How to play the small-cap opportunity

For investors looking to meet steep long-term financial targets, small-cap equity funds are an appealing asset class. But if you’re looking to allocate to this category, there never seems to be a good time to invest!

When markets are rising briskly, experts warn you to stay away from small-caps because they could bear the brunt of a crash. When markets fall, the same experts ask you to wait for the volatility to “settle down” before buying small-caps. However, the wait can be interminable as volatility usually settles down only in trending bull markets. So, how should investors approach this category?

Why you need them?

Let’s settle a basic question first. Do you really need small cap funds in your portfolio? Why not make do with large-cap, mid-cap or flexi-cap funds? You can. But by skipping small-cap funds, you would be missing out on a large opportunity set in the Indian markets.

For one, small-cap funds have a much larger universe from which to select stocks, than large-cap or mid-cap funds. As per SEBI’s market-cap classification, large-cap funds need to invest most of their portfolio in the top 100 stocks by market capitalisation. Mid-cap funds are required to invest mainly in the next 150 stocks.

All the remaining names below these top 250 fall into the small-cap category. The Indian listed universe has 5,000-odd stocks. Therefore, these rules substantially restrict the playing field for funds focused on large-caps and mid-caps, while small-cap fund managers have the field wide open.

Two, with all flexi-cap, multi-cap, large-midcap and hybrid funds investing in these stocks apart from dedicated large- and mid-cap funds, there is now a large amount of money chasing the top 250 stocks. This means limited opportunity for value discovery. The small-cap space does not face this constraint.

Three, a few years ago most Indian small-caps were obscure companies in inconsequential businesses that were yet to make it big. But the market-cap bar for small-caps has risen substantially in the last five years, resulting in this space featuring many quality names.  

As of December 2024, the top stock in the small-cap category was Apollo Tyres at a market-cap of ₹32,800 crore. The small-cap list featured nearly 300 stocks with a market-cap of over ₹10,000 crore. While the large- and mid-cap baskets feature concentrated exposure to sectors such as financials, IT and commodities, the small-cap universe is more diversified.

Therefore, if you want to make the most of Indian stock market opportunities over the long term, you need an allocation to small-cap stocks in your portfolio.

Which funds?

You can acquire this small-cap exposure either through flexi-cap funds or dedicated small-cap funds. The latter are a better choice for high-return seeking investors because flexi-cap funds can pare their small-cap exposures as they grow assets. Flexi-cap managers may also take active calls to reduce small-cap exposure when they perceive upcoming market volatility. These timing calls can sometimes go wrong. Whereas, when you own small-cap equity funds, you can decide on a fixed allocation to them and stick to it.

The other main question investors have is whether they should own active funds or passive ones simply mirroring small-cap indices. One of the main risks with small-cap investing is low long-term survivorship. If you pick a 100 small-cap stocks today at random, only one or two may make it to the mid-cap or large-cap league. Figuring out which small-caps of today will deliver wealth creation calls for professional stock-selection skills.

This apart, small-cap companies also face lower public scrutiny, making for higher governance risks in this space. In a bull market, the throw-a-dart approach delivers great results in the small-cap space, as investors focus more on price action than fundamentals or governance. But to make a success of small-cap investing over a 10-year-plus time frame, you need a seasoned manager with good stock-picking skills. The active route to small-cap investing is thus likely to deliver better results than the passive route.

Even within active funds, in the small-cap category, it is essential to stick with fund managers who have weathered previous bear markets and can filter stocks for governance, balance sheet and liquidity risks before adding them to their portfolios. In India, this means managers with a minimum 15-year record.

When to invest?

That brings us to the final question of when one should invest in small-cap funds. Investing in small-cap funds at the peak of a bull market can be very dicey because this category destroys value much more quickly than any other category.

On a rolling one-year return basis over the last 15 years, the Nifty Smallcap 250 lost 41 per cent of its value in its worst year, while gaining 136 per cent in the best year. In contrast, the Nifty Midcap 150 lost 32 per cent in its worst year and the Nifty 100 fell only 29 per cent. The Nifty Smallcap 250 has delivered losses 35 per cent of the time in the last 15 years on a rolling one-year basis, while the Nifty100 has made losses only 17 per cent of the time. On average though, the Smallcap index delivered annual rolling returns of 19.5 per cent versus the Nifty100’s 14 per cent.

This makes timing a very important component of your small-cap fund strategy and suggests the following.

In the recent market fall, the Nifty Smallcap 250 has corrected about 14 per cent from its peak. This matches the Nifty100 decline. Given that there has been no bear market in the past where small-caps have corrected less than large-caps, there could be further downside in store for the category.

On valuations, the Nifty Smallcap 250 trades at a Price Earnings multiple of about 32 times compared to 22 times on the Nifty100 and 40 times on the Nifty Midcap 150. Thus small-caps offer a better bet than mid-caps today, but are not exactly in value territory.

Overall, if you don’t have a small-cap fund allocation in your portfolio, you can start investing now, because some of the correction is already done. But given the possibility of further downside, you should either take the SIP route or divide your allocation into three parts and invest one portion now, while looking to deploy the rest on a further 10-15 per cent fall in the Smallcap index. Do ensure that you give your small-cap funds a 10-year horizon to deliver results.