What To Do With Small Caps?

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What To Do With Small Caps?
What To Do With Small Caps?
Nilanjan Dey - 03 October 2023

At the outset, I would like to start with an innocuous fact—the number of folios in small-cap funds has accelerated by more than two-and-a-half times over the last couple of years. That number stands at 13 million at this juncture.

And now, a deeper interpretation beyond the apparent innocence of the statement. Small caps have not only generated an enormous interest, they have surpassed their previous records. For the first time, the number of small-cap folios is almost equal to that of large-caps, and in fact, higher than that of mid-caps.

So, how do we interpret this in the current context? What inference, if any, should investors draw from this phenomenon? What strategy must they follow if some of them are over-exposed to the “smallies”? We will find out the answers, and they are bound to reveal a major trend or two.

But, first, a bit about the latest market conditions and the role being played by the mid- and small-cap segments. The second category seems especially vulnerable to market forces.

For the record, the key small-cap indices are all up significantly. The NSE Small Cap 50 Index, for instance, now stands at 5,850 points (mid-September). Its 52-week low and high are 3,984 and 6,047 points, respectively. The NSE Small Cap 100 Index, too, has surged to 12,725 points, its 52-week low and high being 8,682 and 13,079 points, respectively, according to data from the National Stock Exchange (NSE). In sum, this demonstrates the extraordinary potential of this category of stocks.

The major debating point that emerges from the trend is: have common investors stretched themselves too much? Is this over-bought position a cause of concern? To answer these queries, we need to focus on a few important matters.

Allocation Holds The Key

Individual investors must scrutinise their overall allocation strategy. Are they over-exposed to risky assets in the mid-and small-cap spaces? If the answer is in the affirmative, then this is the time to change it.

Additionally, there is need for realignment of weightages. Investors who have allocated, say, 75 per cent to small-caps may consider paring it to more reasonable levels. This will ultimately lead to a more balanced and, therefore, less risky portfolio with greater room for other market cap categories.

Rebalancing may also help investors sharpen their returns over time. This rationale has been tested time and again, and historical evidence underlines the truth in the argument, too. For those who pursue long-term investment strategies, rebalancing is strongly advocated. Professional advisors also suggest the same to their clients.

The reason is not that difficult to understand. Overexposure to small caps will hurt the most when the tide turns and the secular growth in the markets hits a roadblock. After all, small caps are extremely vulnerable to headwinds, perhaps a lot more than large caps.

In fact, the current scenario has prompted a louder call in favour of the large caps. Large-cap funds, I must point out, were not too preferred till recently because a big chunk of the market was aware of their limitations. The latter have been evident in the most recent performance figures as well.

Large Caps To The Fore Again?

In order to continue with the same logic, let’s look at the latest returns generated by large-cap players. The average fund in this category is not likely to impress anyone (when compared to the small caps), which will merely underscore the relatively low-key nature of its performance.

Admittedly, large caps are very nearly a defensive bet for conservative investors. The large-cap funds in question are mostly focused on the major index constituents. These are the stocks representing the nation’s largest corporates, representing diverse industries. A discerning section of investors tend to prefer this investment lot and dedicate a significant part of the overall allocation to large-caps. Now, a potentially volatile small-cap space is compelling investors to look at large caps (and mid-caps, too) once again. Some quarters are said to have already taken the first step on this front. Others are planning to book profits in small-caps and switch to large-caps.

The trend, it is felt, will define investor behaviour in the weeks to come. More particularly, the run-up to the general election will witness a larger number of defensive moves. It is widely believed in investor circles that Indians will exercise their right to vote in the early days of calendar year 2024. Till then, market will witness mixed sentiments.

Will a move from, say, AU Small Finance Bank to ICICI Bank be justified? I cite these names as mere examples of stocks, the first being a small-cap and the second a super-large cap? The answer is difficult to determine. Only the investor concerned will be able to understand this and clarify efficiently.

The point is, switching from a small-cap fund to a large-cap fund is an individual choice. As an investor, you are free to choose whatever you want. However, such choice should be guided by your risk-taking ability.

At the end of the day, it is really a simple question. If your risk appetite permits a switch, and emerging circumstances encourage you, go ahead with the switch. A change in asset mix will probably help you fetch elevated returns. The end, once again, will justify the means.

Don’t Ignore Small Altogether

As things stand, small-cap funds seem to have a mind of their own. Over long stretches of time, a number of them have displayed an outstanding performance. Therefore, even conservative investors often tend to have limited exposure to these funds.

Let us for a moment imagine a mutual fund investor’s life without small caps. It just might resemble a drab desert, one without any green verge in sight!

I will use the desert analogy once more to liken small caps to the occasional watering hole among the dunes. The travelling caravan, which looks forward to it, is often tempted by a mirage. However, a smart investor, guided by a fit and proper financial plan, seeks the oasis and avoids the mirage.

Small is beautiful indeed, but only if one has the right acumen for it. Investors need small-cap funds to energise their portfolio, and add power to the large-cap and mid-cap funds they hold. A combination of the three makes way for the modern-day equivalent of nirvana.

By Nilanjan Dey, Director, Wishlist Capital

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