Small cap stocks: why small caps should be part of your investment portfolio

The economy, as it recovers and demand changes, will benefit the entire value chain across all industries, including small cap companies. Small-cap companies are those whose market capitalization is less than the 250th stock on the stock exchange. With improving economic data, the profitability of small cap companies can be expected to improve. Investors looking for decent returns and with a higher tolerance for risk may look to invest in small caps. When it comes to mutual funds, programs that invest at least 65% of their portfolio in small cap stocks can be considered small cap funds.

To give perspective, there are over 4,500 small cap companies listed on the stock exchange in India. Although they have the potential to give investors good returns, it is advisable to stay invested in them for the long term in order to mitigate the risks.

Why are small cap funds a good investment choice now? What to watch out for before investing in it. Read on to find out more.

Actively managed small-cap funds can outperform other market segments, especially during periods of economic recovery or growth. Historically too, small cap funds have managed to outperform other segments and generate alpha over the long term, as shown in the charts below:


Source: AceMF, PGIM India.


Source: AceMF, PGIM India.

The Small Cap Composite is an equally weighted index of the regular plans of all small cap funds in the sector with assets under management of at least Rs 500 crore in April 2021. Past performance may or may not be sustained in the future. and should not be used as a basis for comparison with other investments.

Slow economic growth during the Covid period, in a way, only helped consolidate small caps. As a result, small cap companies with good management have the potential to produce good results. Now might be a good time to incorporate small caps into your portfolio.

The Whos & Whats of small cap funds

Here are some of the main features of small cap funds that you as an investor should know about.

Fund composition: Small-cap mutual funds invest at least 65% of their corpus in small-cap companies. The remaining 35% can be invested across the entire market capitalization as well as in debt and money market securities. Small cap funds offer the opportunity to invest in emerging companies, companies that have the capacity to scale quickly or companies that are established players in their respective industry in terms of market share, profitability, etc. Therefore, investors are exposed to the PE style of investing in the early stages of these businesses. Because of their high operating leverage, small cap companies can grow at a faster rate than established companies, as shown in the chart below.


Source: Spark Capital, Capitalline.

Large, mid and small capitalization companies included in the S&P BSE 500 index (ex-financials) have been taken into account for

above analysis.

Potential for wealth creation: Small cap funds, especially actively managed ones, have managed to outperform their benchmarks. Actively managed funds have been more stable in volatile market conditions compared to the small cap index. In addition, these small cap companies have the potential to become large or mid cap companies in the future. So, in the periods to come, it is only natural that you build them into your portfolio, if you have a reasonable appetite for risk.


Source: AceMF, PGIM India.

Smallcap Funds Composite is an equally weighted index of the regular plans of all small cap funds in the sector with an Aum of at least Rs 500 crore in April 2021. Past performance may or may not be sustained in the future and will not should not be used as a base. for comparison with other investments.

Diversified portfolio: One of the main characteristics of small cap funds is the diversified portfolio they offer to investors. They choose to invest in new and emerging companies, where large cap companies have yet to make inroads. Thus, they provide investors with exposure to different niche and emerging sectors such as chemicals, textiles, sugar, construction, etc. Although they invest in emerging companies, small cap funds choose market leaders, promising companies and those with the capacity to grow rapidly in the respective segments, in order to mitigate investor risk as much as possible. .

Potential for expansion and growth: The under-researched and under-owned nature of small caps gives them plenty of scope to grow in the future. The market capitalization thresholds for small caps are also constantly increasing. Amfi, in December 2020, classified small-cap companies as those with market capitalization below Rs 8,300 crore. However, within six months, the market capitalization of these small cap companies had grown to over Rs 11,000 crore. Thus, these companies have the potential to generate wealth for long term investors. The key is to stay invested in small caps throughout the recovery or full growth phase to reap the benefits.

Factors to Consider When Investing in Small Cap Funds

Align investor risk appetite with small caps: Small caps are volatile and associated with high risk. Thus, only investors with a high risk appetite and an investment horizon of at least 5 years should invest in it. Staying invested in small caps over the long term is important in order to take advantage of their potential.

Using SIP for Small Cap Investments in MFs: To ensure that investments in small caps do not erode due to the volatility of the stock market, investors can invest in them through SIPs (systematic investment plans). These are regular investments made at regular intervals to take advantage of market volatility and average rupee costs. Laddered investments through SIPs can help overcome high valuations and market volatility and help generate alpha over the long term.

Things to remember when investing in small cap funds

  • Good potential for growth and expansion of market capitalization in the future
  • Provides diversified sectors for investment
  • Actively managed small cap funds have the potential to generate alpha in your portfolio
  • Good option for building wealth for long-term investors
  • Good to invest to achieve long-term financial goals
  • Consider their risk-adjusted returns Higher volatility associated with small-cap stocks, compared
  • Small-cap funds should complement an existing equity-focused portfolio

Why is this the right time to invest in small caps?

Small cap funds invest in companies with high growth potential. As economic activity picks up and demand increases, well-managed small-cap companies can see potential improvements in their profitability and, as a result, a decent revaluation of their business. Small-cap funds can offer a growth opportunity by selecting such well-managed small-cap companies. So if you have a good appetite for risk, small cap funds might be ideal for you.

Small cap funds are suitable for achieving long term financial goals and it would be a good idea to include them in your portfolio. Harness the potential of promising small cap companies by investing in small cap funds through SIPs or lump sums to build wealth and generate alpha over the long term.

(Ajit Menon is CEO of PGIM India Mutual Fund. His views are his own)

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