Why mid & small caps matter in a market at peak

With the equity markets moving towards higher levels in 2023, many investors are wondering where to find value and growth amidst the optimism. While largecaps often dominate headlines and mainstream investor focus, the mid and small cap segments have also attracted serious attention and fund flows. According to the Association of Mutual Funds in India, midcap funds received an inflow of Rs 1,623 crore in July, while not so surprisingly, smallcap funds added Rs 4,171 crore to their assets under management. Large cap funds witnessed an outflow of Rs 1,880 crore during the same period. Due to the significant nature of inflows, especially in small cap funds, a few schemes have stopped accepting fresh inflows. For a long term investor, there are still merits in investing in mid and small cap funds, as we will see:

Time correction and earnings catchup

Both midcaps and smallcaps have gone through a period of more than 18 months of time correction. BSE midcap touched 26,700 in October 2021, then languished at lower levels till the start of 2023. It was only in May 2023 that it crossed its previous highs. The same is true with BSE smallcap, which also exceeded its previous all-time highs in May 2023. In all this period, their earnings have improved, so while the index levels look high, in price to earning ratio (PE) terms they are not overvalued. In Oct 2021, BSE midcap had a PE of 34, which is now at 25. Similarly, for BSE smallcap the PE was 45 in Oct 2021, which has now come down to 28. This makes it clear that the earning growth is ahead of the growth in index and should be comforting for investors. 

Higher returns with some extra volatility

If we look at historical data, midcap funds and smallcap funds have delivered a decent alpha when compared to largecap funds, so while volatility in midcaps and smallcaps can't be eliminated, it has compensated by delivering higher returns. Mid and small caps have not only generated a higher return on a point-to-point and rolling basis, but they also have a much better Sharpe Ratio, meaning for every unit of risk taken by them they have generated excess return.

Growth tailwinds

One of the primary reasons to consider mid and small cap stocks in a growing market is their agility and growth potential. Smaller companies often have greater room for expansion as they operate in less saturated markets. Their ability to pivot quickly and adapt to changing circumstances can lead to significant growth opportunities.

The strong uptick in manufacturing activity in India, courtesy of “Make in India” and “China Plus One” themes, are the most significant tailwinds for mid and small cap companies. 

Undiscovered gems and new themes

Many largecap stocks may be trading at stretched valuations in a record-high market, leaving little room for substantial upside potential. However, mid and small cap stocks often fly under the radar of mainstream investors and analysts, leading to potential mispricing and undervaluation. Many of today’s largecaps were mid and small caps and were unearthed by mutual funds 15 odd years back. 

Also, some companies are involved in niche businesses and unique themes that are considered the sunrise sectors. There are many mid and small cap companies involved in drones, artificial intelligence, IoT solutions, satellite navigation and wealth management, just to name a few without making any recommendation. These kinds of opportunities are difficult to find in the largecap space.

Less institutional coverage 

Largecap stocks tend to attract significant attention from institutional investors and analysts. As a result, their stock prices may be influenced by herd mentality, leading to periods of irrational exuberance or unjustified pessimism.

Mid and small-cap stocks, on the other hand, often have less institutional sell-side coverage, allowing mutual funds to make decisions based on their research and analysis, rather than being swayed by the market sentiment. Bottom up stock picking and a keen eye on companies with free cash flows, instead of profits, become the deciding factors for these funds to deliver on their promise.

Investing is like a Marathon and investing in mid and small caps is akin to an ultra marathon, which takes a longer time and a lot of preparation. Therefore, investors should exercise due diligence, conduct thorough research, and consider their risk tolerance and asset allocation while incorporating mid and small cap funds into their investment strategy. Mid and small caps are fraught with risk as well and therefore the best way to participate is by taking a well-diversified portfolio and investing amounts regularly, instead of taking a one-time lump sum. By doing so, they can potentially uncover hidden opportunities and create significant alpha for the portfolio. 

(The author is the founder and chief information officer of Valtrust)