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. This performance is also reflected in the typical mutual fund as well. The average large-cap focused funds are up while mid and small cap funds are up much more. 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. The Small Cap Index may have risen 200 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 200 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 not too many investible large-cap companies in but hundreds of smaller ones. The quantum and quality of information about many of these is several orders of magnitude poorer than large-caps.
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.