Small and midcap equity mutual funds have been very popular with retail investors over the last three years or so. The popularity of small and midcap funds among investors can be ascribed to the performance of these funds;in the last three years funds in the small and midcap equity category gave on average around 19% annualized returns, while funds in the large cap category gave around 10% returns. In the last 12 months, when market conditions were favourable, small and midcap funds category gave average 26% returns while large cap funds category gave 18%.

Valuation gap between Large Cap and Midcap Segments

At the same over the past 18 months or so, many stock market experts and fund managers were concerned about the valuation gap between large cap and midcap stocks. In normal circumstances large cap stocks enjoy a valuation premium over midcap and small cap stocks. Four years back (in July2013) the P/E ratio of Nifty (which represents the 50 largest market cap stocks) was 17.8, whereas the P/E ratio of Nifty Midcap Free Float 100 (a benchmark of midcap stocks) was 16.4. When the market started rallying from early 2014 midcap stocks outperformed large cap stocks. Usually in bull markets, midcap stocks outperform large cap stocks. However, now(early July 2017), the P/E ratio of the Nifty Midcap Free Float 100 (a benchmark of midcap stocks) is 31.7, while P/E ratio of Nifty is 24.6. This is an unusual situation (midcap stocks trading at a valuation premium to large cap stocks), but this situation has persisted for around 2 years now.

Two Divergent Opinions on the Valuation Gap

The conventional view is that, the valuation premium enjoyed by midcap stocks is an unusual situation. As per the conventional wisdom large cap stocks are better researched than midcap stocks and analysts have better visibility of future earnings growth trajectory of large cap stocks. Earnings of large cap companies are perceived to be less volatile (more stable) compared to small cap and midcap companies. Market experts and fund managers who subscribe to the conventional thinking, therefore, believe that, sooner or later, midcap stocks will go through a period of consolidation before the valuation gap with large cap stocks normalizes.

The non-conventional school of thought regarding relative valuations of large cap stocks and small / midcap stocks is that, the valuation premium currently enjoyed by small / midcap stocks reflects a paradigm shift of how the market perceives these stocks and that the current situation is the “new normal”. They argue that, owing to large FII ownership of large cap stocks, these stocks are subject to global liquidity ebbs and flows. FII ownership in small / midcap stocks, on the other hand, is quite small and therefore, these stocks are more insulated from global liquidity ebbs and flows.

It is too early to say, whether the valuation premium enjoyed by midcap stocks constitute a paradigm shift or is just a transient phenomenon till the situation normalizes. In Advisorkhoj, we think that, over a very long investment period, small midcap equity funds can outperform large cap equity funds and generate higher returns for investors. At the same time, historical data has shown that, midcap funds, their stellar performance in the last 3 years notwithstanding, are more volatile than large cap funds. Investors need to have a higher risk appetite for investing in midcap funds. Therefore, in our view, investors should understand the risk / return characteristics of these two asset categories and make investment decisions that are best suited for their financial goals and risk appetites.

Differences between large cap and small/midcap funds

• As the name suggests, large cap funds invest in large cap companies. These are companies which have a market capitalization of over Rs 20,000 Crores. Large cap companies are large and well established companies with strong market shares. These companies are generally considered to be safer investments compared to mid cap and small cap companies. As discussed earlier, large cap equity mutual funds are less volatile than small and midcap equity mutual funds.


• Small and mid cap equity mutual funds invest primarily in mid and small cap companies across different industry sectors. Mid cap companies are typically companies which have a market capitalization ranging from Rs 5,000 Crores to Rs 20,000 Crores. Small cap companies have market capitalization of less than Rs 5,000 Crores. Mid cap companies tend to be less well known and are thought to be more risky than large cap companies. Small cap companies, which lie at the extreme end of the market capitalization spectrum, are thought to be more risky than midcap companies.


• Small and midcap companies tend to be less researched and therefore there might be a valuation gap between its current market price and its fair value. Often these companies are undervalued towards the end of the bear market cycle and the beginning of a bull market. Hence good small and midcap stocks tend to do better than large cap stocks in bull markets. On the other hand, these stocks can be hit very hard in bear markets.


• A unique feature of Indian equity market is that, Foreign Institutional Investor (FII) activity (buying or selling stocks) constitute a large percentage of trading volumes in large cap stocks. FII activity is influenced by a number of global factors like liquidity flows into emerging markets, relative risk perception of different asset classes, foreign exchange fluctuations, interest rate actions of the US Federal Reserve and other central banks etc. Since FII activity is usually limited to large cap stocks, these stocks are more researched compared to small and midcap stocks. That is why in the bear market of 2015 / early 2016 small / midcap stocks and funds outperformed large cap stocks and funds.


• While small and midcap funds are more insulated from FII activity, they have their own set of challenges in the Indian context. Free float shares (shares not held by the promoter, related parties, management etc) of midcap companies are relatively a small percentage of the total number of shares outstanding in India. When a small / midcap fund receives large AUM (Assets under Management) inflows, the fund manager may not find sufficient free floating shares of high quality midcap companies in the market to invest the investor’s money. In such situations, the fund manager is forced to invest in large cap stocks.


• The low percentage of free float shares of small and midcap companies in India also causes issues, when the fund manager is faced with redemption requests. In bad market conditions (like we had in 2008) fund managers may not find enough buyers in the market to meet the redemption request. In such a situation, the fund manager may be forced to sell shares of his high conviction companies, which is not in the best interest of the investors who remain with the fund.


• We have seen that, investors (especially in India) are more tolerant of issued faced by large cap companies and less tolerant with mid cap or small cap companies. In the past, especially in the stock market crash of 2008, investors panicked and exited small / midcap companies facing even minor problems. Once a midcap or small stock goes out of favour with investors, it can remain subdued for a long period of time. Consequently, performance of mutual funds which invest in these types of stocks can suffer because, even if the fund manager wants to sell the stock, he or she may not find sufficient demand in the market.


• Over the last couple of years, due to outstanding returns delivered by small and midcap funds, these funds have seen huge inflows from retail investors. As a result, the sizes of some of these small and midcap funds grew rapidly. For reasons discussed earlier, Assets under Management (AUM) beyond a certain size, makes it challenging for the fund manager to stick to the investment mandate of the scheme. We have seen that, from time to time, small / midcap funds restrict fresh AUM flows, either by putting a cap on lump sum investments or by stopping fresh subscriptions (either lump sum only or both lump sum and SIP) altogether.

How to decide between large cap and midcap funds?

Most financial planners recommend that large cap and diversified (flexi-cap / multi-cap) equity funds should form the core of an investor’s long term portfolio. Investors can also add small and midcap funds to their portfolio to enhance the overall returns. The relative allocations of large cap versus midcap funds should depend on your risk appetite and investment horizon. Here are a few general guidelines:-

• If you are a young investor, you can have substantial allocations to small / midcap funds relative to large cap funds (as high as 50:50 or even more). On the other hand, if you want stability in your portfolio near the redemption horizon, then large cap funds are more suitable for your portfolio.


• While equity (large cap or midcap) investors should always have long investment horizon, if you are investing in midcap funds, you should be prepared to remain invested to at least 5 to 7 years, if not longer. If you cannot commit yourself to the suggested investment horizon, you should invest in large cap or diversified (flexi-cap / multi-cap) equity mutual funds.


• There are some thumb rules, which suggest 70 - 80% allocation in large cap funds and 20 - 30% midcap funds depending on your risk tolerance. In my view, you do not have to subscribe to these thumb rules; as long as you understand the risk return characteristics of small / midcap funds relative to large cap funds, you can have the allocation which is best suited for your investment objectives.


• For small and midcap funds, it makes more sense to invest in multiple funds, so that you have a diverse selection of small and midcap stocks in your portfolio. For example, if you choose one or two large cap funds for 70 - 80% of your equity portfolio, it may makes sense to select two or three small / midcap funds for the balance 20 - 30% allocation in your equity portfolio. This is because different fund managers have different filters for selecting stocks. By investing in multiple small / midcap funds, you will be able to select a wider variety of stocks which will have a higher potential to do well in the future, in addition to diversifying your portfolio risks.

Conclusion

In this blog we have discussed, the differences between the performances of large cap and small / midcap funds. An efficient mutual fund portfolio consists of a combination of large cap, flexi cap and small/midcap mutual funds, based on your investment objectives. If you are a savvy investor, you can switch between large cap and midcap funds, based on market conditions to get enhanced returns. However, if you are not, then you should stick to your investment plan, continue to monitor the performance of your investment portfolio and make adjustments as necessary. A thoughtfully constructed mutual fund portfolio can give excellent returns over different investment horizons, depending on your own financial goals.