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Explained: The risks to assess before investing in small and mid-caps

Against a growth of 6.4% in the Sensex since April 1, 2021, the BSE mid-cap and small-cap indices have risen over 10% and 20% respectively.

Since June 1, against a Sensex rise of 1.5%, mid- and small-cap indices have gone up by 2.6% and 5.5% respectively. (Pixabay/ Representational)

Over the last three months, while the benchmark indices — Sensex at BSE and Nifty at NSE —did not get affected much by the second wave of Covid-19, mid-cap and small-cap indices saw a strong rally. Against a growth of 6.4% in the Sensex since April 1, 2021, the BSE mid-cap and small-cap indices have risen over 10% and 20% respectively. Amid concerns around valuation in this space, experts say investors need to be careful while entering fundamentally weak, small- and mid-cap companies, and should instead invest through mutual funds schemes that have the flexibility to invest across large, mid- and small-caps.

How much have mid- and small-cap indices risen?

Mid- and small-cap indices at BSE have outperformed the Sensex not only over the last one year and three months, but even in the near term of the last three weeks. Since June 1, against a Sensex rise of 1.5%, mid- and small-cap indices have gone up by 2.6% and 5.5% respectively.

It is often seen that when the market witnesses a big rally, mid- and small-caps rise much more as they see a significant re-rating of stocks in these categories, and both large and retail investors invest in them.

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However, as the momentum in the small- and mid-cap segment has resulted in a rally even in stocks of companies with weak fundamentals, experts say retail investors should be cautious and not get lured by the high returns that some of the stocks (with weak business fundamentals) may have generated over the last month or two.

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What is the risk for investors?

While this segment does have a number of good companies with strong business fundamentals, investors must be careful about the quantum of their exposure as they may decline sharply in times of correction in the market.

“The rise in mid- and small-caps is driven by excess liquidity in the market and large investors investing in them. However, when they exit, these companies (though they may be good) could go down faster than they went up as the liquidity is low in many of these stocks,” said CJ George, MD, Geojit Financial Services.

While mid- and small-caps have outperformed the Sensex and Nifty over the last one year, market participants say their recent rally is also driven by a jump in participation by retail investors, and that is another reason for concern as a large number of such investors have increased their exposure across mid- and small-cap companies.

While investors need to be cautious at an aggregate level, some feel there are pockets of opportunity in sectors still under Covid-related stress, such as hotel and multiplexes.

Experts feel investors need to limit their exposure to smaller companies. Stating that there are interesting opportunities in small cap space, S Naren, CIO, ICICI Prudential AMC cautioned that investors should look at flexi-cap funds. “During times of a global synchronised market correction, small caps tend to witness aggressive corrections… We believe flexi-cap is an interesting category as it allows the corpus to be deployed across large, mid- and small-caps based on the relative attractiveness of these individual pockets. Furthermore, this is one category among the equity schemes which is the most flexible,” said Naren.

Why are flexi-cap funds seen as a good bet?

While multi-cap funds were earlier free to invest across small-, mid- and large-cap companies, the regulator SEBI has restricted these schemes to compulsorily invest a minimum of 25% each across these segments. But flexi-cap funds have no such cap and fund managers enjoy the flexibility to increase or decrease exposure across a small, mid- and large-cap stock depending on the market outlook. SEBI created flexi-cap as a new category last year.

While investors with sizeable funds can spread their investment across large-cap, mid-cap and small-cap funds, retail investors with limited funds to deploy but looking to take advantage of the growth across companies can look at flexi-cap funds. Some feel that since the fund manager has the flexibility to move funds from one to another, they can do active management in line with emerging growth opportunities or risk perceptions.

What are the risks to market growth?

While the risk of another wave of Covid lingers and concerns build around inflation, market participants also feel that a good monsoon will provide strength to rural India and demand recovery in the economy. As far as inflation is a concern, many feel it may not be a factor to worry about as long as central banks remain supportive of growth. Only if central banks get hawkish and take steps to taper their buying programme significantly could the impact be negative. At that point, there could be a meaningful correction in asset prices and the economy.

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