Most of the people, I speak with, have either fallen the victim to hype that “The small cap funds give the best returns over the long investment horizons” or invested in small cap segment due to return chasing mindset as they saw 80% returns in year 2014 or 60% returns in 2017. Now the funds have fallen between 20-40% since the start of Jan 2018, they are trying to understand what did they do wrong. Today, We will try to understand if one should invest in small cap funds and if we should, then what are the checks & balances to keep in portfolio.
What are small cap companies?
Value of the company is represented by their market capitalization (No of Shares x Price of the share). The biggest company in India it is TCS or Reliance industries, who has market valuation of approximate 700,000 Cr, are known as Large cap/ Giant cap stocks. The small cap stocks are the stocks ranked 251-500 based on market capitalization and it ranges from 100 Cr. to 7,000 Cr.
People share the hypothesis that “You need to catch the company young to get great returns so small cap companies are great hunting ground.” This probably is right but we fail to realize that it is also the lot where lot of companies are fallen angels, which were the great companies of yesterday and being in this segment does not mean you are buying a winner alone.
Small Cap index Performance vs Mid Cap/ Large Cap index
As per the clear demarcation by SEBI that Top 100 companies are defined as Large Cap, Companies ranked 101-250 are defined as Mid cap and 251-500 as Small Cap. Let us try to compare these three categories to see if the Small cap category actually outperforms the other two or it is just a myth. We have used the Total Return Index for this analysis, which is available for Small Cap 250 TRI since 1 Apr, 2005. This gives us a history of 14.5 years to analyze and compare. If we have invested 1,000 Rs in Nifty Small Cap 250 TRI on Apr 1, 2005, this would have grown to 5,657 Rs as of 30 Sep 2019, a whopping 5.6x returns. Though the same money in Nifty Mid cap 150 TRI would have grown 7.1x and in Nifty 100 TRI 6.9x.
Some will argue that it is due to recent corrections, let’s try to Analyze their 1 yr Rolling Returns. Blue line in the below chart represents the Nifty Small Cap 250 TRI returns, you will notice that it is having a higher returns as well as lower return points which means that it is more volatile.
Mean/ Median value for 1yr rolling returns for Nifty Small Cap are 11 – 11.5% vs Nifty 100 returns of 13 – 14% and Mid Cap returns of 14 – 14.5%. This means on an average Small Cap do not out-perform but under-perform the Large/ Mid cap counter parts. This does come as a shocker to lot of investors as they always thought the reverse in true. Let me elaborate further as why the mean values for small cap index returns are smaller.
The return distribution (how many times the 1 yr rolling return has been in the specific range) chart above will show you that Small cap returns have a wider swing from the returns as bad as less than -70% to as high as more than 150% in a year. Though on average Small cap have -ve returns 36.4% times vs 29.7% for Mid Cap and 20.2% times for Large Cap. This drags down their average returns and also makes it more risky. The same is also represented in terms of volatility which lot of people want to look for but 99% don’t understand it or know how to interpret it. They take it as a measure of risk for them, yes it is risky as volatility for Small cap index is 41.1 vs 40.6 for Mid cap and 35.4 for Large cap.
If you still want to argue that there is a possibility of getting 150%+ return in a given year and i should take that chance, i can present one more observation which might convince you. There are 47% cases when Small cap returns beat Large cap returns by 1% or more in a given 1yr period, while if lags in 50% cases to large cap by 1% or more. Therefore, you can get a very good portfolio just sticking with Large & Mid Cap space.
If so far, I am not able to convince you and you still want to bet your hard earned money into the Small cap category then at least do the following and you will be rewarded or will avoid the risk to your portfolio by large extent.
- DO NOT EVEN THINK OF BUYING A SMALL CAP INDEX FUND
- KEEP THE ALLOCATION TO SMALL CAP CATEGORY <10% OF EQUITY PORTFOLIO
- DO NOT INVEST IN SMALL CAPS UNLESS YOUR TIME HORIZON IS OF 7+ YEARS
- STICK TO CONSISTENT HISTORIC PERFORMERS IN THIS CATEGORY
You can check my pick of small cap funds for those brave souls who want to do some daring at Category Review: Small Cap funds. Do share your feedback and Questions to us. If you like this analysis, don’t forget to subscribe our blog. Happy investing!!