Play safe in small-caps even though the valuations seem attractive

Given their high volatility, conservative investors must limit exposure to 5-10% of equity portfolio

Two developments have taken place within the small-cap space. One, these funds have, on average, run up 22.8 per cent over the past three months, outperforming their mid- (15.5 per cent) and large-cap (10 per cent) peers. Two, SBI Mutual Fund has announced that its Small Cap Fund will only accept money via the systematic investment plan (SIP) route, and not lump-sum investments. This has led to speculation that the category may have become overheated.

Valuations not exorbitant yet: The market rally since March has been driven by liquidity, which has lifted all boats, including small-caps. “During 2018 and 2019, small-caps were beaten down more drastically than large-caps. After the March downturn, their valuations were very attractive. Hence, when money started flowing in, some part went into small-caps,” says Arun Kumar, head of research, FundsIndia. He believes small-caps can rally further if economic recovery materialises and earnings improve. 

This space is not overheated yet. “We have not reached the overheated valuations of 2017, if you go by the price-to-book value. The SmallCap index has not even touched its previous peak of January 2018,” says Kumar.

Restricting inflows a positive step: The closure of SBI Small Cap Fund to lump-sum investments does not signal that valuations have become overheated, as was the case when fund houses took similar action in 2017.

“The fund manager may be finding it difficult to manage fund size while sticking to his mandate,” says Kaustubh Belapurkar, director-manager research, Morningstar Investment Adviser India. The small-cap space suffers from capacity constraints.

 

 

In SBI Small Cap Fund’s case, the fund manager may not have been comfortable adding to his positions in existing stocks, or he may be finding it difficult to come up with more stocks that meet his investment criteria.

According to Belapurkar, restricting flows is a positive step that shows the fund house is not keen just to gather assets under management, but wants to keep the existing strategy intact and protect the interests of existing investors.

A volatile category: These funds have the ability to give higher returns than large-caps. “If a stock in this category manages to grow in size, business risks reduce and analyst expectations rise, leading to price-to-earnings rerating,” says Gautam Kalia, head–investment solutions, Sharekhan by BNP Paribas.
 

However, the category is inherently risky. 

“These funds invest in small-cap companies whose ability to borrow money and handle shocks is not as much as large-caps,” says Kumar. Adds Kalia: “These companies could carry key-man risk and corporate governance risks.”

Exercise caution: New investors who wish to enter this category because of its recent performance should ask themselves two questions. “One, do they have an investment horizon of 7-10 years? Two, do they have the risk appetite to stay invested even if their fund sees drawdown of 50-60 per cent?” asks Belapurkar.
 

Conservative investors should restrict allocation to these funds to 5-10 per cent, while the aggressive ones should not allocate beyond 15-20 per cent of their equity portfolio. Take the SIP route.