Tackling Sebi's rules: Don't ignore high risk in mid and small-caps

These stocks may see better valuation, but stick to firms with good track record

There is little doubt that the new rules for multi-cap schemes, announced by the Securities and Exchange Board of India (Sebi) last Friday, are positive for mid- and smallcap stocks. Many market experts believe fund managers will increase their allocation for mid- and small-cap stocks based on the new rules. But, given the characteristics of this universe, investors should also consider the higher risks involved.

Pradeep Kumar Kesavan, senior vice president-strategy at Elara Securities, says: “Mid- and small-cap stocks will see support only in the near term. This can change the risk-reward ratio in the multi-cap space, which one needs to understand.” 

The risk profile of investors should be large enough while increasing the allocation for mid- and small-cap stocks, he adds. 

According to Sebi's new definition, multi-cap schemes will need to allocate 25 per cent each towards mid-, small- and large-caps, starting January 2021.

However, the data shows that many multi-cap mutual fund schemes are well below the 25 per cent-mark as far as midand small-caps go. It is no secret that equity investing comes with risks. But, risks are greater in mid- and small-caps, given the heterogeneous nature. Many of these are less/not at all tracked by brokerages, and liquidity in such counters is also lower, leading to higher transaction costs.

The sharp underperformance of midand small-cap indices in the past twothree years clearly spells out the Street's reluctance towards investing in these stocks and the risk element.

 

 

Between January 2018 and March 20, 2020 (until the market fall amid Covid19-led disruptions), the BSE MidCap and SmallCap indices lost 37 per cent and 47 per cent, respectively, against around 12 per cent fall in the BSE Sensex during the same period. In the past three months, however, both mid- and small-cap indices have done some catching up, and are up 17-23 per cent, against a 16 per cent rise in the Sensex.

Given the new rules, G Chokkalingam, founder and chief investment officer at Equinomics Research, foresees around 300-500 basis point expansion in valuation multiple of mid- and small-cap stocks. However, he cautions: “While impressive opportunities still exist, there are many stocks, including penny stocks, which are in a bubble zone in the mid- and small-cap segment. Thus, one needs to be very careful and should make a distinction between quality and non-quality stocks.”

Experts say the risk in mid- and smallcaps has only increased with the ongoing Covid-19 crisis. Smaller companies with a weak balance sheet and liquidity position may not be able to find a way to survive the blow. “While large-cap names, which have large moats, tend to grow at a faster rate, the challenge for small- and mid-caps is to gain market share and grow their business. And, these challenges are coming to the fore amidst the pandemic, given the need to manage liquidity (in business) and overcome supply chain disruption,” says Mayuresh Joshi, head of equity research-India at William O'Neil and Company.

Good management track record, strong balance sheet with no working capital issues, consistent earnings growth, prudent capital allocation, and clean corporate governance are key factors investors should consider while investing in mid- and small-cap stocks, suggest experts. Joshi says that investors should be wary of intercorporate and related party deals, promoter pledges, and unrelated diversification, which destroy the confidence and value of the business.

With higher mutual fund exposure to these equity classes, some of these concerns may get addressed. It is expected that higher fund flow will reduce volatility and take care of liquidity at the counter.

A JM Financial report shows of the existing asset allocation of multi-cap schemes with total assets under management (AUM) of Rs 1.4 trillion, 74.2 per cent was invested in large-caps, and only 15.8 per cent and 5.3 per cent in mid-cap and small-cap firms, respectively, as of July 2020. As fund managers increase allocation to bridge the gap, it can push up midand small-cap stocks in the near term.

The Street may also witness incremental investor interest towards such stocks and sectors beaten down due to the pandemic, but for those having a good ability to bounce-back as the economy unlocks.

Thus, investors with an appetite to stomach the risk should consider mid- and small-cap stocks from sectors like consumer durables, automobile, and IT, advise experts.