Go long to make the most of strong run in the small-cap fund category

Allocate 10-15% to these funds for a 10-year period, don't just rely on history

The small-cap fund category has yielded average returns of 88.9 per cent over the past year. After a six-year bull run (2012-2017), this category’s performance peaked in January 2018. Thereafter, it languished for two years. Both new investors, who wish to take exposure because of the FOMO (fear of missing out) factor, and existing investors, who are wondering if the rally has any steam left, must take a close look before diving in.
 
Sound long-term prospects
 

Fund managers believe that once the second wave of the Covid-19 pandemic ends and demand recovers, this segment could continue to perform. “Several factors are bringing the economy back on track: The Centre’s production-linked incentive (PLI) scheme, the China-plus-one strategy that has led to global supply chains being more open to sourcing from India, the government’s focus on infrastructure, and so on. These developments will create many opportunities for small-cap companies,” says Samir Rachh, fund manager, Nippon India Mutual Fund.
 
Rajesh Cheruvu, chief investment officer, Validus Wealth, holds a similar view. “The Atmanirbhar Bharat and import substitution programmes augur well for smaller mid-caps and small-caps. Smaller companies with specialised manufacturing abilities will be able to benefit from government concessions and incentives to scale up quickly.”
 
While fund managers mostly follow a bottom-up investment approach in this segment, they feel some sectors offer good prospects. “We are bullish on chemicals, which we feel will offer growth opportunities over multiple years. We are also positive on capital goods, since India has not invested in capex for many years, and sugar, where earnings are likely to be more stable in future,” says Rachh.
 
Valuations are rich
 
Valuations are on the higher side after the rally. “This is the result of low interest rates and high liquidity prevailing globally,” says Rachh. He adds that if growth rebounds and is reflected in financial year 2022-23 (FY23) earnings, then current valuations, which look expensive, will not appear so.
 
However, if the second wave is more disruptive than the market anticipates, or if there is any other adverse development, then equity markets could correct and small-caps could also take a hit.
 
Rewarding in limited doses
 
Investing in small-cap funds can be very rewarding over the long term —10-year category average return stands at 15 per cent compounded annually. However, these funds are also capable of gut-wrenching declines (see table).
 
“Take exposure to these funds if your risk profile permits. They may have a 10-15 per cent allocation in a well-diversified equity portfolio. In addition, have at least a 10-year horizon while investing in them,” says Mrin Agarwal, founder-director, Finsafe India.
 
Fund managers, too, emphasise the need for a long investment horizon. “In this segment, we select good companies and hold them. To get the full benefit, investors, too, need to hold on for a long period,” says Rachh. He adds investors need to have more moderate return expectations from the category in the near future.
 
If your exposure has increased above the pre-decided level, book partial profits, else a correction could hurt.
 
Finally, don’t rely only on historical performance. “Look at the stocks in the underlying portfolio. Check whether the portfolio has been built just on the basis of momentum, or there are fundamentally strong firms that can deliver returns over the next several years,” says Cheruvu.