Is it time to pause investing in small caps?
Small-cap funds are flooded with funds. Investors are heavily pumping money into small-cap equities in the hope of high returns.
Investors have put in more than Rs. 33,040 crores in small-cap funds from April-2022 till June-23.
It can be inferred from the data released by AMFI that the investors are taking aggressive bets by flocking into high-risk funds such as small-cap, mid-cap, and thematic funds.
The reason behind such a huge increase in small-cap investments is the returns given by small companies in the recent past.
The average returns delivered by small-cap funds in the last 1 year is 30.92% compared to the average return of 20.96% of the large-cap funds.
Clearly, the returns delivered by small caps are way higher than the large caps. But, what about the risk? Aren’t the small cap equities too risky compared to the large caps? Let us see what the data says.
As can be inferred from the above graphs, the returns delivered by small caps are well above the large caps and contrary to the general perception, the volatility in the prices is not significantly higher than the large caps.
After looking at this, now the question arises whether investors should continue to invest in the small-cap funds, or should they hit a pause on investing in the small-caps and book some profits. Let us try to find out.
Valuations: The first parameter the investors look at is the valuation. Are the small-cap companies overvalued? Let us look at the P/E ratio.
Although P/E alone cannot be used to conclude whether the companies are overvalued or not, it can be used to get a quick idea about the relative valuations of the companies.
And as can be seen in the above chart, the current state of P/E does not suggest that small-cap companies are extremely overvalued.
Small Cap Premium: In a paper titled “The Relationship Between Return and Market Value of Common Stocks,” Rolf W. Banz concluded that the common stocks of smaller firms outperformed the common stocks of larger firms on a risk-adjusted basis.
Many have argued that the inference drawn in the said paper does not hold good in today’s world. However, this has always been the case for developing economies like India where smaller companies have outperformed the large caps by a significant margin.
India’s Growth Story: India is a developing nation, and we are growing at the fastest rate. Small-cap companies are expected to benefit disproportionately higher than large-cap companies from such high growth.
The primary reason behind this is the smaller base of the small companies which translates into higher growth in relative numbers. And secondly, it becomes difficult for large companies to grow faster due to their large size.
Volatility: As seen earlier, the volatility of small-cap companies reduces significantly over a longer period. Hence, small-cap companies are not as volatile in the long run as we generally perceive.
Small-cap equities offer tremendous growth potential over the long term, especially in a growing economy like India. However, it is possible that investors might not see extremely high returns in the short term.
But stopping investments based on this rationale implies nothing but trying to time the market and doing so may prove to be harmful if the markets do not correct.
Hence it is advisable to continue to invest for the long term keeping in mind the said factors