If you have invested in small- and mid-cap funds during recent times, you would be sitting on substantial gains on your investments as stocks in these two segments have seen a huge spurt in prices.
Is the trend sustainable? What investment strategy should you adopt? Should you hold on to your investments, bet more money in the small and mid-cap funds or sell?
Vidya Bala, Head of Mutual Fund Research, FundsIndia.com feels that if you have been investing in this segment for long, it could be time to rebalance your portfolio after the sharp run up. However, the strategy woud be different if you are recent entrant.
“If you have been holding for long and have very high double-digit returns, you can consider switching some money to a large-cap fund. But if you entered it recently (which is likely as the mid- and small-cap category has seen more inflows from investors in recent times), do not try and exit now as you will incur costs and taxes,” she said
She feels this could be a good time to look at large-cap and diversified funds. “The best you can do to rebalance is to make your future investments, or add more investments now, in large-cap and diversified funds, as this is also a good time to enter the large-cap category given the relatively reasonable valuations. This will also help bring down overall your exposure to mid- and small-caps, and thus reduce the volatility in your portfolio,” Bala said.
She feels that among the problems small- and mid-cap fund managers would face would be to locate good stocks in these segments. “A very direct challenge for fund managers would be to find such winning stocks time and again in this category, given that not many stocks will be fundamentally sound for a fund to pick. Another real challenge for these funds arises from illiquidity, especially in small-cap stocks. Due to their illiquidity, these stocks cannot be liquidated by the fund manager in one shot at the appropriate time. ,” according to Bala.
Mid-cap valuations have risen sharply as seen by the price to earning ratio. From a point three years ago (as given in table below) when large-cap stocks were higher in valuation by a small margin, mid-caps are now at a significant premium compared with large-caps. Such a wide margin often indicates bubble territory.
At a valuation of over 33 times, the earnings growth of companies in the small- and mid-market-cap segment will not find it easy to catch up with the index price run up. “Essentially, this is a case of stocks rallying way ahead of the earnings. Over the same period, you will see that large-cap valuations have moved in a more measured way,. Recent 3-month and 6-month data shows that large-caps are catching up in terms of returns, without any undue movement in their valuations,” says Bala.