Looking to invest in small cap mutual funds? Here’s why it may be a good idea

Published: December 1, 2018 4:00 PM

Due to steep decline in stock prices of small cap stocks, their valuations are now looking a lot better than before.

A historical analysis of relative returns shows that small cap stocks tend to outperform large cap stocks over long term.

By- Harshad Patwardhan, CIO, Equity at Edelweiss Asset Management Ltd

This year is turning out to be the worst on record in relative terms for small cap stocks. Small cap index (Nifty Small Cap 100 index) is down 32% YTD versus large cap index (Sensex) which is up 3% in same period. It is important to note that in many cases the stock decline is caused by redemption based (i.e. non-discretionary) selling. Attribution analysis of stock returns reveals that most of the damage is caused by valuation correction rather than EPS cuts. In fact, in most cases EPS progression has been positive, in line with broader pick up in EPS growth trajectory.

Due to steep decline in stock prices of small cap stocks, their valuations are now looking a lot better than before. For anyone looking at investing now; cheaper starting valuations improve the odds of small cap stocks out-performing large cap stocks over medium to long term.

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A historical analysis of relative returns shows that small cap stocks tend to outperform large cap stocks over long term. We believe a fundamental reason why quality small cap stocks will likely outperform their large cap peers is that they can grow faster (on a small base) and also will likely re-rate as they consistently deliver on operating performance thereby appearing on the radar screen of more and more investors.

It is important to remember that while small cap portfolios will likely deliver better returns from here on over a medium term; they are also likely to be more volatile compared to large caps. Therefore, only investors having appropriate risk profile should consider investing in this segment. In addition, whilst investing in small cap portfolio over medium to long term, it is critical to make sure that the portfolio satisfies the following three criteria – Quality, Liquidity and Diversification.

Disclaimer: The views expressed above are the author’s own. Mutual Fund investments are subject to market risks, read all scheme related documents carefully.

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