated. Following Russia’s invasion of Ukraine, crude oil prices are increasing in international markets, and global equities markets have become turbulent. The US is poised to impose tough economic sanctions against Russia. As a result, global financial markets will be extremely volatile. Small caps have historically underperformed in highly volatile market situations, according to historical statistics.

Can small caps outperform in the medium to long term?

The current geopolitical environment is extremely volatile, making it impossible to forecast how stock and commodity markets will react until the Ukrainian situation de-escalates. In the medium to long term, Indian stocks have strong growth potential as the economy recovers from the longer-term effects of the COVID-19 pandemic. Small-cap stocks have historically outperformed large-cap stocks over time.

Why small caps can outperform large caps in the long term?

• Smaller companies are typically less capital intensive, allowing them to produce higher Return on Equity (ROEs). In the long run, companies with greater ROEs can provide better returns to investors.
• In comparison to high cap equities, small-cap companies are also under-researched. Stocks trading at significant discounts to their intrinsic values can be identified by fund managers. For small size funds, such equities can provide significant alpha.
• The Nifty 500 index has 250 small-cap stocks compared to only 100 large-cap stocks. For investors, small caps offer a considerably greater range of options. Large capitalization companies are absent from a variety of industries. Small caps can be used to invest in these sectors.
• During periods of increased demand, mid and small-cap equities tend to outperform. Small caps may outperform in the post-COVID economic recovery scenario.

Ideal stock concentration in a small-cap fund

When opposed to large size or even midcap equities, small-cap stocks have a higher share of promoter ownership. As a result, the fraction of free-floating shares in small caps is lower. In extreme market conditions, this might lead to liquidity concerns. As a result, with small-cap funds, concentration risk is critical. In a small-cap fund, a single stock concentration should not exceed 5–6% of the portfolio.

How to select small-cap funds?

On small-cap funds, a bottom-up stock choice has a greater impact on returns. The alphas generated by different schemes indicate considerable variances in performance statistics for small-cap funds. Different stock selection strategies are used by different fund managers. You should invest in small-cap funds managed by fund managers with a proven track record over time. When evaluating the performance of different small-cap funds, you should look at at least three years of data.

How much should you invest in small caps?

Your small-cap allocation will be determined by your risk tolerance and investing horizon. Small- and mid-cap stocks are more volatile than large- and mid-cap stocks. Small-cap allocations should not exceed 20% of your equity portfolio, according to financial advisers. Consult your financial counsellor and make appropriate plans.

Who should invest in small-cap funds?

• Investors that are searching for capital growth over a long period.
• Those with a high to extremely high-risk appetite. In the short term, these funds can be extremely volatile.
• Investors that have at least a 5-year investment horizon.
• Small-cap funds are ideal for SIP investors because they allow you to benefit from volatility through rupee cost averaging. Deep corrections can also be used to make a lump-sum investment.
• If small-cap funds are appropriate for an investor’s needs, they should contact their financial experts.