Small Cap Fund

EQUITY STRATEGY

Small can be big

Sandeep Singh

Posted online: Monday , May 21, 2007 at 1359 IST
Updated: Wednesday, June 29, 2005 at 1257 hours IST -->

About 10 years ago, Pantaloon was known for selling exactly what its name suggests: men’s pants. Its stock quoted at the price of a button, Rs 1.6, and the market valued the whole business at just Rs 3.5 crore. Around this time, the company, led by Kishore Biyani, decided to enter organised retailing, becoming one of the first to do so.

Risks and rewardsIn 2002, its Big Bazaar hypermarket chain completed a year. The stock was at Rs 10 and the company’s market capitalisation was Rs 100 crore. Today, when Big Bazaar symbolises middle-class shopping jamborees, the Pantaloon stock quotes at Rs 445 —up 45 times in five years — and the market places its worth at Rs 6,268 crore. An investment of Rs 10,000 in Pantaloon made in May 1997 is now worth Rs 27.5 lakh. Pantaloon sums up the rewards of investing in small-cap companies — businesses in the early stages of their growth curve. But for every Pantaloon that graduates to the middle and big leagues, there are 10 that fail to survive even little league. Cranex, Mahan Industries, Spice Island Apparels, Hindustan Everest Tools all had a market cap of about Rs 3.5 crore in 1997, but have slipped into oblivion. They sum up the risks of small-cap investing. As an investor, these risks and rewards are real, given the growing number of investment options in the small-cap space clamouring for your savings.
Invest in moderationPresently in the market, there’s the Micro Cap Fund from DSP Merrill Lynch Mutual Fund, which, it says, will invest in stocks that are smaller than small-cap (See interview on Page 4). This scheme will invest 65-100 per cent of its corpus in companies ranked outside the top 300 by market cap — in today’s numbers, whose market cap is less than Rs 1,500 crore. Then, in the private investing space, there’s Kotak Securities, with its portfolio management scheme (PMS), Kotak Origin, which will invest in small-cap companies — defined by it as companies with a market cap of less than Rs 2,500 crore. Says Shashank Khade, senior vice-president and fund manager, Kotak Securities: “Over the past year, small-and mid-cap stocks have trailed the index. Their revenues and profits have grown, shrinking their PE, and making them attractive.”While most equity funds have varying degrees of exposure to small-cap stocks, the Micro Cap Fund will be only the second fund targeting small caps or below, after Sundaram BNP Paribas Select Small Cap Fund (launched in January 2007). Both are closed-end schemes that will turn open-ended: DSP after three years, Sundaram BNP after five. In other words, till they go open-ended, the NFO (new fund offer) period is the only time you can, or could, invest in them. Only if you have the stomach for high risk should you aim for those high returns. Says financial planner Surya Bhatia: “Invest only if you are comfortable with the higher risk and you have an investment horizon of at least five years.” Even then, small-cap funds shouldn’t form the core of your portfolio, but rather the topping on it. “Not more than 20 per cent of your portfolio should be invested in small-cap schemes,” says Bhatia.
Extreme behaviourThe conservatism stems from the fact that, while a smaller base enables companies to grow faster, the strike rate is low. For instance, in the past five years, of the 302 stocks with a market cap of Rs 50-300 crore, as on 16 May 2002, 11 would have doubled your money every year, including Unitech, Aban Offshore, Areva T&D and Pantaloon. Ninety of them, or one in three, delivered a CAGR of above 50 per cent.At the other end, however, half the 302 stocks have under-performed the BSE Sensex. Worse, at a time when the Sensex has delivered a compounded annual 33.5 per cent, 49 of them gave negative returns (See graphic: High risk, high returns). By comparison, of the 80 stocks with a market cap of over Rs 1,000 crore on 16 May 2002, just four gave negative returns. Fund managers say this risk can be managed, but even they admit they face constraints. Like lack of liquidity. You can buy and sell a large-cap stock anytime you want, that too in large numbers, but not small-cap stocks.Small can be bigFor a mutual fund, that poses problems while buying (big purchases might be difficult or it might send the stock price soaring) and selling (big sales might be difficult or the share price might crash).
Before you invest…Fund houses alter their product structure to work around such limitations. Sundaram capped its corpus at Rs 300 crore; DSP Merrill Lynch has said it will cap its NFO collections at Rs 500-600 crore, and refund the excess. Says S. Naganath, president and CIO, DSP Merrill Lynch Fund Managers: “We want to keep the corpus at manageable levels.”Similarly, while all three schemes allow premature exits during the closed-end period after paying an exit load, Sundaram allows unitholders of its small-cap scheme to withdraw only 10 per cent of their investment in a year. Says Sanjay Santhanam, vice president-sales and marketing, Sundaram BNP Paribas Mutual Fund: “This is to lend stability to our portfolio and give our stocks time to perform.”Another variable you need to check is how a scheme defines a small-cap stock. There are as many definitions as there are small-cap indices and funds. The BSE Small Cap Index, which has 508 companies shows a wide range: there’s an aberration in Cairn India (market cap of Rs 24,687 crore), the rest range from Rs 10.4 crore to Rs 3,260 crore. According to Sundaram, it is all companies except the top 100 companies by market cap on the NSE (on Friday, the 100th ranked company had a market cap of 6,300 crore), while DSP says it is companies that occupy rank 200-300 in market cap (micro cap is beyond 300). Says Naganath: “There is overlap, as everyone has a different definition. Peer group comparison will remain tough until market players draw up and accept a common classification.” But that’s not happening anytime soon. That’s why you need to be alert how a scheme defines small cap. As an investment category, small-cap is still evolving, which magnifies the risks. There are huge rewards to be had for getting it right and hard knocks to be taken for getting it wrong. Venture, but in moderation.

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