Getting the jitters about mid and small-cap funds now is perfectly normal, whether it is because of their rapid rally or since the headlines are urging caution. After all, the Nifty Smallcap 250 and the Nifty Midcap 150 have soared 30% and 27% in the year-to-date; the Nifty 50’s 9% return is a pale comparison. So, should you heed those concerns, make hay while the sun shines, and get out of mid and small-caps?
Mounting concerns
The concern over the mid and small-cap space has been mounting for multiple reasons. There is steep outperformance by the two segments over the large-cap space. The past three months have seen a flat Nifty 50, but the Nifty Midcap and Smallcap indices have yet rolled on with 12% and 14% gains.
This has also sent valuation multiples of stocks in these market cap segments well ahead, leaving less room for further rally.
There have been very strong inflows into mid and small-cap funds in June-August even as categories such as large-cap and focused saw net outflows. Some small-cap funds have themselves shut off lump sum investments and limited SIP inflows. And now, there is a new Israel-Palestine conflict that has caused fresh worries over crude oil, global inflation and other possible fallouts of yet another geopolitical tension point.
The mid and small-cap indices fell harder than the Nifty 50 at the time of writing this article, after news of the geopolitical tension. All these issues raise the dilemma of whether to exit mid and small-cap space.
Essential component
It’s important to look at the mid and small-cap segments in terms of potential and from a portfolio perspective. In this light, the mid and small-cap space is an essential component of your mutual fund portfolio for three reasons.
One, the large-cap space has capped return potential and returns may not be at the level of yore. The Nifty 50 index has about 61% weight in just three sectors — financials, IT, and FMCG.
All three are not high-growth sectors and growth is more or less linked to nominal GDP growth rates. Other index components are also conglomerates or very large enterprises that don’t scream high growth, either. Two, the high sector concentration in this largecap space means that the next set of opportunities as the economy grows and broadens belongs to sectors outside the index — and so, you need to invest beyond it to access those.
There are several such pockets of growth. The rise in manufacturing through government initiatives is an example.
Another lies in R&D and manufacturing in the pharmaceutical, agriculture and chemicals spaces. These are also spurred by the China+1 shift. Yet another example is the growth in discretionary consumption and changing lifestyle habits.
All these opportunities can be found in companies in the lower rung of market capitalisations. This apart, a more conducive market environment can bring in hitherto unavailable opportunities through IPOs.
Finally, the Indian market is made up of several regional markets, where tastes differ, markets differ and competition differs. These specific opportunities, too, are found more in mid-and-small caps.
For example, sectors such as banks and NBFCs, jewellery, fashion, hospitals, food, and so on have region-dominant players. Nor does the regional focus cap growth potential, given the size of these micro-markets.
Therefore, moving down the market-cap curve is needed to capture up-and-coming and new sectors as the economy expands and taps different markets. All this also bodes well for companies to scale up the value chain, helping them graduate from small to mid to large caps.
Need for prudence
The concern with mid-caps and small-caps is that falls are swift, steep, and take longer to recover than the large-cap basket. To offer some perspective, the Nifty’s fall from its 2020 high to the COVID low was about 38%. The Nifty Midcap and Smallcap indices had already corrected in 2019, after hitting a peak in 2018. From their 2018 peak, the two indices dropped about 44% and 61%. Not just that, the Nifty’s post-COVID rally was sharper than the small-cap index; it’s only over the past year that small-caps have well and truly caught up. What is really needed in the mid and small-cap market segment is prudence.
If your allocation to mid and small-cap funds is high, well, it certainly is time to be afraid and bring it down to safer levels by doing a simple rebalancing and bringing allocation back to your initial level.
If your allocations are within reason, there’s really no need for anything other than letting your SIPs continue.
Now is also not the time to be making lump sum investments in these funds. The SIP route will let you both maintain your allocation to high-returning market segments and will let a market fall, if it comes, benefit you.
(The writer is Co-founder, PrimeInvestor.in)