The road map to investing in small-cap funds

For investors looking to put in money in small-cap funds, market experts believe in having a stock-selective approach, at a time when the Nifty Smallcap index has given returns of 46.10 % in the past 1 year.

As of October 19, 2024, the small cap index was overvalued at a Price-to-Earnings (P/E) of 33.39, while the 3 year long term average stands at 24.49. But experts think there are certain sectors within the small cap that are fairly valued.

Coming to overall markets, a lowered earnings expectation is seen as a reason for investors becoming conservative in their investment approach. FII outflows, stimulus by China, rate cuts by US Fed, and other geopolitical risks such as Iran-Israel conflict are other reasons why investors are jittery.

Mihir Vora, CIO, Trust MF believes that small-cap category is no longer small. He says, “15 years ago, the Top 100 stocks used to be 80% of the market cap, today it is 62%, and 40% comes from small- and mid-caps.” He further says growth-adjusted valuations are more attractive in small caps than even large caps. According to Mihir, some of the high growth choices are only available in small caps like consumer durables, AC, fridge, mobile and even chemicals which has just 2 large cap stocks and 60 small cap stocks.

Vora says that one should do long-term investing in high growth stocks in small caps due the growth potential they offer. He said, “If you see the next few years and try to value the stock (high growth stock), you might find them expensive, but if the market believes that these stocks are going to grow at high growth rates, not for 2-3 years, but for 5-10 years, then the value of back-ended profits is far higher in the overall valuation.”

But he also cautions investors about certain sectors in small-cap stocks like low floating stocks which have high valuations, such as micro-cap, SME stocks, and some PSU stocks that can be skewed by few investors.

Ajay Khandelwal, Fund Manager, Motilal Oswal MF Fund Manager, says investors can look at certain sectors in small cap—like power ecosystem, transformer cables—where there is good demand and inquiry. He also said that the earnings results have been fairly decent for small caps as opposed to large caps. In large caps, starting with financials, loan growth, and deposit growth have been weak. Even in the IT sector, 7-8% growth was expected with a few companies performing well and a couple of companies which didn’t perform well. FMCG results have also been disappointing. Khandelwal says, “To start with, investors had low expectations that is why market is holding up and that is why we are not seeing that kind of volatility and in broader markets.”

He advises investors with short horizon of 1-2 years can allocate funds to large-caps more and those with a long term view between 3-5 years can keep their allocations in mid-and small-caps allocation higher.

Mahesh Patil, CIO, Aditya Birla Sun Life MF is of the opinion that earnings in small-caps have been good, but rerating has been much higher. He suggests that investors should not go for lump sum in small caps but rather should be prudent and spread out their investment. He said, “Choose a fund with moderate risk within small- and mid-cap which focusses more on quality to withstand volatility.” He also advises investors to allocate more towards large caps and flexi caps for safety. Overall, he observes that broader markets are being driven by domestic liquidity from MFs and EPFO and earnings growth momentum has slowed and the number of stocks outperforming the benchmark post elections has gone down.