Match limited exposure with long investment horizon for small-caps' safety

Such companies tend to be less resilient than their peers: hold only a couple of funds in them and diversify

One segment of the equity market that has been hit hard in the ongoing downturn is small caps. The Nifty Smallcap 250 Total Return Index (TRI) is down 15.1 per cent year-to-date (YTD). Small-cap mutual funds have, on average, declined 11.1 per cent over the same period.

Among stocks belonging to the Nifty Small-cap 250 Index, while the median performer has declined 33.8 per cent, the worst performer has lost 85.9 per cent value from its 52-week peak.

An intrinsically volatile category

Small-cap stocks, by their very nature, are volatile. Since the free float market cap of these stocks tends to be low, small inflows and outflows result in large price changes.

Small-cap companies tend to be less resilient than their large- and mega- cap peers. “Within the small market cap segment, you have small but healthy companies, and also those struggling to survive. During an economic slowdown, companies that were struggling to survive earlier are more likely to go bankrupt,” says Avinash Luthria, a Sebi-registered investment advisor and founder, Fiduciaries. This is one reason, according to him, why overall small-caps tend to fall more than large-caps during a market downturn.

Analyst coverage tends to be much lower in small- and micro-cap stocks than in large- and mid-cap stocks. “Lack of analyst coverage means the market price of these stocks tends to deviate more from their fair or intrinsic value,” says Ajay Bodke, an independent market analyst.

More intense coverage of mega- and large-cap stocks, according to Bodke, also means the shenanigans of promoters and their associates get flagged off by analysts and the media. “This doesn’t happen in the case of small- and micro-cap stocks, and that adds to the risk of investing in them,” says Bodke.

Rein in exposure

Most experts believe retail investors may take limited exposure to small-cap stocks and funds. “Many of the large-cap names, which investors feel comfortable holding today, were small caps 10-15 years ago. There is no harm in allocating some money to a well-chosen basket of small-cap stocks, each of which has the ability to survive and grow into a mid- and large-cap stock over time,” says Vishal Dhawan, chief financial planner, Plan Ahead Wealth Advisors.

Before retail investors allocate money to the small-cap segment, however, they must prepare themselves for their higher volatility. In fact, they may need to view volatility through slightly different lens. “Investors in a small-cap fund need to appreciate that volatility, especially that caused by liquidity, isn’t risk. Risk, to us, is the chance of permanent loss of capital,” says Harish Bihani, fund manager, ICICI Prudential Small Cap Fund.

According to Bihani, the best way to beat the higher risk in small caps is to have a longer investment horizon. “As time horizon increases, the chance of a permanent loss of capital in a small-cap fund decreases,” he says.  

The Nifty Smallcap 250 index makes up around 6.7 per cent of the Nifty 500 Index. Says Luthria: “Most retail investors should invest in small caps in that proportion in their equity portfolios.”

According to him, only ultra-high net worth individuals have the financial strength to have a higher allocation than 6.7 per cent of their equity portfolio to small caps in the hope of getting a higher return. During the market downturn of 2008-09, the Nifty 100 TRI (large-cap) fell by 61.1 per cent while the Nifty Small-cap 250 TRI fell by 75.6 per cent from peak to bottom. Luthria says only ultra-high net worth individuals are likely to have the financial strength to live through that kind of a downturn (with a high allocation to small caps) without selling at the bottom.

Retail investors must also have a long horizon. “If the investment horizon for investing in other equity segments is 10 years, it must definitely be 15 years for small-cap investing,” says Dhawan.

Long-term exposure to this category can, in fact, be rewarding.

Investors with a low risk appetite should avoid this category altogether.

Time for a portfolio check

During bull runs, the small-cap segment does much better than others. Going purely by past performance, retail investors, especially the less experienced ones, take exposure to three-four best-performing funds, all of which often turn out to be small-cap.

“Exposure to the small-cap category should be limited to one or two funds,” says Dhawan.

If you are unable to handle the volatility in small-cap funds, exit the category. If that’s not the case, stay put. Pare the number of funds to two over time. Continue with your systematic investment plans in the funds you intend to hold over the long term.

Within the small-cap category, disparity in fund performance is also evident currently. Year-to-date, the worst performer has declined 21.7 per cent while the best performer has fallen only 2.7 per cent. Investors may be tempted to migrate from the worst to the best performers. That may not always be a good idea.

“Don’t exit a fund based on six-seven months’ performance. See how it has done over a longer horizon of seven or 10 years,” says Dhawan.

Understand the reason for a fund’s underperformance before you exit. Each fund has its own fund management style, which works in certain market conditions and doesn’t in others. “Over the past 12 months, value-style funds have done better than growth-style funds. Instead of migrating from a growth style fund to a value style fund, diversify across styles. In other words, hold one growth- and one value-style fund in the small-cap portion of your portfolio,” says Dhawan.

Direct investors: Time for a reality check

During bull runs, since small-cap stocks run up more than their mid- and large-cap peers, retail investors, especially the new entrants, tend to pour more money into these stocks.

Investors who took exposure to these stocks without analysing them should do a thorough appraisal of their portfolios, or get an expert to do so. According to Bodke, “Check whether the underlying business has a sustainable competitive advantage, a strong brand, robust distribution capabilities, strong return ratios, free cash flows, and a low debt-equity ratio.”

Stocks that pass muster on these counts should be retained in the portfolio. Those that don’t should be purged, even at a loss. In poor-quality holdings, the investor could keep waiting until eternity, but those stocks may never bounce back to their previous highs.

In the future, investors should buy a small-cap stock only after doing the due diligence on business fundamentals, valuations, and management quality. According to Bodke, in the small-cap space especially, most retail investors will be better off handing over their money to a quality mutual fund manager.