After a strong rally in the small-cap segment this past year, some mutual fund asset management companies are now suggesting that the time is ripe to relocate assets to large-cap or mid-cap stocks.
In the calendar year 2023 till today, Nifty small caps have delivered a 40 per cent year-on-year growth, surpassing Nifty Midcap (38 per cent) and Nifty 50 (12 per cent), as per data provided by ICICI Securities.
According to data from the Association of Mutual Funds in India (AMFI), as of December 6, 2023, the average one-year returns for 23 small-cap funds stood at 32.68 per cent. In contrast, 30 large-cap funds and 28 mid-cap funds delivered average one-year returns of 15 per cent and 28.02 per cent, respectively in the same period.
Large caps stocks consist of the top 100 publicly listed companies by market capitalisation, mid caps include 150 companies ranked 101st to 250th, while small caps encompass those starting from the 251st position onward.
According to WhiteOak Capital Asset Management, it is time to reallocate assets from small caps to large caps and mid-caps. While the AMC does not predict a small-cap collapse going forward, their guidance suggests relative outperformance of large caps over the next year when compared to small caps.
“In the last year, there has been exaggerated outperformance of the small-cap index vs the large-cap index. Roughly 40 per cent vs nine per cent as of November 30, 2023, when seen YoY. With the robust rise in underlying earnings large caps are significantly undervalued compared to the rest of the markets. Mid-caps have also run up but for mid-caps earning growth is even better while small caps look expensive when seen vs earnings,” said Aashish P. Somaiyaa, CEO, WhiteOak Capital Asset Management.
FPIs inflow to impact small-cap performance
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The small cap outperformance, as per Somaiyaa, is partly influenced by the fact that markets have been driven by domestic flows while FPI flows have been hugely negative over the last two years or muted at best.
 "Portfolio rebalancing: Is it time to move away from small-caps? (6)")
Source: WhiteOak Capital AMC
As of October 2023, category-wise net inflow data in mutual funds reveals that small-cap funds secured the most substantial share, drawing in over Rs 26,547 crore or 33 per cent. In contrast, large-cap funds witnessed a net outflow of Rs 4,975 crore.
 "Portfolio rebalancing: Is it time to move away from small-caps? (7)")
Source: WhiteOak Capital AMC
For the financial year 2022-23 to date, nearly 60-65 per cent of mutual fund net flows are in small, mid and small/mid heavy fund categories, noted Somaiyaa.
As the US interest rates ease and the US dollar weakens, coupled with changes in domestic politics, there's an expectation of resumed FPI flows across emerging markets (EMs), particularly in India, said Somaiyaa.
The anticipated rotation inflows and favourable valuations may lead to large-cap outperformance in the next year, he said.
“We expect FII flow to drive the next wave of the rally in the market and in that case, large-cap can remain in focus as FIIs prefer to allocate funds to larger companies with deep liquidity,” said Mukesh Kochar, National Head of Wealth, AUM Capital.
In October 2023, Kotak Institutional Equities noted that the recent correction in stock prices may not be the end of the downward trend for mid and small-cap stocks. The report suggested that the correction seen so far is not significant enough considering the rally these stocks have experienced over the past few months.
The report highlighted that while there has been a meaningful price correction in Indian equities, the degree of correction has varied across market caps and sectors. In particular, mid and small-cap stocks have seen sharp declines, but the correction in their prices is relatively small compared to the rally they have witnessed in recent months.
Kotak's analysis indicates that most mid and small-cap stocks in their coverage universe do not offer value, considering the extent of rerating in multiples seen in the past year. “We do not find value in most mid- and small-cap. stocks in our coverage universe given the extent of rerating in multiples seen in the past 9-12 months despite weakening business models and eroding business moats," it said.
In fact in September 2023, Kotak Institutional Equities dropped its recommended mid-cap portfolio as it could not find too many stocks beyond the BFSI space that offer decent potential upside to its 12-month fair value.
The brokerage added that it sees limited point in trying to find fundamental reasons behind the steep increase in stock prices of several midcap and small-cap stocks.
“Many of the stocks have jumped in the past few months (some within weeks of inclusion in the portfolio). We have changed the portfolio frequently in the past few months to keep up with rampant stock prices, but have largely run out of options now. It is obvious that we have not developed some special stock-picking skills recently. In our view, the steep increase in stock prices simply reflects the irrational exuberance of investors in the midcap and small-cap parts of the market,” Kotak Institutional Equities said.
Kotak suggests that large-cap stocks offer a better reward-risk balance, as they have more reasonable valuations compared to the lofty valuations of most mid and small-cap stocks.
Risks associated with small caps are also high
While small companies offer good growth opportunities, they also come with higher risk.
“The volatility (as defined by standard deviation of daily returns) of the Nifty Largecap 100 Index is 9.79 per cent vs the Nifty Smallcap 250 Index which is 13.51 per cent, which makes small-caps around 38 per cent more volatile and indicates the inherent additional risk one takes while investing in small-caps,” said Vishal Jain, CEO, Zerodha Fund House.
 "Portfolio rebalancing: Is it time to move away from small-caps? (8)")
Source: Zerodha Fund House.
Mid-, small-, and micro-cap stocks are also seen as having high valuations without a substantial margin of safety. Their prices rely heavily on sustained earnings growth, posing potential risks for investors. Any slowdown in earnings could lead to corrections in these stocks, emphasising the importance of closely monitoring financial performance.
This chart by ICICI securities shows how trailing earnings yield spreads of mid, small and micro caps over large caps at each point in time and how has been sliding into the unattractive zone:
Source: ICICI Securities
According to Somaiyaa, the money going into small and mid-cap, value/cyclical, thematic funds and others reflects investors' tendency to follow past one-year returns.
“When macroeconomic parameters change, winners (in terms of best-performing funds) rotate. In the last few days US macroeconomic and India’s political macroeconomics have changed, despite this, if everyone wants to chase what worked in the last 1-2 years then it doesn’t augur well for the relative performance of their portfolios going forward,” said Somaiyaa.
Small caps are more volatile in the short-term
Historical data from the past 18 years reveals that for a one-year investment in small-cap funds, the worst-case scenario is a 61.2 per cent decline, as per data analysed by Value Research. However, there is a stark trend - this risk diminishes with time. Over three years, it drops to 16.4 per cent, and over five years, it's a mere 2.9 per cent. Even in a 10-year worst-case scenario, small-cap funds return a positive 7.4 per cent CAGR.
A double-edged sword
In investing, small-cap success stories are common, but so are wealth-eroding disasters. "Small-cap investments can yield a staggering 94 per cent return in a year (as witnessed in 2009) but can also drain your wealth by a brutal 57 per cent (as demonstrated in 2008). Furthermore, it is also noteworthy that over the last 23 years, just 13 per cent of small-cap stocks graduated to mid-caps or large-caps, while 29 per cent tumbled into the micro-cap territory," said Hrithik Madan of Value Research.
What should retail investors do?
For an average investor, small-cap funds should not exceed 20-25 per cent of the overall portfolio.
In an equity-only portfolio, as per Kochar, around 40-50 per cent can be in large cap, 40-45 per cent in mid-cap and 10 per cent in small-cap funds.
Small and mid-cap firms are great sources of alpha generation because there is great heterogeneity in businesses, said Somaiyaa. Heterogeneity or the presence of diversity or variation amongst businesses is a pre-requisite for alpha generation.
Allocate small-cap funds judiciously in your portfolio. They can be a valuable addition but also come with higher risk and volatility. Over the long term, they can boost your overall returns, said Madan.
According to Aditya Vohra, Research Analyst at Equitymaster, investors should increase cash levels by cleaning up their portfolio with the valuation guidelines as follows:
Point to note: Standard deviations are usually used to find the Z-score of stocks. Z-score is a statistical measurement that describes a value's relationship to the mean of a group of values. In investing and trading, Z-scores are measures of an instrument's variability and can be used by traders to help determine volatility. If a Z-score is 0, it indicates that the data point's score is identical to the mean score. A Z-score of 1.0 would indicate a value that is one standard deviation from the mean. Z-scores may be positive or negative, with a positive value indicating the score is above the mean and a negative score indicating it is below the mean.
He also recommends exiting stocks of average/below-average quality companies and not committing funds where the valuations are not comfortable.
Who should sell their small-caps?
If your portfolio is 70 per cent in small-cap, it is a good time to get out, as per Value Research. "What I suggest you should do is think of what is the target allocation to small-cap, if not 20 per cent, maybe you have aggressive one - 40 per cent into small-cap. And it has gone up to 70 per cent or maybe you have two small-cap funds and it is 100 per cent, reduce it methodically to 40 per cent. Move that money to mid-cap and large-cap in a methodical way and do it on a month-on-month basis," said Dhirendra Kumar of Value Research.
But if small-caps are just 20-30 per cent of your portfolio, and you are investing for long, say 10 years, you need not sell your small caps. "mall-cap is not a bad thing, it is just that you should have the time-frame. If you're investing for any 10 year, small-cap will beat all other kinds of funds hands down, but if you are coming with a very short-term expectation, you will be very surprised in a very negative way," said Kumar.
Disclosure: Entities controlled by the Kotak family have a significant holding in Business Standard Pvt Ltd
