Mid- and small-caps may gain from broader recovery but won't come cheap

Take limited exposure to these stocks and opt for the fund route if you aren't adept at direct investing

With the Sensex touching the 50,000 mark recently, there is fear among market participants that equities may have become overpriced. Nonetheless, one category that is being pitched actively to investors is mid- and small-cap funds. The rationale being advanced is that earnings of mid- and small caps tend to rise sharply during a broad-based economic recovery. Investors need to understand the opportunities and risks in these segments fully before entering them.   

Positive drivers 

Many listed mid- and small-cap companies are present in segments that have a large unorganised component. “Whenever a disruption occurs, organised-sector players benefit at the expense of the unorganised players,” says Shreyash Devalkar, senior fund manager-equity, Axis Mutual Fund. He expects this trend to continue in the future as well. 

Many export-oriented mid- and small-cap companies were doing well earlier as well, but initiatives like Make in India and the production-linked incentive (PLI) scheme have provided a fresh impetus to them. 

The housing sector is showing signs of recovery, owing to low mortgage rates and subdued property prices. “When housing does well, a number of ancillary industries, such as cement, pipes, and so on, which are in the mid-and small-cap space, also benefit,” says Devalkar. 

Valuations no longer inexpensive 

The BSE Midcap and the Small-cap Index have run up 25.3 per cent and 31.3 per cent respectively over the past year. Valuations are no longer cheap. "There is no valuation arbitrage between large caps and quality stocks in the mid- and small-cap segment," says Devalkar. 

Lower interest rates have supported higher valuations. The interest-rate cycle is turning now. Interest rates appear to have bottomed out and could rise in the future. If that happens, they could drive valuations down. 

Earnings growth holds the key

Earnings growth was visible across sectors in Q3 FY21 results. The future performance of mid- and small-caps will depend on whether growth continues on a sequential basis over the next few quarters.  

In the Budget, the government said that it will borrow and spend on infrastructure to create a multiplier effect within the economy. “Much will depend on how well the central and state governments execute these plans,” says Madanagopal Ramu, fund manager, Sundaram Alternates. He adds that the monsoon also needs to be good for rural demand to sustain.

Foreign fund flows will also have an impact on the course of the market. “If the developed economies recover early, flows to emerging markets could consolidate. But if they don't, flows into India could continue,” says Ramu. 

Stick to quality names

If the expected recovery in the economy and in corporate earnings does not materialise, many mid- and small-caps could correct sharply. “Stick to quality companies with good cash flows,” suggests Ramu. Devalkar adds that in case a of a correction, stocks of leveraged companies tend to fall more steeply, so avoid them. Ramu adds that investors should focus on earnings and adjust their positions accordingly. 

Beware the risks of investing directly

Investing directly in mid- and small-cap stocks is not everyone’s cup of tea, given the paucity of information in this segment. "Corporate governance standards tend to be lower, especially within the small-cap segment. Due to the low float in these stocks, prices tend to be volatile," says Sarvesh Gupta, founder, Maximal Capital and a Sebi-registered investment advisor. Balance sheets of smaller companies tend to be weaker. This limits their ability to absorb shocks. Most investors, according to Gupta, will be better off entering this segment through the mutual fund or portfolio management services (PMS) route. 

Avoid market timing  

Follow an asset allocation approach. Based on your investment horizon, risk appetite, and age, decide on an 80:20 (80 per cent to large caps and 20 per cent to mid-and small caps), or 70:30 allocation, or whatever suits you. Then stick to it for the long term instead of trying to time your entry and exit based on market valuations. Market timing is extremely hard to pull off consistently.

Those with less ability to accept volatility, and higher age, should take a lower exposure to mid- and small-caps. 

Don’t be swayed by talk that this is a good time to enter large-caps or mid- and small-caps. Instead build a diversified portfolio where you also have exposure to large caps. "The bulk of earnings are accounted for by the top 70-80 companies, so exposure to this profit-generating universe is crucial," says Prateek Mehta, co-founder and chief business officer, Scripbox. 

Select a consistent performer 

While selecting a mutual fund, go with one that has managed to create considerable alpha over the long term. Make sure that the fund manager who delivered the returns is still at the helm. "Go with a consistent performer. Also pay heed to the fund manager's ability to mitigate risk," says Mehta. Invest via the systematic investment plan route and have at least a seven-year horizon.  

Small caps in particular display a lot of cyclicality. "If you have invested in small caps, book profits regularly," says Mehta.