Caveat Emptor: A Warning for Small-cap Investors in Volatile Times

Statutory warning: consumption of small-caps in large quantities is harmful to your financial health.

After the recent angst in the public space about how fund managers, and the financial system more broadly, have let investors down in smallcap equities, I felt compelled to put pen to paper.

Reportedly, of around 2,000 small and mid-sized stocks (outside the largest 250), 800 or 40% are trading at less than half their all-time highs, while about 1,300 or 65%, are below 60% of those peaks (with a nod to my friend Vikram Kotak). This is sobering, especially when the principal indices, the Nifty and the Sensex, are just about 1-2% below their own all-time highs.

The contrast is sharper when one looks at the performance of some large-cap mutual fund schemes. Over the past five years, HDFC MF Large Cap Fund has delivered around 20% CAGR, HDFC Infrastructure Fund about 32%, and Kotak Large Cap Fund 17%, to name just three. I cite these partly because I have a personal stake in them. Over the same period, the bellweather indices have also held up reasonably well, with the Nifty returning about 14% CAGR and the Sensex around 12.7%. 

The poor performance of small-cap stocks, and the losses many portfolios have suffered as a result, are not unprecedented. Prudent fund managers and finance professionals have long cautioned against treating investing like a game of Russian Roulette. Investments are meant to build long-term wealth, not mimic a lottery ticket. Tales of spectacular gains from early bets on tiny companies are often overstated, and in any case hard to repeat with consistency. 

That is where mutual funds have generally proved their worth. Even many small-cap schemes have maintained limited exposure to the riskiest end of the market, keeping a meaningful portion of their portfolios in large-caps, as permitted by their scheme mandates. This discipline has helped them navigate sharp market corrections more steadily (with thanks to Juzer Gabajiwala for highlighting this).

There is another point worth making, even if it is an uncomfortable one. Caveat Emptor applies not just to stocks, but also to portfolio managers and investment advisors. At times, incentives can encourage more churn than necessary, or a tilt towards riskier ideas in the name of adding value. Both can distract from a simple, time-tested principle: invest in strong, well-managed companies — typically recognised by the market as large-caps — and stay invested for the long haul. One lesson that has served me well is to place greater trust in the skill of good fund managers.

In conclusion, while this may puncture a few popular myths, the most reliable wealth creation comes from patience, by staying invested over long periods and letting professionals do their job. With SEBI’s proactive role in keeping mutual fund fees in check, this approach is also relatively inexpensive. There is little need to constantly hunt for the next quick win. Sometimes, the quieter path of discipline and trust does the heavy-lifting, as this fund manager, who has spent a lifetime investing through mutual funds, can attest. 

*Opinions expressed are personal