Are Small-Cap & Mid-Cap Funds Still In The Race?
Dalal Street Investment Journal|November 22, 2021
History suggests that small-cap and mid-cap companies tend to grow faster than the large-cap universe in an economic recovery scenario. Hence, we can expect companies from this category to register robust earnings’ growth as we go forward, further supported by a lower base. The article explains this particular phenomenon and provides guidelines to investors

The broader equity market in India has witnessed a vertical rise in the last 18 months. In August 2021 we saw this rise in small-cap and mid-cap stocks coming to a screeching halt after gaining 48 per cent and 23 per cent for the year, respectively. The reason for such a fall in these categories of stocks was largely driven by the introduction of new surveillance rules by India’s oldest stock exchange, the BSE. This was introduced to maintain market integrity and curb excessive price moves. It caused panic among investors and there was sell-off in these categories of stocks. Although at the index level there was not much movement and BSE Mid-Cap and Small-Cap indices saw a fall of between 2-5 per cent after the announcement, many stocks saw a fall of more than 20 per cent.

Nevertheless, soon a clarification was issued, supporting the price. This led to underperformance of the broader market compared to the large-cap-dedicated stocks by a margin of 5 per cent. This was probably the first time in the year we saw them underperforming on a monthly basis. The chart below shows the performance of BSE 100 representing large-cap, BSE Mid-Cap and BSE Small-Cap for the last one year. It clearly shows the dip in August.

What is also visible from the above graph is that since September 2021 once again the price of mid-cap and small-cap stocks is gaining. The same performance was also visible for funds dedicated to these categories. They too saw their performance declining in August by 2-5 per cent only to regain in the following months. What is good to note is that the average performance of the funds has been better than their respective benchmarks. For example, year-till-date on an average the mid-cap and small-cap-dedicated funds have generated returns of 47.35 per cent and 64.4 per cent, respectively. Their benchmark in the same period has given return of 39.18 per cent and 61.11 per cent, respectively.

What this episode highlights is that even the regulator and exchanges are not very comfortable with such a huge rise in the share prices of the broader market in such a short span of time. This is not the first time we are witnessing such a rise in the equity market in such a short span of time. The last time we saw such a spectacular rise in the equity market was after the great financial crisis of 2008 and subsequent recovery in 2009. During that time the equity market had seen such a vertical move. The mid-cap and small-cap indices as well as funds dedicated to these categories have almost doubled during this time. Nevertheless, exactly after 18 months of vertical rise they started showing signs of fatigue. Will history repeat itself? In the following paragraphs we will take a 360 degree view to understand if it is the right time to book partial profits.

So Far So Good

One of the reasons for such a sharp rise in the performance of the small-cap and mid-cap stocks was strong economic recovery. India’s GDP contracted 24.4 per cent in the quarter ending June 2020, followed by 7.3 per cent contraction in the subsequent quarter. However, it moved north in the third quarter with a marginal 0.4 per cent growth and recorded a growth of 1.6 per cent in the last quarter of FY21. Finally we saw the economy contracting by 7.3 per cent for the entire FY21. However, for the first quarter of FY22, India’s GDP grew at a record pace of 20.1 per cent. History suggests that small-cap and mid-cap companies tend to grow faster than the large-cap universe in an economic recovery scenario. Hence, we can expect companies from this category to register robust earnings’ growth as we go forward, further supported by a lower base.

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