Small Bets, Big Profits

Small- and mid-cap funds have been outperformers in the past one year, but this should not make them the mainstay of your fund portfolio.

Tanvi Varma/Money Today        Print Edition: November 2010

You didn't need the Midas' touch. All you required were some mid- and small-cap stocks to make your portfolio shine. All 10 top performing equity diversified funds in the past one year have midand small-caps packed like sardines in their portfolios.

There's DSPBR Small and Mid-Cap Fund, the top performer (see table), which has 58 per cent of its corpus invested in mid-caps and 37 per cent in small caps. Stocks such as Bayer Cropscience and EID Parry in its portfolio have risen by around 150 per cent since the January 2008 peak.

Mid- and small-cap funds are also known as emerging opportunities or emerging businesses funds. They typically invest in small companies that have the potential to turn into large-cap companies. The IDFC Premier Equity fund, for instance, focuses on emerging companies and has allocated more than 70 per cent to midcaps and nearly 10 per cent to small-caps.

These companies are significantly more nimble in their operations and because of a low base they grow much faster, says Kenneth Andrade, head of investments at IDFC Mutual Fund. IDFC Premier Equity has delivered a 52 per cent return in the past one year, outperforming the diversified equity category by 22 percentage points and the Sensex by 31 percentage points.

49 & 44 YEARS

Their Investments
They have nearly Rs 42 lakh in equity mutual funds invested over more than a decade.

Their Strategy Now
They are using the current rally to sell off the riskier mid- and small-cap funds in their portfolio. We are reducing our exposure to high-risk investments because we are approaching retirement."

"We are reducing our exposure to high-risk investments because we are approaching retirement."
Going for Growth

Similarly, the Magnum Emerging Business Fund has delivered a 51 per cent return in the past one year. Its top holding, Page Industries, has grown at 30 per cent compounded annual growth rate in the past five years. The stock has risen from Rs 481 in January 2008 to Rs 1,240 now.

Another key stock in its portfolio, Manappuram General Finance & Leasing, has seen a 700 per cent appreciation since January 2008.

Eicher Motors is up 200 per cent. Many of the mid-caps in funds' portfolios boast competitive valuations and can deliver higher growth compared with the broader market.

Currently, the average return on equity (RoE) for the Sensex companies is 18-20 per cent, whereas stocks like Rallis have an RoE of 30 per cent, which is available at 15 times its 2011-12 projected earnings, says Sageraj Bariya, analyst (mid-cap), Angel Broking.

Even the current price to earnings ratio of the BSE Midcap Index stands at 21 times compared with 24 times for the Sensex.

Stock-specific Story

These spectacular examples apart, the growth isn't true for all mid-cap stocks. "With mid-caps, it's usually a stock-specific story," says Bariya. This explains the large variation in the performance of mid-caps. From January 2008 till now, mid-caps have delivered returns between 800 per cent and -80 per cent.

"These firms have the disadvantage of high capital costs and low margins because they are low on the value scale and are processors for larger companies. However, the firms that sell their end products to consumers have fared well," says Satish Ramanathan, head of equity at Sundaram BNP Paribas Mutual Fund.

During a downturn, mid-caps tend to fall harder than large caps mainly because they are not as liquid. The BSE Midcap Index lost 75 per cent from its peak value in January 2008 till March 2009, compared with a 60 per cent fall in the Sensex. Mid-cap funds fared no better.

The Kotak Mid Cap Fund, for instance, performed poorly between January 2008 and January 2009. The fund lost 64 per cent compared with the 52 per cent drop in the index. The category average was -55 per cent.

Should you Invest?

This raises the crucial question: should you invest in mid- and smallcap funds? These are inherently more volatile than large-caps. While they offer good growth, they are also riskier and should ideally not be a part of the core portfolio.

Use them to add zing to your portfolio but don't binge on them. Experts also suggest one should not allocate more than 10-15 per cent of one's portfolio to mid- and small-cap funds. It's pertinent to note that midcap funds have not fared as well as large-caps over the longer term. In the past five years, large-cap funds have delivered superior returns.

However, there are still some sectors that are likely to do well within this space, says Bariya. Be it the India growth story, which will be consumer driven, the capital goods sector, which will see a surge in demand with rising private capex, and the agriculture sector due to the thrust on agriculture and allied activities, he adds.

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