Massive gains in small-cap mutual funds: Is it time to take some profits?

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Doubling their money within a year is a dream for most mutual fund investors. In the last one year, three small-cap equity funds did just that. But after a 30 percent in the S&P BSE Sensex in March 2020 soon after the COVID-19 pandemic broke out, few investors had the guts to invest equities. But now, investors seem willing to get into even small-cap stocks or funds, going by the stupendous returns generated in the last one year.

The Nifty Small Cap 250 TRI gained over 94 percent over the last one year. Small-cap funds delivered 92.5 percent in the same period. In CY 2018 and CY 2019, small-cap funds as a category had fallen by 18.62 percent and 1.51 percent, respectively, on an average. The wave of liquidity unleashed to fight the pandemic-induced economic slowdown ensured that stocks continued to rally.

Small-sized companies are still attractive

Using the traditional tools of valuations such as price to earnings and price to book ratios is difficult at this moment, as the economy is yet to come out of impact of pandemic. The price to book value of Nifty Small Cap 250 TRI stands at 2.92 compared to 1.35 a year ago. The price to earnings ratio has declined to 43.39 from 61.58 a year ago.

Fund managers say that there is scope for earnings growth, as the economy revives. The risk of the second wave of COVID-19 remains, though.

Mahesh Patil, Chief Investment Officer, Aditya Birla Sun Life AMC, says, “The economy is expected to grow at a much faster rate in the next three to five years. Many small-cap companies are expected to report healthy earnings growth, making them good investments for the medium term.”

Small-cap stocks are also expected to get a boost from additional buying by multi-cap funds, thanks to the recent Securities and Exchange Board of India ruling. It said that Multi-cap funds need to invest at least 25 percent in small-cap companies. Now, 11 schemes remain in the multi-cap category.

Diversified portfolios should reduce portfolio risk in small-cap funds. “Many new companies will get listed and the universe will grow with new categories of businesses,” says Ravi Kumar TV, Founder of Gaining Ground Investment Services.

Volatility will be higher

That doesn’t mean you should rush to invest in small-cap mutual funds. “Avoid investing lump-sums in schemes that did well over the last one year at the first sign of consolidation in the stock market,” says Nitin Rao, CEO, InCred Wealth.

The spread of the second wave is expected to keep equity markets on the edge for some time. Harish Bihani, Fund Manager-Equities, ICICI Prudential Mutual Fund says that further dips in the markets  can be good entry point for investors in small cap funds, “but mainly for those investors who can stay invested for five years.”

“When the markets bounce from a trough, the small-cap index does well, as many companies irrespective of quality see the prices appreciate. However, after the initially recovery phase, only well-managed companies report better earnings growth than the average,” says Patil.

Alternatively, multi-cap funds also give you a reasonable exposure to small-cap stocks.

Should you still take some money off the table?

Though the stock market may remain volatile for quite some time, do not sell your existing investments in small-cap funds in a hurry. “Profit-taking in small-cap funds should be done only if equity allocation has become much higher than the desired level, due to the market rally,” says Nitin Shanbhag, Head- Investment Products, Motilal Oswal Private Wealth Management. But if you heavy gains from investments made in small-cap funds last year, it makes sense to shift a portion of your corpus to large-cap schemes.