Invest in small & mid-cap funds for long term investments

Mutual Funds | admin | December 20, 2010 at 10:42 pm

invest in midcap funds Rahul Zope, a designer with an engineering firm, is a perplexed man. He prefers to do some homework before investing his money and sometime tries to maximise returns on his investments by taking extra risk.

His analysis shows that the mid- and small-cap-oriented funds have offered the best returns in the diversified equity fund category. As he was not comfortable with sectoral funds, generally he used to let the fund manager decide which sector to bet on .But now he is wondering whether he should invest in some focused mid- and small-cap funds to enhance his portfolio returns.

Mid- and small-cap funds, as a category, have done extremely well in the past one year. According to Value Research , a mutual-fund tracking entity, the one-year category average returns of mid- and small-cap funds touched 16.33% as on December 8, 2010.

The category has outclassed the multi-cap funds as a category that offered 14.83% over one year. However, a look at the market indices suggests otherwise . The BSE Sensex (12.36%) has outperformed the BSE Mid Cap Index (10.07%) over one year. The conflicting signals make the question tough — should one invest in these mid- and small-cap funds now?

Before taking any decision, let us first understand what is on offer.

A mid-cap or small-cap-oriented fund is a mutual fund scheme that invests most of the money into stocks that have market capitalisation below a stipulated level, say Rs 5,000 crore. Market capitalisation is calculated by multiplying the stock price by the number of shares of the company. Some funds allow fund managers some headroom to invest a part of the money – say up to 35% of the scheme corpus – in larger companies with a market capitalisation above the stipulated levels.

“Mid- and small-cap stocks offer an opportunity to the investor to participate in the process of transformation from a small business to a big business and the wealth creation expected on the way,” explains Vetri Subramaniam, head of equities , Religare Mutual Fund. In normal circumstances, a large company grows at a pace in sync with the rate of growth of the economy.

When the economy grows at a rate of growth of 8% year-on-year , the large-sized corporate entities are expected to experience around 20-25 % growth in their profits. The large base ensures that the growth will not be super-normal in most cases. But that is not the case with small- and mid-sized companies. Due to the small size, it has the potential to grow at a much higher speed than its larger counterpart .

It is seen that some of the growth stories in mid- and small-cap space comes from the ‘sunrise industries’ where there are no large companies. Such cases offer the small companies a large untapped opportunity and a huge potential to grow. As stock prices depend on the profits of the company, the shareholders here stand to gain a lot, if they get it right. Of course, there is another side of the coin.

Most small companies are characterised by information asymmetry, which means lack of uniform distribution of information to the market participants compared to their larger counterparts where the analyst community has access to information . Large companies share information pertaining to their capital structures, profitability and growth plans with shareholders and analysts at regular intervals, say quarterly.

The track record of large companies is easily available in the public domain. But the information does not flow as smoothly in the case of mid-sized companies. The investors do not have a track record to fall back on in most cases. Then comes the second element that makes the small- and mid-cap stocks risky due to poor liquidity.

Given the small size of the company , the number of shares outstanding is not likely to be much and the stocks may be thinly traded. It may not be easy to buy or sell the stock without disturbing the price, especially if you are holding a large chunk.

Price movements can be extremely volatile in both directions — up and down — and not all investors are comfortable with such extreme situations. These companies do extremely well in booming times but may suffer a lot when the economy slows down compared with their larger counterparts. These factors make the stocks more volatile and a risky proposition.

Given the high risk involved in small companies, it is important that the investor understands his risk-taking ability before considering any investment in these types of funds to cash in on the opportunity. “Aggressive investors with highrisk profile should look at the mid- and small-cap funds with a 15-20 % weight in their portfolio,” advises Pawan Joseph, national sales head, Motilal Oswal Wealth Management. But, of late, some of these stocks are in focus for the wrong reasons.

Some mid- and small-cap companies are under pressure due to multiple factors such as lack of corporate governance and regulatory actions on non-compliant promoters of some such companies. This has brought the stock prices down in some cases. Funding-related issues in real estate and infrastructure space have also bogged down prices of some stocks. But still they have not reached levels that attract investors.

“Stocks in mid- and small-cap space were not quoting at much discount to large caps in the past few months. Though the prices of small- and mid-cap stocks have corrected in the last couple of weeks, the valuation gap that has emerged between large-cap and small-cap stocks is not too much to make them attractive,” says Vetri Subramaniam. As the market corrects further, quality businesses will manage to separate themselves from the herd of also-ran counters.

“Companies with good management quality and good growth prospect will bounce back to emerge winners as the market uncertainty goes down,” says Vinod Ohri, executive director, Gupta Equities, who advocates a stock- specific approach. A retail investor may not be best placed to identify such companies.

But a seasoned fund manager can do it for him. This makes a strong case for mutual funds when one considers investing in mid-sized companies.

“It makes sense to invest in funds with a long-term track record and keep reviewing your investments at regular intervals ,” advises Pawan Joseph. But do not jump in for a quick buck. “Mid- and small-cap stocks enjoy high beta and, hence, it is not the best time to invest in this space for the short-term in volatile markets. But investors with at least a thr midcap ee years’ view on markets can see good wealth creation in this segment ,” says a mutual fund manager with a fund house, who declined to be named.

Good mid-cap funds in the long term can not only help investors to create wealth, but also digest the volatility. If you judge yourself to be an aggressive investor, then do consider these funds. If you do not have the necessary attitude to stomach high volatility, it would be better to stick with diversified equity funds with a good track record.

The fund manager with a diversified equity fund offers you exposure to midsized companies when he thinks that the same are available at a good price compared with their large-cap counterparts and exits when he thinks otherwise. So, go for the option that will suit your growth objectives in the long-term .

Source: Economic Times