Smaller companies are lesser-known and undiscovered but could generate extraordinary returns for you, provided they are spotted right by conducting adequate research, and the investment is made at an opportune time — much before most other investors begin to chase them. They hold the potential to become tomorrow’s large-cap companies.

However, not all smaller companies can grow, or they consciously decide to limit their scale of operations. They have limited resources compared to large and well-established companies (or industry leaders), plus face tough competition. Moreover, being small makes them vulnerable to business cycles. Similarly, there may be corporate governance in some of them. For these reasons, not all small-cap stocks are growth-oriented. They may expose you to a very level of risk, wherein liquidity could be an issue. Thus, investing in them involves high impact costs, and you may end up making poor returns. Hence, you ought to be extremely careful when selecting small-caps for your investment portfolio.

To identify the hidden treasures — meaning the ones that have the potential to grow wealth–an extra effort in the form of in-depth research is necessary. For a retail investor, it makes sense to take exposure to small-caps by investing in worthy Small-cap Funds and generate alpha.

Over the last one year, the Nifty Smallcap 250-Total Return Index (TRI) has outperformed the Nifty 50-TRI. At the same, the Nifty Smallcap Index-TRI has been extremely volatile, as depicted in chart 1.

Graph 1: Performance of Nifty 50-TRI Vs Nifty Smallcap 250-TRI


Note: The graph depicts the value of investment of Rs 10,000 each in Nifty 50-TRI and Nifty Smallcap-TRI
Data as of June 3, 2022
(Source: NSE, PersonalFN Research)  

As per SEBI’s mutual fund classification norms, a Small-cap Fund is an open-ended equity mutual fund scheme investing at least 65% of its total assets in equity & equity-related instruments of small-cap companies.

Small-cap companies are the ones beyond the first 250 companies on full market capitalisation, according to the capital market regulator’s definition.

If we assume the Nifty 500 companies, by and large, as the complete universe of companies that mutual funds track and choose from, then the small-cap component may have 250 companies.

That said, not all small-cap companies are small or tiny companies nowadays. According to the Association of Mutual Funds in India’s (AMFI’s) market cap classification, SKF was the largest stock with a market cap of Rs 16,088 crore as of 31 December 2021. And the 250th small-cap stock was Deepak Fertilizers & petrochemicals, with a market cap of Rs 4,476 crore as of 31 December 2021.

Now let’s check out top-3 Small-cap Funds that have built wealth for investors over the last 5-7 years.

Out of 23 Small-cap Funds on offer, 20 have completed 3 years, and only 14 have a track record of at least 5 years. To find the 3 best Small-cap Funds, we have considered 5 years as an appropriate time horizon given the high risk involved.

Plus, this period of 5 years is considered as it automatically filters out funds/schemes that haven’t seen longer market phases. This could include a prolonged challenging phase for small-cap companies. If you remember, in the market downturn that began in 2018, the small-cap category got impacted the most.

Table 1: Performance of the 3 best Small-cap Funds across timeframes

Scheme Name Returns (Absolute %) Returns (CAGR %) Risk-Ratios
1 Year 2 Years 3 Years 5 Years 7 Years SD SR
Quant Small Cap Fund 17.5 88.1 38.9 20.6 16.9 33.74 0.31
SBI Small Cap Fund 16.3 51.3 26.0 20.4 20.7 23.63 0.27
Kotak Small Cap Fund 18.3 65.5 30.6 17.9 18.7 27.31 0.30
Category Average 16.5 55.9 24.7 14.6 15.6 26.56 0.24
Nifty Smallcap 250 – TRI 10.8 55.9 18.5 9.0 11.7 31.06 0.18

Direct Plan and Growth Option considered.
Past performance is not indicative of future returns.
Data as of June 1, 2022
(Source: ACE MF, PersonalFN Research)  

We have also considered Standard Deviation (SD), which is a measure of volatility/risk, and the Sharp Ratio (SR), a test of risk-adjusted returns.

[Read: 3 Important Ratios to Consider Before Investing in Mutual Funds]

Ideally, a fund with a lower SD and higher SR tends to compensate investors better than a highly volatile fund having a low SR.

But again, ‘high’ and ‘low’ are relative terms here. Thus, comparing the performance of a fund against the category average and the benchmark index is necessary.

Table 2: Performance of the 3 Best Small Cap Funds in the bull market phases

20-Dec-11 To 03-Mar-15 25-Feb-16 To 14-Jan-20 23-Mar-20 To Till Date
Quant Small Cap Fund 10.5 -0.5 96.9
Kotak Small Cap Fund 36.0 16.0 70.2
SBI Small Cap Fund 43.5 18.9 58.3
Category Average 36.3 13.6 62.9
Nifty Smallcap 250 – TRI 32.5 10.7 64.1

Direct Plan and Growth Option considered. Returns up to 1-year are absolute and over-1 year compounded annualized.
Past performance is not indicative of future returns.
Data as of June 1, 2022
(Source: ACE MF, PersonalFN Research)  

When evaluating the performance of the 3 best Small-cap Funds across market phases, we came across some interesting observations.

The Quant Small Cap Fund has done exceptionally well across market phases. SBI Small Cap Fund has outperformed during bearish market phases, while Kotak Small Cap Fund has done well during bull markets.

Table 3: Performance of the 5 best Small Cap Funds in the bear market phases

05-Nov-10 To 20-Dec-11 03-Mar-15 To 25-Feb-16 14-Jan-20 To 23-Mar-20
SBI Small Cap Fund -24.5 -1.8 -30.3
Quant Small Cap Fund -10.9 6.3 -33.6
Kotak Small Cap Fund -30.4 -13.4 -34.8
Category Average -27.6 -11.8 -34.5
Nifty Smallcap 250 – TRI -38.7 -19.2 -41.5

Returns up to 1-year are absolute and over-1 year compounded annualized.
Past performance is not indicative of future returns.
Data as of June 1, 2022
(Source: ACE MF, PersonalFN Research)  

It’s important to understand the quantitative and qualitative aspects of these 3 best Small-cap Funds in greater detail.

Fund #1: Quant Small Cap Fund

Launched in November 1996, the primary investment objective of the Quant Small Cap Fund is to seek to generate capital appreciation and offer long-term growth opportunities by investing in a portfolio of small caps.

Contrary to the widely accepted belief that the time spent in the market is more crucial than timing the market, Quant Small Cap Fund isn’t averse to frequent portfolio churning. It exposes its investors to very high-risk than its category average but has handsomely rewarded its investors on risk-adjusted returns.

Table 4: Top-10 holdings of Quant Small Cap Fund

Stocks % of Assets
ITC Ltd. 5.6
IRB Infrastructure Developers Ltd. 4.0
Arvind Ltd. 3.8
Linde India Ltd. 3.6
Hindustan Copper Ltd. 3.5
The India Cements Ltd. 3.1
HFCL Ltd. 3.0
Just Dial Ltd. 2.9
TV18 Broadcast Ltd. 2.8
E.I.D. – Parry (India) Ltd. 2.6

Portfolio data as of April 30, 2022
(Source: ACE MF, PersonalFN Research)  

Quant Small Cap Fund follows the proprietary VLRT (Valuation, Liquidity, Risk appetite, and Time) framework of the fund house. It uses predictive quantitative indicators to measure the market sentiment and identify investment opportunities while being sector and style agnostic.

The fund hasn’t refrained from investing in high beta stocks in sectors such as metals and construction. It hasn’t held itself back from taking contra bets on sectors such as media & entertainment and FMCG. Interestingly, Quant Small Cap Fund’s largest holding is ITC, comprising 5.6% of its total assets.

According to the fund’s portfolio as of April 2022, it held 60 stocks with the contribution of top-10 stocks accounting for 34.9% of the portfolio. The cash & cash equivalents comprised around 1.1% of the portfolio to address liquidity needs.

Respectable portfolio characteristics and an astute strategy have led to the superior performance of the fund.

Fund #2: Kotak Small Cap Fund

Launched in February 2005, the investment objective of the scheme is to generate capital appreciation from a diversified portfolio of equity and equity-related securities of small-cap companies.

Kotak Small Cap Fund attempts to spot small-cap companies that are managed by promoter groups with strong integrity.

The fund prefers to invest in companies that have done well across various business cycles, have simple business models, generate free cash flows, and have low leverage. The fund pursues a bottom-up approach and growth style of investing.

Table 5: Top-10 holdings of Kotak Small Cap Fund

Stocks % of Assets
Century Plyboards (India) Ltd. 5.2
Sheela Foam Ltd. 4.6
Carborundum Universal Ltd. 3.9
Amber Enterprises India Ltd. 3.4
Galaxy Surfactants Ltd. 3.2
Blue Star Ltd. 3.0
Ratnamani Metals & Tubes Ltd. 2.9
Persistent Systems Ltd. 2.8
Supreme Industries Ltd. 2.6
Cyient Ltd. 2.5

Portfolio data as of April 30, 2022
(Source: ACE MF, PersonalFN Research)  

As per the portfolio, as of April 2022, the fund held a total of 71 stocks – very diversified. The top-10 holdings formed 34.1% of its portfolio, while the fund invested 95.4% of its net assets in equity.

The fund has been betting heavily on materials, FMCG, consumer discretionary goods, chemicals, mining & metals, and the capital goods sector, amongst others.

Many of the underlying stocks of the respective sectors have fared well during the bull market phases and accentuated the fund’s return. Kotak Small Cap Fund doesn’t churn its portfolio often and follows a buy-and-hold strategy.

Fund #3: SBI Small Cap Fund

Launched in September 2009, the SBI Small Cap Fund has an objective to provide investors with opportunities for long-term growth in the capital by investing predominantly in a well-diversified basket of equity stocks of small-cap companies.

SBI Small Cap Fund held 9.2% cash as of April 2022, and it remains interesting to see if it has deployed the same in equities in May.

The fund follows a bottom-up approach to stock-picking and is selective while choosing companies while following a blend of growth and value style of investing.

The fund manager looks to invest in high growth-oriented multi-bagger stocks of small-sized companies but is cautious about the price he is willing to pay for the stock.

Table 6: Top-10 holdings of SBI Small Cap Fund

Stocks % of Assets
Sheela Foam Ltd. 4.6
Vedant Fashions Ltd. 4.1
Elgi Equipments Ltd. 4.0
Blue Star Ltd. 3.8
Carborundum Universal Ltd. 3.1
Fine Organic Industries Ltd. 2.9
Lemon Tree Hotels Ltd. 2.7
Navin Fluorine International Ltd. 2.6
Narayana Hrudayalaya Ltd. 2.5
Hatsun Agro Product Ltd. 2.5

Portfolio data as of April 30, 2022
(Source: ACE MF, PersonalFN Research)  

As per its portfolio as of April 2022, SBI Small Cap Fund held 48 stocks, wherein the top-10 stocks constituted 32.8% of the portfolio, while the overall equity allocation is 90.8% of the net assets.

Currently, the fund has been betting big on FMCG, capital goods, chemicals, metals & mining, and construction, among others. It has kept exposure to financial services and IT minimal (unlike some of its peers).

Going by its portfolio characteristics, it appears the fund has been betting on a variety of themes like Atmanirbhar Bharat, as well as capex growth in industrials that are expected to play a role in unlocking the growth potential of the economy.

The impeccable performance of the SBI Small Cap Fund has come at a lower level of risk than the category average. Its risk-adjusted returns have been attractive.

The outlook of Small-cap Funds

Amidst rising inflation and rising interest rates, the performance of Small-cap Funds is likely to come under pressure since smaller companies may feel the pinch of rising raw material costs and sliding growth on account of higher inflation. That said, the adverse market condition might make valuations in the small-cap space look reasonable.

You may add some Small-cap Funds as part of your satellite portfolio only if you have an investment horizon of 5 to 7 years (or longer) and the stomach for very high risk. Given the market volatility, it would make sense to stagger your lump-sum investment in Small-cap Funds and/or take the Systematic Investment Plan (SIP) route.

This article first appeared on PersonalFN here

Leave a Reply

Your email address will not be published. Required fields are marked *