When the market hits a new high, it tends to chase the value stocks or those lower at the pyramid but with high growth potential as well as has not much run up compared to the large cap companies, Mukesh Kochar said
The small cap funds continued to attract inflows for the seventh consecutive month. The segment received the highest inflows in July among all equity categories. The small cap funds received a total inflow of Rs 4,171 crore in July. Inflows into small cap funds touched a record high of Rs 5,471.75 crore in June 2023, according to data released by the Association of Mutual Fund (AMFI).
In the first quarter of the financial year 2024, the small cap segment saw net inflows of Rs 10,937 crore, the highest ever quarterly inflows for the category. This was also the ninth consecutive quarter in which the category witnessed net inflows. The assets under management (AUM) for the small cap category hit its peak of Rs 1.68 lakh crore in the quarter ended June.
According to AMFI, the inflows into category declined by around 24 per cent but it continued to attract investors. The small cap segment accounted for 55 per cent of the total inflow into the equity category in July.
In an exclusive conversation with Outlook Business, Mukesh Kochar, National Head-Wealth Management, AUM Capital Market discussed the reasons behind the recent surge of inflows in small cap segment and various aspects around the trend.
Why are small cap stocks witnessing massive growth?
According to Kochar, this phenomenon can be attributed to the way the market behaves. When the market hits a new high, it tends to chase the value stocks or those lower at the pyramid but with high growth potential as well as has not much run up compared to the large cap companies. This pattern repeats itself whenever the market reaches new peaks.
In addition, the Securities and Exchange Board of India (SEBI) redefined the classification of small, mid, and large-cap companies. This reclassification, sets top 100 companies by market cap as large cap, 101-250 as mid cap and 251 onwards as small cap. The market cap of small cap companies ranges between Rs 22,000 crore to Rs 8,500 crore, which are reasonably large and matured companies. So, the type of companies available in the small cap segment in recent times gives comfort to investors and fund managers due to their high rate of growth and rising stock prices.
What are the factor driving higher gains in Small Cap Funds?
a) Massive Fund Flow and Investor Interest
Over the last year, the small-cap space has seen a massive influx of funds, with approximately 22,000 crore invested solely in mutual fund schemes. Beyond mutual funds, other investment vehicles like Portfolio Management Services (PMSEs) and Alternative Investment Funds (AIFs) are also oriented towards small-cap stocks. Family offices, High Net Worth Individuals (HNIs), and individual retail investors are also actively participating in this trend. HNIs often allocate around 20-25 percent of their equity to small-cap stocks, further boosting their demand, said the analyst with over 20 years of experience in analyzing market trends.
b) Improved Company Performance
Small-cap companies have showcased notable growth in their financial statements, coupled with debt reduction strategies. Government initiatives like the Production-Linked Incentive (PLI) scheme have helped enhance their overall performance. These factors contribute collectively to the upward trajectory of small-cap stocks and funds.
What are the most preferred sectors by small cap funds?
Kochar said many small cap funds are heavily invested in 4-5 sectors such as auto components and ancillaries, Public Sector Banks (PSBs), and construction companies. These sectors seem to offer favorable prospects for growth
For how long this trend is likely to continue?
According to Kochar, despite the substantial run-up in small-cap stocks in recent months, there remain untapped opportunities within the space. Out of the 250 small-cap stocks, several are yet to experience significant valuation growth. Many companies possess untapped growth stories, presenting potential investments. However, retail investors should exercise caution, as markets can correct by 5-7 percent at any point. Market cycles are inherent, and being prepared for both upswings and downturns is essential.
He suggested that one should stick to fundamentals of investing and be a disciplined investor instead of trying to play the momentum or rumors and that will pay off.
Why some AMCs are declining fresh lump-sum investment in small-cap schemes?
Asset Management Companies (AMCs) often find it challenging to manage large-sized small-cap funds due to liquidity constraints. Small-cap stocks tend to have lower trading volumes, leading to substantial price impact when larger investments are made.
Explaining through an example, Kochar said, Nippon Small Cap Fund, which boasts an impressive AUM of Rs 31,000 crore. Similarly, the SBI Small Cap Fund (SCF) holds an AUM of approximately Rs 18,000 crore. If Nippon intends to acquire a 5 per cent weightage in a specific company for their portfolio this would necessitate a purchase of Rs 1,500 crore worth of shares from that particular company as we are talking about the companies ranging between Rs 8,500 crore and Rs 22,000 crore of mcap. Consequently, executing a transaction involving even 5-7 per cent buy/sell of shares could be challenging in small cap space.
Additionally, fund managers maintain conviction in specific stocks, often adhering to a limited set of companies. This selection process demands caution, as the nature of small-cap stocks requires thorough research.
Why most fund houses have been selective in expanding their exposure despite the increase in fund inflows?
When it comes to selecting small cap stocks, fund managers have to be more cautious compared to choosing large cap stocks because of the need for increased attention and prudence in the small cap space. Each fund manager follows a unique approach to stock selection, which can range from favoring value stocks to being growth-oriented or a mix of value and growth strategies. Some managers target turnaround stories, while others wait for a more visible narrative.
Fund managers typically invest in high conviction stocks that align with their individual strategies. While they do explore new stocks, the turnover rate is generally very low. The addition of new stocks might comprise only 5-10% of the overall portfolio, which has minimal impact on performance.
However, the case of Nippon stands out, with an average stock holding of 70-75 in small cap funds. Nippon's approach of holding 179 stocks in these funds has been successful due to their incremental size, resulting in impressive performance. It's important to note that not all funds can replicate this strategy successfully.
What investment strategy investors may follow when investing in Small Cap Funds?
Investors should be aware that small-cap funds carry high volatility. To navigate this, adhering to certain rules is crucial. Opting for Systematic Investment Plans (SIPs) can help reduce volatility risks. Spreading investments over time through SIPs or Systematic Transfer Plans (STPs) is a prudent approach.
Regular top-ups during market downturns can enhance returns over the long term, generating extra alpha compared to the market. Diversification is also important. Instead of focusing on a single top-performing scheme, investors should allocate their investments across 2-3 schemes and diversify their exposure across different funds.
In conclusion, the remarkable growth of small-cap funds is driven by several factors, including market behavior, regulatory changes, fund flows, improved company performance, and sector preferences. While the trend has been favorable, cautious investment strategies, such as SIPs, top-ups, and diversification, are essential for investors aiming to capitalize on the potential of small-cap funds. Remember, while the road may be promising, navigating it requires careful consideration and adherence to fundamental investment principles.