The promise and perils of small-cap funds

Today, we will be discussing a very sensitive topic - the promise and perils of small-cap funds. Dhirendra, I would like you to evaluate and define small-cap funds.

Dhirendra: It is a very delicate issue right now. Because most investors got attracted by the lure of how small-cap funds performed, particularly in 2017. They saw those big numbers. Funds doubling in one to one-and-a-half years' time and they started investing. Ever since then, we have seen a decline. So they're questioning this whole premise, saying that we got started with these and they turned out to be very disappointing. That typically happens whenever you get attracted by recent performance.

But yes, small cap funds are promising though they have their own hazards. Small-cap funds are now well articulated by the regulator. These are funds which invest in small companies. Quantitatively, small-cap companies are defined as companies with a smaller worth or market cap. So if you list down companies according to their market cap, small-cap companies are those excluding the top 250 companies on the basis of market cap. Market cap is the money that you would need to buy a particular company completely. The regulator has required that small-cap funds invest at least two-thirds of their money in such small companies.

For a common man like me, what are the advantages or the promises and disadvantages or the perils of small-cap funds?

Dhirendra: The promise of a small cap fund or a small company which you buy early is that you can't think how much benefit it may give you. Think of HDFC Bank. It was founded in 1994, and it was a small bank. Nobody knew how it would shape up, but in the last 25 years or so it went on to become one of the largest Indian banks. So if anybody would have bought it as a small bank, they would have seen it convert to a promising bank which was organized better.

That is the charm of it. You buy a small company and it eventually turns big. There are hundreds of examples like this, where you pick a small company and it turns big. That is a phenomenal thing. It actually creates wealth. The peril is that for every such company or HDFC Bank there could be another which destroys your wealth. The company which fails on its promise or what you expected of it. And small companies are more vulnerable. They lack the robustness and the ability to withstand the cyclicality. Businesses are cyclical. So it is about how you withstand a down cycle and avoid mistakes. Most companies are unable to withstand the down cycles or the changing market dynamics. So that is the disadvantage or the risk, that you picked up a small company and it fails on the promise.

But if small-caps can go so far and if the long-term average return is good, despite the risk or cyclicality, then why should one not go for small-caps only?

Dhirendra: It is very unnerving. An investor's heart has to be tested. When you ask anyone if they have strong heart in a rising market, they say 'yes, we do'. But the minute you are faced with a 50 per cent decline, you say 'I was not'.

So it is required that you understand the concept that smaller companies hold the promise. But they come with the risk that some of them will actually fall by the wayside. And that is part of the game. The way to deal with it is to build a diversified portfolio which mutual funds deliver you efficiently.

Then, they are extremely cyclical and you need to continue investing through the lean times. If you buy small caps every five years but only in the upside, you will never make money. This is what can also be called as the suitability. These funds are suitable only if you have experienced the market for at least 5-6 years and understand that they can be wild.

So would you like to lay down some ground rules for anyone who would like to invest in small-cap funds?

Dhirendra: First, look at the long term performance of these funds. And check before investing whether the same fund manager is still there. The fund should also not be very big. I will ignore a small cap fund which has an AUM of more than 2,000 to 2,500 crore. Because beyond this point it becomes difficult for the fund to find adequate volume, quantity and opportunity. Finding many ideas in small caps is difficult.

The last thing I wanted to ask is whether we are at the cusp of a golden run?

Dhirendra: I don't know whether we are at the cusp of a golden phase of the stock market or the economy. Whether it's round the corner or not. But it is definitely there. I'll tell you why. We have seen a huge operating system change for our economy, for businesses. And the result of this is that good businesses will get a premium. We have seen this huge thing which has come our way, that corporate tax in India has been brought down in a substantial manner. This means that for a company generating 20 per cent return on equity, that 20 percent growth goes up substantially forever in the future simply because now they have to pay less taxes. And that reduction from 33 per cent with all the surcharges and other things to 22 percent is huge. And then we saw that readjustment. But I don't think that readjustment is very objective.

The corporate tax rate cut will accrue and will have a far different meaning over a period of time because they can multiply the money much faster. The return on equity on more retained earnings will have a different meaning. Then I think there is a fundamental change in the way businesses conduct their affairs. Honesty, integrity, good governance, good conduct are coming into play and will get rewarded. The bad guys will get phased out or they will get marginalized. Another thing is that big businesses will turn bigger, simply because what has happened additionally is that new businesses or new operations being set up by existing businesses are liable for a 17-per-cent tax rate. That is phenomenal.

It will not happen tomorrow, or say in 6 months, but it will definitely happen. Because now this is a global advantage created for Indian businesses. Also, I don't think there was any surprise in terms of the GDP numbers going down. The economy is slowing down, obviously. Mind you, we are still brewing. The growth rate has come down from much higher levels to 4.7 per cent or 4.8 per cent. But despite that, these are still growth rates. We are still growing at 4.7 per cent or 4.8 per cent. It's not a decline. It's a decline in the pace at which we were growing. That's one thing.

Just think of it this way - some years you get a salary hike of 10 per cent while some years it is only 5 per cent. But you do get a hike. You are not jobless. I'm not justifying it at all or saying that it is good or bad, just that it was bound to happen for the obvious reasons - the way houses are being sold, which is a very people-intensive activity that definitely has changed forever in this country. Big builders are in jail, which we could never imagine could happen. And then we have witnessed the bankruptcy bill. Such things never used to happen in our country. So all this will translate into a slowdown but it's a big change. These are big permanent changes which were bound to cause a slowdown. But this is something which we owe to our future generations so that they will not be embarrassed about being born in India which is made up of dishonest businesses.

So should one invest in small caps?

Dhirendra: One should invest in small-caps, but as I said earlier, you should have the experience. Just the investment time frame of five to seven years and more is not enough. So if you have seen what had happened in the market and to small caps and you understand you can withstand this, by all means go ahead and invest in them.

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