Aniruddha Naha: Small caps with active management have potential over the long term

The stock markets are currently very volatile. In your opinion, is it the right time to invest in midcap and small cap funds?

The markets might appear stretched in general, but there are some decent opportunities to be had across the entire capitalization range. Investors who enter with a 3 to 5 year time-frame should be able to benefit from the rising demand and profits for corporate India. Although it might be harder to be positive on sectors outright than last year, there are still a lot of opportunities at a company level, and stock pickers will benefit from this.

What should be the long-term strategy of investors?

It is positive for the economy that vaccine availability has increased and that Covid second wave numbers are under control. Steel, cement, logistics and B2B segments are doing very well. With lower Covid numbers and higher vaccines, B2C segments such as retail chains, hotels, malls, and multiplexes will open up over time. In terms of growth, there is demand across industries, which is good news for the companies. Eventually, the markets will capture a growth in profits. In the longer term, we remain positive about the markets, even though the near term might be volatile given a strong performance in the past year.

In the next three to five years, financialization, digitisation and consumption will be dominant themes in a developing country like India. As the per capita GDP exceeds $2000, consumption should increase. 

There will also be a formalization of the economy and people will move away from cash to more formalized banking channels. Internet penetration will lead to digitisation with the acceptance of digital platforms for different needs.

In the small cap funds segment, which sectors are performing well?

The 2nd wave of Covid has taken its toll on the economy. B2B businesses like cement, steel, logistics, etc. have not been impacted as much as B2C businesses like retail chains, hotels, restaurants. As the economy opens up, one should see B2C businesses rebound. By the beginning of FY23, a vaccinated population should help the economy return to normal. Because small caps are more stock-specific than sectors, commenting on sectors will be challenging. There are stocks across sectors that are doing well and should generate decent returns.

What are the points investors should take note of while investing in small cap funds?

Over the long term, actively managed small caps can generate alpha. Furthermore, small caps provide exposure to many sectors like textiles, construction, chemicals, IT product companies, and real estate, among others, which are underrepresented in major indices. The segment is underowned and underresearched, which offers the opportunity to generate alpha over time. Small caps are volatile and may experience deeper drawdowns compared to large caps or midcaps. Compared to their history, small caps have cleaner balance sheets and stronger cashflows, hence they have a better chance of surviving and exhibiting better resilience. With time, good small cap companies have graduated to midcap companies and even large cap companies.

A new investor must be aware of the risks associated with an asset class before investing. Segments like small caps are prone to higher volatility within an asset class. To gain a better understanding of the underlying asset class, investors must understand the extent of notional losses that can occur after investing. If they become comfortable with volatility, they will be able to sit through volatile markets and even add during volatility to generate returns over a longer period of time.

What percentage one should invest in the small cap funds?

Investments in small caps will vary according to the investor’s risk return profile and time horizon. Risk-averse investors should avoid the segment. If they are looking to receive some risk-adjusted returns, small cap investors could invest around 10-15% of their portfolios. However, there is no one-size-fits-all solution. Investors should consult a financial advisor to get the right asset allocation mix.

Why do investors need to look at small cap funds in their portfolio?

In the last year, small cap stocks generated very strong returns and therefore it is wise to temper expectations in the next few years. However, the positive returns came after a year in which the small cap index corrected close to 50%, so over the past few years the returns have been more realistic. Small caps have underperformed large caps over the past 3 to 5 years. Investors looking to invest in small caps must have a 5-year view, and in such a case, should be able to achieve good risk-adjusted alpha.

(Disclaimer: The article originally appeared on Financial Express on 9th July, 2021 authored by Sanjeev Sinha)