Mid-cap and small-cap segments in the Indian equity market have seen significant price increases, offering both risks and potential gains. Navigating these segments demands economic insights and a clear investment strategy for effective decision-making.

Within the broad equity market universe of India, mid-caps and small-caps have had a good run-up this year in terms of pricing or share value. This run-up presents both a threat and an opportunity.

Mainly, if you can read the economic tea leaves and know your investment priorities, the shoals in the mid-cap and small-cap ocean can be navigated.

“Small and mid-cap stocks have outperformed large-cap stocks in the recent past,” says Anurag Jhanwar, Partner and Co-Founder, Upwisery Private Wealth, leading to many investors increasing their allocation to these asset classes.

“Both small and mid-caps witnessed an almost unhindered rally between March and September this year,” says Mayank Bhatnagar, Chief Operating Officer, FinEdge.

It was only natural that the rally would see a retracement, which happened in September and October. After such a fierce rally, a retracement is not just a natural phenomenon but healthy for the overall markets, as it allows new participants to enter the markets and prevents a bubble from forming.

To be sure there are certain trends that may be interpolated, from market movements.

The recovery period has been strong so far and it seems like markets needed a reason to take a pause, catch a breath and start again. The length of that pause/snooze seems to be intricately linked to multiple global headwinds that have come about, unexpectedly. In a relatively bleak global macro picture, the Indian economy seems to be standing tall and the Indian markets are holding strong even under consistent FII selling pressures over the last few months.

“The companies and sectors that showcase a strong quarter of results might be the least affected (by negative trends) and vice versa,” says Jhanwar.

What does the retail investor need to know about the various extraneous factors that will affect mid and small-cap stocks?

Long-term trends in the small and mid-caps are intricately linked to the overall domestic growth story, as well as the degree of risk-on sentiment that is prevalent in the market at that point in time.

With corporate earnings breaking out of a long hiatus after the lows of 2020, small and mid-caps have been the natural benefactors, and their stock performances have broadly been backed up by resilient corporate earnings growth. Moreover, this has also fuelled a more risk-on sentiment among retail investors who have pumped in money through mutual funds and otherwise, further giving them a boost.

Since small and mid-caps are extremely sensitive to market sentiment, any bad news (such as the situation in the middle east escalating, for instance) could lead to very sudden, sharp, and deep corrections in the segment, say experts.

But therein lies the rub; and the opportunity!

As long as you maintain your breath (read investment horizon) and don’t try to time the market, stocks in the small and mid-cap segment may actually offer an opportunity for the investor.

“Any investor coming in at this juncture into these sectors needs to keep a longer-term view, and keep return expectations in check, as one cannot extrapolate the last three years’ returns into the future,” says Karan Doshi, Senior Equity Research Analyst & Fund Manager, LIC Mutual Fund Asset Management.

Despite the increased volatility, many experts believe that the allocation towards small and mid-cap stocks will continue to increase in the future. “This is because these asset classes offer the potential for higher returns over the long term,” says Jhanwar.

The Equity Small Cap MF’s and mid-cap MF’s AUM has seen a growth of 48.8% and 34%, respectively, in the last 6 months compared to 13.5% in Large Cap MF AUM (As of September 30, 2023), according to data compiled by Upwisery.

However, due to the illiquid nature of small caps, deployment takes time, as one has to wait for the right opportunities. Chasing the stocks may drive up the price, thereby defeating the very purpose of investing.

Discretionary consumption is an evergreen theme, considering the rising per capita, demographics and low penetration across categories, says Doshi about specific sectors in the mid and small-cap space that have the ability to outperform.

With the government’s focus on Make in India, manufacturing as a theme seems to have a long runway for growth in India. Mid and small-cap funds offer investors to invest in many manufacturing, discretionary consumption and other multiple sectors.

“The best way to approach small and mid-cap investing is undoubtedly through the mutual fund SIP route,” says Bhatnagar.

An investor should consider a professional fund manager while also staggering investments into the market and benefiting from rupee cost averaging.

Experts feel that most investors are not able to successfully cherry-pick small and mid-cap stocks and hold on to them long enough to create wealth from them.

ETFs are a cost-effective option, but the fact that you cannot invest in them systematically makes them prone to many of the same behavioural biases as direct stocks themselves.

“Besides, actively managed funds still have significant outperformance potential within small and mid-caps, when compared to passives,” says Bhatnagar.

“To avoid major downside, investors may consider investing in companies with good corporate governance, a healthy balance sheet, good growth potential over the next 3-5 years and valuations at reasonable levels,” advises Doshi on the characteristics of good companies in the mid and small caps sector.

What precisely is a mid-cap and a small-cap stock?

SEBI the regulatory body has issued some guidelines about the differences between the large-cap, mid-cap and small-cap categories. Essentially it’s about the market capitalisation or the market valuation of the shares.

Thus, stocks with a market valuation of above ₹20,000 crore are classified as large caps. Midcaps have a market capitalisation of ₹5,000 to ₹20,000 crore. Small caps are those listed companies that have an equity valuation of up to ₹5,000 crore.

Timeframe – the secret to success

“The only due diligence that a retail investor really needs to do before investing into small and mid-caps is a thorough examination of their own investing beliefs, expectations and understanding of risk/reward that is associated with them! In the long run, neither will market timing nor cherry-picking the best mutual fund be the differentiator. The only thing that will matter is investing resilience,” says Bhatnagar.

For instance, when COVID struck, small and mid-caps promptly tanked 40-60% in a matter of a few trading sessions! Even the most seasoned investors were left gasping for air. Most retail investors converted their notional losses into permanent losses and sat on the fence while an equally ferocious recovery ensued soon after.

So, one should spend more time building a robust investing process that revolves around clear financial goals and systematic, disciplined investing rather than trying to acquire market knowledge.

“Certainty in the market extracts a premium, so be picky and pick quality names across the mid and small-cap universe. Most importantly, stay put!,” says Jhanwar.

By Admin

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