Exercise caution towards small-cap allocations

There has been news of one after the other small cap mutual funds restricting the inflows to their funds. The small funds as a category have attracted more than 25,000 crore in the last twelve months. This is as the current markets notch to the new levels. The present valuations are high though relative to earlier highs, there are still lower and seem to be attractive. The 10-year average Price-to-Earnings (PE) on small cap category stands at 38 vs the current PE of 27. For comparison, the PE of the category hovers at about 100 in April ’18, which was just around when the peak at that time.

The biggest concern with small caps as the name suggests has a smaller capitalisation. Capitalisation is the total value of all the company’s shares of a company or stock. So, when more inflows are passed into these stocks, the stock valuations rise very quickly. The other concern is the liquidity ie, the availability of the floating stocks. As fewer stocks are available, it will be difficult to make transactions ie, enter or exit with a higher quantum of capital.

As the operations are small and lesser known, it will be difficult to identify good businesses. Moreover, few of the company managements are professional and very hard to evaluate their businesses. As less and lesser quality companies are available to invest, larger inflows create issues of risk management for the small cap fund managers. As further flows increase, the valuations of these quality stocks increase leading to possible lesser future returns.

However, the SEBI (Securities Exchange Board of India) regulations prescribe at least 65 per cent of their investment corpus to small-cap stocks as categorised to small cap funds. So, this gives flexibility for the fund manager to allocate if the ideas are restricted or liquidity issues are faced to allocate in the small cap space.

So, to control the flows while ensuring quality allocations into the fund, especially trying to stick to the fund objective or mandate of allocating to majority to smaller cap stocks, some of the funds have begun to pare down the inflows by completely stopping lumpsum investments while continuing to accept funds through staggered mode like systematic investment or systematic transfer plans ie, SIP or STP respectively.

This is a sure sign that the valuations are heating up and time for investors exert caution. This doesn’t mean that this category of funds underperform in the short or immediate run but it’s important to pare down expectation of returns in the short to medium term. The one-year returns have been over 30 percent and continuation of such high returns are slim. Investors would gain wisdom from the past such cycles where all eye-popping returns were followed by bouts of unattractive returns. It’s time to exercise caution and have a longer horizon to make better risk adjusted returns to the fresh allocations.

(The author is a co-founder of “Wealocity”, a wealth management firm and could be reached at [email protected])