Small-cap funds have been outperforming other categories lately, with impressive returns over the past year.

They yielded a remarkable 28% return, surpassing large-caps at 18% and mid-caps at 22%. Even when considering a three-year performance, small-cap funds continue to shine. Making an impressive annual gain of 39%, as opposed to 21% for large-cap funds, according to data from Morningstar India.

The driving force behind this trend is the market’s inclination towards the manufacturing segment, which is well-represented within the small-cap space. This has contributed to the significant outperformance of small-cap funds.

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Kalpen Parekh, the managing director and CEO of DSP Mutual Fund, brings attention to an interesting insight.

He points out that since 2008, the small-cap index has yielded returns comparable to government bonds, both around 6.3%. He also emphasizes the importance of selecting the right small-cap stocks and timing one’s investments properly. While small caps can be lucrative wealth creators, it is crucial to avoid the wrong choices, as the difference in returns between the small-cap index and bonds narrows to just 2% when considering the period from the peak of 2010 until now.

Over the last three years, small-cap companies have shown remarkable growth, around 20%, presenting unique investment opportunities that may not exist in the large-cap space.

Record Inflows and Challenges:

Small-cap funds are currently experiencing record inflows due to their strong performance. However, this influx of funds is presenting challenges. While investors are eager to invest, there are limited ideas and investment opportunities in the small-cap space, which makes diversification more difficult. Additionally, the small-cap segment is less liquid, leading to the potential concentration of risk.

Small-cap funds have proven to be volatile, even though some stocks in this space have delivered high returns. These funds have thrived on high-conviction bets made by experienced fund managers.

Experts advise investors to consider a long-term investment horizon of more than 10 years, given that the sector is currently deemed expensive.

Top-performing Small Cap Funds:

1. HDFC Small Cap Fund: Leading the pack with remarkable returns of nearly 39.44% over the one-year period
2. Franklin India Smaller Companies: Following closely with an average return of 36.05%.
3. Nippon India Small Cap: Exhibiting strong performance with a return of 35%.
4. HSBC Small Cap: Showing robust returns of 31%.
5. DSP Small Cap Fund: Delivering a return of 28.44%.

Investment Strategy and Success Factors:

The success of these small-cap funds can be attributed to investments in key companies like

-KEI Industries, Carborundum, Brigade Enterprises, Sonata Software, and Apar Industries before 2020.

These strategic investments have played a pivotal role in delivering substantial returns for the funds.

Investment Philosophy at DSP Small Cap Fund:

Resham Jain, the fund manager at DSP Mutual Fund, has been managing DSP Small Cap Fund since March 2018.

Their investment strategy revolves around thinking like an owner of the business and participating in the journey alongside the company. This approach is reflected in their portfolio turnover ratio, which has consistently remained between 15% and 20%, indicating a long-term investment horizon.

Key Criteria for Investment:

-The fund focuses on companies with strong business models, managed by credible and capable managers, and available at reasonable valuations.

-They seek out companies with the potential to grow faster than nominal GDP and generate returns on equity higher than 16%.

-The fund managers consider various factors such as growth, returns ratio, management quality, earnings stability, cyclicality, and optional drivers while evaluating valuations.

-The higher the consistency in growth and return on equity, the more favorable the business is perceived.

Navigating Business Cycles:

Jain acknowledges that most businesses go through cycles, which can bring volatility to stock prices. During downturns, if the fund managers believe the impact on the company’s performance is temporary, they take the opportunity to build larger positions.

Although this phase may not generate immediate returns, it can prove beneficial over the medium term. On the other hand, during upcycles, fund managers book profits and trim exposure to capitalize on favorable market conditions.

DSP Small Cap Fund’s Top Performers:

1. Suprajit Engineering: With a portfolio weightage of 3.54%, this stock delivered an impressive return of 22.31% in one year.
2. Ratnamani Metals & Tubes: Accounting for 2.76% of the portfolio, this stock displayed outstanding growth with a return of 56% in one year.
3. La Opala RG Ltd: Representing 2.40% of the portfolio, this stock outperformed with an impressive return of 62.25% in one year.

These top-performing stocks contributed significantly to the overall returns of the DSP Small Cap Fund before 2020.

Nippon India Small Cap Fund’s Top Performers:

Nippon India Small Cap Fund achieved an impressive return of 43.5% over the past year. Its top five stocks, acquired before 2020, were:

1. Tube Investments of India
2. KPIT Technologies
3. Credit Access Grameen
4. Apar Industries
5. Zydus Wellness

Diversified Investment Strategy:

Samir Rachh, the fund manager – equity at Nippon India Mutual Fund, highlights their approach to investing.

They are not limited to any specific style of investing, instead focusing on creating a well-diversified portfolio of stocks across different investment styles and sectors. The fund incorporates a mix of growth, value, and GARP (growth at a reasonable price) stocks. This diversified strategy enables them to offer better risk-adjusted returns to investors.

By holding onto their winning positions for a longer time and maintaining exposure to a variety of sectors and investment themes, they can remain active in the market even if some of their investments do not perform as expected. This flexibility and diversification contribute to their ability to navigate market fluctuations and aim for a well-rounded and successful portfolio.

Stock Selection Criteria at Nippon India Small Cap Fund:

-The fund manager considers two crucial criteria – the quality of the promoter and the quality of the business.

These factors are of utmost importance in his stock selection process. Rachh believes that businesses inevitably experience ups and downs, and the quality of management plays a crucial role in maximizing opportunities during the upside and effectively navigating challenges during the downside.

The quality of the business is also a significant determinant, as even exceptional management cannot compensate for poor business quality.

ICICI Prudential’s Small Cap Fund: Three-Bucket Approach:

ICICI Prudential’s small-cap fund adopts a unique strategy, dividing the entire small-cap universe into three distinct buckets:

1. Bucket A – Quality Compounding: This group includes companies with characteristics that exhibit “quality compounding.” These are businesses with strong fundamentals and the potential for consistent and sustainable growth over the long term.
2. Bucket B – Normalcy Candidates: Stocks falling into this category are termed “normalcy candidates.” These are companies with current earnings below their normal levels but are expected to normalize within the next two to three years.
3. Bucket C – Wealth Destroyers: This group comprises “wealth destroyers,” which are companies that the fund manager intends to avoid to minimize potential mistakes. These companies might have weak fundamentals or limited growth prospects.

Portfolio Strategy:

Harish Bihani, the senior fund manager at ICICI Prudential Mutual Fund, manages the small-cap strategy.

He aims to build a portfolio consisting of companies from buckets A and B while avoiding those from bucket C.

The fund focuses on holding stocks where earnings are expected to grow at high double-digit rates over the next three to five years. This approach, applied consistently, is expected to deliver satisfactory overall portfolio outcomes over time.

By adopting a structured three-bucket approach and emphasizing quality and growth potential, ICICI Prudential’s small-cap fund seeks to build a well-performing and diversified portfolio that aligns with their investment objectives.

Investment Approach of Harish Bihani at ICICI Prudential’s Small Cap Fund:

-He primarily adopts a bottom-up stock-picking strategy.

-He selects stocks based on fundamental metrics, themes, and the three-bucket strategy approach.

-This approach helps him build a well-diversified portfolio with a focus on quality companies with strong growth potential. Bihani is mindful of valuations but is willing to pay a premium for a company as long as it meets his growth criteria.

Challenges and Outlook for Small-Cap Funds:

With the markets reaching all-time highs, small-cap funds have attracted a surge in investor inflows, leading to all-time high inflows of INR 5,500 crore recorded recently. Despite achieving the highest returns in the last 10 years, small-cap funds are facing challenges due to several factors:

1. Increased Valuations: The substantial influx of money into small-cap funds has caused valuations of many stocks to soar. As a result, fund managers are finding it challenging to identify attractive investment opportunities at current elevated valuations.
2. Decreased Liquidity: The surge in assets under management has reduced liquidity in the small-cap segment. Limited liquidity makes it difficult for fund managers to execute large trades without significantly impacting stock prices.
3. Limited Investment Opportunities: With soaring valuations and reduced liquidity, the universe of viable investment prospects for small-cap funds has become more limited.

Fund House Actions: Tata Mutual Fund has taken a proactive step to manage the situation by suspending lump sum investments into its small-cap fund. This decision was made to ensure careful consideration of deploying funds in a market environment with elevated valuations and limited opportunities. Investors can still continue investing in the fund through SIPs and STPs.

Investor Considerations: Given the current situation, veteran fund managers are considering alternative options and asset allocation strategies. Betting against the flow and looking for opportunities outside the small-cap segment might be prudent for some investors.

As small-cap funds experience a surge in inflows and face valuation challenges, thoughtful consideration of investment decisions and potential alternatives is crucial for investors looking to make the most of their portfolios in the current market scenario.

Please note that we are not SEBI-registered advisors or analysts. All the views shared in this article and all the content shared on aceink.com are only for learning and educational purposes. Any part of the article or any information on Aceink.com should not be interpreted or considered as investment advice. None of the opinions, views, or content posted on Aceink.com constitutes investment advice, as we are not SEBI-registered advisors or analysts.

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