The Securities and Exchange Board of India’s (Sebi’s) recent nudge to the mutual fund industry body, the Association of Mutual Fund in India (Amfi), to sensitise fund houses to be cautious about mid and small-cap schemes comes at a time when stocks in both these segment have been rising steadily and valuations have also gone up significantly.
For instance, the current price-to-earnings P/E ratio of the mid-cap index is 32.39x, higher than the ten-year trailing average of 31.05x. However, it is lower than the five-year average of 32.80x. The small-cap index’s P/E ratio, on the other hand, is at 28.41x, way below the 10-year average of 44.24x. But it is significantly higher than the five-year average of 19.29x. Obviously, the market regulator’s worries, therefore, are justified.
According to fund managers, it has been holding meetings with fund houses for the last few months over the heady valuations and investor over enthusiasm in these segments.
Sources said that the market regulator has asked fund houses to provide investors a detailed break-up of various key risk factors when they put in money in such schemes.
These will include, portfolio concentration – the top 10 and 5 stocks; single investor exposure to scheme; liquidity challenges if there is sudden redemption of say, 10-20%; portfolio construct between large, mid and small caps and ratios like Sharpe ratio (which compares the return of an investment with its risk) and others.
“All these parameters were given earlier as well. However, they will now be given in a single sheet to the investor at the time of investing to make them fully aware of all the risks that are involved with the scheme,” said a fund manager who did not wish to be named. It has left it to the discretion of fund houses to implement other guidelines like a temporary increase in exit load.
However, it is not just the markets regulator but both fund managers and analysts have been worried for more than some time about the valuations in the mid and small-cap space.
Shankar Sharma, partner, GQuant, said, “The current rally is limited to the small cap market and if one were looking at the large caps, the market picture appears distinctly tepid as it has been for the last 10 years when overall returns are just 13% compounded for 10 years – even below than what the markets have enjoyed over the last 40 years which is 15% compounding,” adding that the small cap rally is clouding this basic fact that large caps have hit a wall in terms of growth.
He warns the current generation of investors, though they believe that they have far better tools and equipment to understand markets and therefore navigate them better than their predecessors, that for some time such theories workout beautifully well because that is the nature of this business. “And just when it seems that this theory is finally ‘the fail safe theory of investing’ the theory falls apart,” he added.
Others like Sanjeev Prasad, head of research, Kotak Institutional Securities, for example, has been warning investors about the mid-cap rally for months now. In September, Kotak dropped a model 15-stock portfolio, saying that the rally in these stocks was ‘irrational’. In fact, Prasad’s comments created quite a furore as it was interpreted as Kotak decided to ‘stop recommending any mid-cap stock.’
