In the Indian investment landscape, a hot topic is buzzing around – the extraordinary rally seen in mid and small-cap stocks. These small-sized companies have been showing strong performance lately, which might lead to increased earnings for you and could mean more money in your pockets.

But here’s the big question: Is now the right time to invest in these stocks, or should you think about selling some of what you already have?

In this article, we will dive deep into the realm of mid and small-cap stocks and funds. We will also try to understand the reasons behind their impressive performance and why they are doing so well, what potential risks you should watch out for, and whether it is the right time to buy or sell.

Past performance is not indicative of future results
Source: ACE MF; PersonalFN Research 

Over the past year, mid and small-cap stocks have outperformed and exceeded all expectations, posting impressive gains and even helping the markets reach a new peak. They have recorded gains of over 30 to 35% alone in the past year and around 60-65% since the decline observed in June 2022. And if we calculate the overall appreciation in the small-cap index, since the March 2020 low, it has appreciated by an impressive margin of over 300%.

Now, this remarkable surge in mid and small-caps has ignited several questions in the minds of many investors and left them wondering about their next move.

And chances are that some of you, too would have questions like…

– Should I hold onto my mid and small-cap investments?

– Should I grab the opportunity to buy more to catch the rally?

– Is it prudent to consider selling some of my mid and small-cap holdings?

While the recent surge is undoubtedly exciting, it is important to remember that with great rewards come greater risks.

So, here are three quick questions you should have an answer to…

– Are you certain about investing heavily when the market is at its peak?

– Do you really want to have a higher exposure to mid and small-cap stocks in your portfolio?

– Are you confident that your investment aligns with your standard asset allocation?

You should revisit your investment plan and have your own answer to these.

The unprecedented rally in Mid and Small Caps…

In recent times, the mid and small-cap segments have experienced a significant upturn, beating expectations and delivering returns that have astonished many investors. These stocks, which are often associated with higher risk due to their volatility, have surprised even the most seasoned investors by yielding a remarkable increase of more than 30% in the past year.

Mutual Fund Category-wise Average Returns

Category Average Absolute CAGR
6 Months 1 Year 2 Years 3 Years 5 Years
Small Cap Fund 30.1 29.7 14.4 38.7 24.2
Value Fund 21.2 24.3 10.1 28.1 16.8
Mid Cap Fund 25.3 24.0 10.6 30.9 20.9
Contra Fund 20.2 23.2 11.9 29.8 19.5
Multi Cap Fund 23.3 22.7 10.0 29.8 19.7
Large & Mid Cap 20.0 19.9 7.7 26.1 17.8
Flexi Cap Fund 18.9 18.3 6.7 23.3 16.6
Focused Fund 17.6 16.6 6.2 22.8 16.4
Large Cap Fund 14.9 15.3 4.9 20.6 14.8
Nifty Smallcap 250 – TRI 37.4 34.9 12.6 36.9 20.9
Nifty Midcap 150 – TRI 28.9 29.7 12.2 34.3 21.6
NIFTY 50 – TRI 12.3 13.6 4.4 20.1 14.8

Performance as of 18-October-2023; Past performance is not indicative of future results
Source: ACEMF 

For a clearer understanding, let’s consider an example: Imagine you invested Rs 1,00,000 in a small-cap mutual fund a year back. Thanks to the rally in small caps last year, your small cap fund has delivered, say, a 30% return in a year’s time. Accordingly, your investment in the fund has now grown to Rs 1,30,000. This 30% gain in just one year is indeed tempting and enticing.

The appeal of such extraordinary gains in mid and small-cap stocks and funds is hard to resist, but it is crucial to approach such a situation by thinking clearly and staying well-informed. You must also remember that market dynamics can change, so it is crucial to consider the potential risks involved with these stocks and funds.

Key Factors behind the Rally…

The substantial upswing recently witnessed in the Indian stock markets, particularly in the mid and small-cap stocks, has been driven by various factors, including:

1. Robust Economic Growth: The Indian economy is expected to grow at a robust pace in the coming years. This is likely to boost corporate earnings and drive stock prices higher.

2. Favourable Interest Rates: The low interest rates maintained by the RBI in recent years have helped support economic growth and even made investing in stocks more attractive than other fixed-income assets.

3. Increased Liquidity: In recent years, there has been a significant increase in liquidity in the Indian stock market, injected by both domestic and foreign investors. The increased liquidity has helped to push stock prices up, especially in the mid and small-cap segments.

The recent surge offers you opportunities and challenges, showing how the market dynamics are always changing. As you make choices in this ever-changing market, what will really make a difference for your financial future is your ability to adjust, plan, and match your investments with your own financial goals. The investment journey is marked by opportunities and uncertainties, and it is how you as an investor handle this changing landscape that shapes your financial dreams.

Is the rally in small caps approaching an end?

In 2023, we have witnessed a substantial rally in mid and small-cap stocks, making the small-cap segment quite appealing to aggressive investors. However, it is essential to gauge the risk in small-cap valuation, which is expanding.

Another risk indicator could be using the Smallcap to Sensex ratio.

Source: ACE MF; PersonalFN Research 

Small caps are considered safer when this ratio falls below the long-term average of 0.45x. Currently, the Smallcap to Sensex ratio stands at around 0.57x, which is well above the long-term average.

This suggests that weakening interest in small caps could pose a significant risk to key indices. It is not just the Smallcaps that might experience a temporary dip; even the mid-caps and large-caps could be impacted. While most of the positive factors are already factored in, any negative surprise could dent the index. Hence, a cautious approach is advisable.

However, is this the all-time peak? Not necessarily.

We have witnessed several peaks in the past, and historically, after each time the market corrected, it bounced back strongly to set new records. Short-term downturns have often proven to be excellent buying opportunities for long-term investors.

The Investment Dilemma…

The recent surge in mid and small-cap stocks has posed an interesting challenge for many who actively invest their money in such high-risk stocks and funds.

Let us understand this dilemma with an example: Suppose you have held a small-cap fund in your portfolio for several years, which has recently doubled in value. You may be thrilled with the gains, but you are also concerned about the impact of the potential market correction. This dilemma is common among investors during market highs and periods of higher market volatility.

In such a situation, many of you may be asking yourself: Should I continue with my mid and small-cap holdings, i.e. stocks and funds? Have I missed the chance, and should I increase my investments in them by buying more now? Or is it time to exit after such a substantial rally by selling some of them?

These are valid concerns…

As you make these decisions, you are dealing with a blend of opportunities and uncertainties, and these choices will affect your financial future. This choice isn’t just about money – it’s also about understanding how risky these investments are, what you want to achieve with your money, and trying to figure out what might happen in the market.

So, deciding what to do with your mid and small cap investments comes down to three key things:

1. Your Financial Goals: When making investment decisions, consider your financial goals and how much risk you can handle. This will help you design your investment plan. So, think about what you want to achieve with your money. If you are looking to build wealth over many years, you might want to keep or buy more mid and small-cap stocks. But if your goals are short-term, you might decide to do something different. You can shape your investment strategy with a clear view of your goals and risk comfort.

2. Your Comfort with Risk: Everyone has a different comfort level when it comes to the ups and downs of investments. If you are a long-term investor with a high risk tolerance and okay with the idea of your mid and small-cap investment values going up and down in the short term, you might want to consider holding onto them or even buying more of them. If you are risk-averse and not comfortable with those short-term fluctuations, you might think about reducing the exposure to your high-risk mid and small-cap investments by selling some of them and rebalancing your portfolio by including more large caps.

3. Your Time Horizon: This simply means how long you plan to stay invested before you need it for some other purpose. If you are in it for the long haul, like 10 or 20 years, you might be more inclined to stick with a ‘hold’ or ‘buy’ strategy because you have time to ride out market ups and downs. On the other hand, if you need your money in the short term, say within a year or two, you might lean toward selling some of the mid and small-cap stocks to lock in profits or limit potential losses. Think long-term and avoid chasing quick gains or getting worried when the market moves up and down.

You should think carefully about what you want to do with your money, how much risk you are comfortable with, and how long you plan to keep your investments.

The Sensible Approach to Adopt…

While the recent upswing in mid and small-cap stocks has been exciting for investors, it has raised lots of questions and concerns. The mystery that many investors find themselves in today is both understandable and challenging.

You as an investor, might be wondering if you should maintain your current investments as they are, increase your exposure to them, or opt for an exit strategy by selling some of them. Each of these options carries its own set of factors and results that should be considered carefully.

The answer lies in crafting a well-thought-out and rational strategy.

So, here are a few guidelines or steps that you should follow to make informed decisions in such uncertain market conditions:

Step 1 – Set Clear Goals: Define your financial objectives and revisit your investment goals. Are you looking for long-term growth, a steady stream of regular income, or a mix of both? Having clear goals will guide your investment decisions.

Step 2 – Diversify Your Investments: Review your current portfolio allocation and ensure it is diversified across various asset classes. If not, then diversify your portfolio by spreading your investments across different assets, market caps, and sectors. A diversified portfolio can cushion the impact of high market volatility and improve your chances of overall success.

Step 3 – Manage Risk through Portfolio Rebalancing: Periodically review and adjust your portfolio to maintain your desired risk level. Rebalancing involves selling instruments and assets that have performed well and buying those that may have potential for growth in coming years. For instance, if your mid and small-cap stocks and funds have surged and now dominate your portfolio, you may consider selling some to maintain your desired asset allocation.

Step 4 – Stay Informed: Keep yourself updated on market trends, economic conditions, and the fundamentals or developments in the stocks and funds you are invested in. An informed investor is better equipped to make sound investment decisions.

Step 5 – Think Long-Term: Successful investing often requires a long-term perspective and patience. Avoid chasing short-term gains or getting anxious during market fluctuations. A long-term perspective can help you ride out market volatility.

By following these 5 steps, you can confidently navigate the ups and downs of the market, making informed decisions that align with your financial goals and risk tolerance.

If you are unsure about your investment strategy, don’t hesitate to consult a SEBI Registered Investment Advisor, who can provide personalised guidance and help ensure your decisions fit your unique financial situation and goals.

To conclude:

The recent rally in mid and small-cap stocks is undoubtedly exciting, but it should be approached prudently and rationally. Whether you should buy, hold, or sell your mid-cap and small-cap holdings clearly depends on your risk profile and financial priorities. Don’t make any decisions just based on short-term market sentiments. Better relate it to your overall investment objectives and strategies. A well-thought-out strategy can help you navigate market storms and reach your financial goals.

Remember, investing wisely is about making informed choices that align with your financial goals.

This article first appeared on PersonalFN here

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