Mid- and Small-Cap Mania

Periodically, the stock markets go through a mid-cap and small-cap excitement. We are in such a stage currently. Over the last one year, the small- and mid-cap indices have outstripped the large cap indices by wide margins. During this period, the BSE Small Cap Index is up 129 per cent and the BSE Mid Cap index is up 104 per cent. During the same period, the Sensex has gained 61 per cent. This performance is also reflected in the typical mutual fund as well. The average large-cap focussed funds are up an average of 72 per cent while mid and small cap funds are up 117 per cent. There's also no shortage of analysts proclaiming that the smaller companies is where the action is.

However, as always, investors need to be extremely wary of this space. Volatility and liquidity have always scuppered investors' gains in this space, mostly because by the time the mass of investors notice the action, things are already over the hill. You can make money in these stocks, but you need to be careful.

So let me give you a different perspective on small and mid-cap performance. One-year and six-month and year-to-date comparisons with the Sensex are all very well, but if you look just a little way further back, there's a different story to be told. From the peak that markets hit in January 2008, the Sensex is still down about 15 per cent. The BSE Mid Cap index, however is still down 31 per cent and the BSE Small Cap Index 36 per cent. The Small Cap Index may have risen 215 per cent from the bottom in March 2009, but to reach that bottom, it had fallen to one fifth its value. It takes a lot more than a 215 per cent gain to wipe out that kind of a fall.

As cautious investors know, these stocks rise a lot more than the large caps and then they fall a lot more too. This means that we need to have slightly different ground rules for such stocks. Here's how I think you should approach this space. The most important thing is that smaller companies should never be a major chunk of your portfolio. Everything depends on your personal risk profile but I doubt whether anyone should have more than 20 or 30 per cent of their equity portfolio in small caps.

Secondly, this is one area where investing through an open-ended mutual fund dedicated to smaller companies makes even more sense than otherwise. There are just about 60 or 70 investible large-cap companies in India but hundreds of smaller ones. The quantum and quality of information about many of these is several orders of magnitude poorer than large-caps.

According to the Value Research capitalisation criteria, companies totalling up to 70 per cent of the total market cap of the BSE are large cap companies. These are just 77 in number currently. Mid-cap companies are another 20 per cent of the total market cap and these number 209 currently. Small caps are the remaining 10 per cent and they are a humongous 2,899.

There could be a few hidden gems in that long tail but there's a lot of garbage as well. Since investors are eternal optimists, they firmly believe that they'll get that one gem that will turn out to be the next blockbuster. But let's face it. The chances of doing so are not great. Choosing the right stocks at the right time is simply too large an exercise to be feasible for the individual investor. When the markets start tanking, investing through a fund can also provide better liquidity. In small and mid-cap stocks, trading volume dries up very quickly in a negative phase. If you have invested through an open-end fund, you can always get out at a day's notice, no matter what.

At the end of the day, it's good to hear about smaller stocks doing well, and there's no reason why any investor cannot participate in the gains. However, the risks are higher and the traps are well-hidden. You need to go into this with open eyes and open ears.