Why smallcaps should be part of your investment portfolio

The economy, as it revives and demand plays out, the full value chain across sectors will benefit, including smallcap companies. Smallcap companies are those that have a market capitalization of less than the 250th stock on the stock exchange. With economic data improving, corporate profitability of smallcap companies can be expected to improve. Investors looking for decent returns and having a higher risk tolerance can look to invest in smallcaps. When it comes to mutual funds, schemes that invest at least 65% of their portfolio in smallcap stocks can be deemed as smallcap fund.

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

Why do smallcap funds make for a good investment choice now? What should you watch out for before investing in them. Keep reading to know more.

Actively managed smallcap funds can outperform other segments of the market, especially during phases of economic recovery or growth. Historically too, the smallcap funds have managed to outperform other segments and generated alpha over the long term, as you can see from the graphs below:

Source: AceMF, PGIM India.

Source: AceMF, PGIM India.

Smallcap funds composite is an equal-weighted index of regular plans of all smallcap funds in the industry with an AUM of at least Rs 500 crore as of April 2021. Past performance may or may not be sustained in the sfuture and should not be used as a basis for comparison with other investments.

The slow pace of economic growth during the Covid period, in a way, only helped consolidate smallcap companies. As a result, smallcap firms with good managements have the potential to produce good results. Now, it may be a good time to make smallcaps a part of your portfolio.

The Whos & Whats of Smallcap Funds

Here are some of the salient features of smallcap funds that you as an investor should be aware of.

Fund Composition: Smallcap mutual funds invest at least 65% of their corpus in smallcap companies. The remaining 35% can be invested across the market capitalisation and also debt and money market securities. Smallcap funds provide opportunity to invest in emerging businesses, companies that have the ability to scale rapidly or companies which are established players in their respective sector in terms of market share, profitability, etc. Therefore, investors are exposed to PE style of investing in the early stages of these companies. Due to their significant operating leverage, smallcap companies can grow at a faster pace compared with established companies, as shown in the chart below

Source: Spark Capital, Capitalline.

Large, mid and Small Cap companies which are part of S&P BSE 500 index (ex-financials) have been considered for

above analysis.

Potential to Create Wealth: Smallcap funds, especially the actively-managed ones, have managed to outperform their benchmark indices. Actively managed funds have been more stable during volatile market conditions, when compared with the smallcap index. Also, these smallcap companies have the potential to become largecap or midcap companies in the future. So, in the coming periods, it is only natural that you make them a part of your portfolio, if you have a reasonable risk appetite.

Source: AceMF, PGIM India.

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

Diversified Portfolio: One of the key features of smallcap funds is the diversified portfolio they offer to investors. They choose to invest in new and emerging businesses, where largecap firms haven’t made inroads, yet. So, they give investors exposure to different, niche and emerging sectors like chemicals, textiles, sugar, construction and more. Though they invest in emerging businesses, smallcap funds choose market leaders, promising companies and those that have the ability to scale up rapidly in the respective segments, to mitigate investors’ risk as much as possible.

Expansion and Growth Potential: The under-researched and under-owned nature of the smallcaps gives them a lot of scope to expand in the future. The cut-offs for market capitalisation of smallcaps are also continuously on the rise. The Amfi, in December 2020, had classified smallcap companies as those with a marketcap of less than Rs 8,300 crore. However, within six months, the market-cap cut off for these smallcap companies had gone up to over Rs 11,000 crore. So, these companies have the potential to generate wealth for investors in the long run. The key is to stay invested in smallCaps throughout the full recovery or growth phase to reap the benefits from them.

Factors to consider, when you invest in smallcap funds

Aligning investors’ risk appetite with the smallcaps: Smallcaps are volatile and associated with high risk. So, only investors with a high risk appetite and an investment horizon of at least 5 years should invest in them. Staying invested in small caps for the long term is important to benefit from their potential.

Using SIP for smallcap investments in MFs: To ensure that investments in small caps don’t get eroded due to the volatility of the stock market, investors can invest in them through SIPs (systematic investment plans). These are regular investments made at periodic intervals to benefit from market volatility and rupee cost averaging. Staggered investments through SIPs can help overcome high valuations and market volatility and help deliver alpha over the long term.

Things to remember while investing in smallcap funds

• Good potential for growth and marketcap expansion in the future
• Provides diversified sectors for investment
• Actively managed smallcap funds have the potential to deliver alpha in your portfolio
• Good option of wealth creation for investors over the long term
• Good to invest in to fulfill long-term financial goals
• Consider for their risk adjusted returns Higher volatility associated with small caps stocks, comparatively
• Smallcap funds should complement an existing equity-oriented portfolio

Why is this the right moment to invest in smallcaps?

Smallcap funds invest in businesses that have a high potential for growth. As economic activity revives and demand picks up, well managed, smallcap companies may see potential upgrades in profitability and as a result decent re-rating of their business. Smallcap funds can provide an opportunity for growth by selecting such well managed smallcap companies. So if you have a decent risk appetite, smallcap funds might be ideal for you.

Smallcap funds are suitable to achieve long term financial goals and it would be smart to include them in your portfolio. Harness the potential of promising small cap companies by investing in smallcap funds through SIP or lump sum to create wealth and generate alpha over the long term.

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