Newbies in small and mid-cap space should invest for at least five years

With fund managers beginning to sound warning signals, it is best to be extra careful

Recently, ICICI Prudential Asset Management decided to shut down two schemes run by its portfolio management services (PMS) arm. The two schemes are PIPE and Small Cap Portfolio Series 1. Together these funds will return around Rs 7 billion to investors.

According to the asset management company, valuations within the small-cap space have become very expensive. Says Nimesh Shah, managing director and chief executive officer (CEO), ICICI Prudential Asset Management Company: “Small-cap stocks tend to outperform if you invest in them at an early stage when valuations are cheap and earnings growth is at a cyclical bottom. At the current juncture, we believe that valuations in small caps is pricing in most of the positives, including a sharp earnings recovery.” When the fund was launched (November 1, 2013), the price to book value ratio of the Nifty Free Float Small-Cap Index stood at 0.85 (P/E was 24.75), while now it has risen to around 1.93 (P/E 79.95; source: NSE). “We are in a situation where valuations are very rich and too much money is chasing very few quality small-cap companies,” says Shah.

While the practice of returning money is not common, ICICI Prudential AMC has earlier distributed capital along with profits in ICICI Prudential PMS Wellness Portfolio and ICICI Prudential PMS Exports Portfolio. “This course of action was in tandem with our philosophy of identifying a dominant theme, riding it, and then distributing profits and capital at an opportune time,” adds Shah.

Others won't follow suit: Other portfolio management service providers said that they don’t plan to shut down their funds or restrict inflows. “At present when investors come into our small-cap strategy, we tell them that they must invest with a horizon of three-five years. We also inform them that their money will be deployed gradually, over a period of time, as and when opportunities arise,” says Ajay Bodke, CEO and chief portfolio manager (PMS), Prabhudas Lilladher. He adds that they zero in on the right valuation for investing in a stock and then wait for those valuations to become available.

Sanctum Wealth Management currently runs a large-cap strategy and a multi-cap strategy, and doesn’t offer a small-cap strategy. It is currently advising investors to bet on the multi-cap strategy. “There is a dichotomy in the current market environment. Valuations are more attractive in the large-cap space, but they have not delivered high growth. Mid- and small-cap stocks have delivered higher growth, but their valuations have become prohibitively expensive. In such an environment, we are recommending investors with a moderate risk appetite to invest in the multi-cap strategy,” says Roopali Prabhu, head of investment products, Sanctum Wealth Management. According to her, fund managers need flexibility at this point to perform. If there is a sharp correction, and valuations in the mid- and small-cap segment become more attractive, the fund manager should have the flexibility to move down the market cap curve, she says. 

A welcome move: Financial planners think that returning of money to investors is a positive step. “There is a large amount of risk in the small- and mid-cap space at present. It has given fantastic returns in the past, but if there is some negative news, either on the global or domestic front, this space could see a sharp correction. This move of closing down the fund and returning money to investors is a very appropriate one for managing investor expectations,” says Arvind A Rao, financial planner and founder, Arvind Rao and Associates. Currently, investors say that if there is a correction they will pump more money into the markets. But when such a correction actually happens, the same people may regret investing in the small- and mid-cap space. 

Be wary of the small- and mid-cap space: The larger implication for investors is that after the run up over the past few years, fund managers are finding it extremely difficult to zero in on quality stocks that are available at a discount to their intrinsic value. Experts think that the Indian market still offers opportunities over the long term, so investors should not exit equities entirely. “However, they need to ensure that their asset allocation doesn't get skewed. To achieve this they should rebalance their portfolios aggressively,” says Prabhu.
 

Any profit booked in the small- and mid-cap space should be invested in a well-diversified manner. “If an investor has an investment horizon of six to eight years, he could make a 50 per cent allocation to large-cap funds (higher if his risk appetite is low) and 50 per cent to mid- and small-cap funds. But if someone needs the money in the next two to three years, he should invest in debt funds. Given the uncertainty surrounding interest rates, investors should not expose themselves to high duration risk at this stage and should stick largely to accrual-oriented funds having an average maturity of one-two years,” says Rao.

Above all, treat this as a year for defensive investing. Do not take short-term bets on the small- and mid-cap space.