The dos and don’ts with small-caps, mid-caps to get best returns

These stocks are not for investors with a low appetite for risks – or limited patience

The dos and don’ts with small-caps, mid-caps to get best returns

It has not been a pleasant experience for small-cap and mid-cap stocks over the past year. They saw negative earnings growth during the course of the 12 months ending February 5. Factors such as stretched valuations and rising oil prices have been cited as reasons, and mid- and small-cap companies have lost their charm for investors, who moved away to large-cap stocks. 

Yet, there are mid- and small-cap stocks that outperformed their respective benchmark indices towards the end of 2018, perhaps to a certain degree because of the low overall participation throughout the year. Thus, the BSE mid-cap index ended 3.2% higher and the small-cap index was up 2.8% for the week ended December 14, and some 58 stocks in the S&P BSE small-cap index rose between 10-40%.

Related: Types of mutual funds and how to start investing in them 

This has naturally given rise to optimism for 2019. A Bloomberg analysts’ consensus has projected a 25% growth in net profit for mid-sized companies for 2018-19 and 21% for 2019-20. Experts also expect investors to recoup their losses from since 2016-17 by as much as 20%.

One such analyst is ICICI Prudential MD and CEO Nimesh Shah; in a signed article on February 4, Shah recommended investors to “continue with their systematic investing” into equity assets such as small-caps, mid-caps, and value funds.

Exercising caution

So does this means the bad days for mid-cap and small-cap stocks/funds are over? Perhaps not, but what has to be kept in mind is that mid-cap and small-cap funds are riskier investment options than large-cap stocks, because they do not have the scale and the capital to ride out downturns. Simply put, these stocks are not for investors with a low appetite for risks.

But rest assured; serious wealth can be had with a small-cap if it’s picked up at the right time (say, an Infosys IPO) as smaller companies can grow at a healthy pace. However, a long-term horizon is essential. Investing in such funds requires caution, and investors are better off with established funds or those of a certain size.

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Given that small-cap and mid-cap stocks have taken a serious beating in 2018, let us look at the various boxes that need to be ticked when investing in these stocks and funds. 

  • The first, of course, is risk assessment: for reasons cited earlier, small- and mid-caps carry high risk, and an upward price movement over a few years does not mean such a stock has overnight become less risky. In fact, if the price rise is not accompanied by a similar rise in earnings, there is something seriously wrong.
  • The second area that needs to be looked at is a stock’s long-term track record; it is advisable to assess performance over a period of 5-10 years. A tip: back stocks/funds that have outperformed the benchmark – during both bull and bear phases.
  • A higher risk appetite does not mean losing focus on quality, which investors tend to do in a mad quest for higher alpha. Underestimating quality is fraught with risk, because it can lead to losses if the market starts correcting.
  • Also, investors should aim to keep their portfolio objectives in sync with the fund’s investment philosophy – it helps them to not lose focus when the chips are down and patience is severely tested. In a way, it helps them to stay invested and reap benefits over the long term.
  • This brings us to the last point – and one of the most important while dabbling in small and mid-cap stocks: patience. It is not uncommon for a company to begin to perform well only after three or four years have passed. Thus, investors are advised to keep a long-term horizon with these stocks.

Related: How to diversify your portfolio like an expert?

Last words

An investor in small- and mid-cap stocks should also consider the basic trait of these categories: they perform well in value terms during bull runs, but plunge when markets are down. Having said that, here are few mistakes you must avoid while investing in a bull market. This is mainly because such stocks are marked by modest market capitalisations and limited liquidity due to the smaller number of shares offered by the company. 

However, as recent trends have shown, small-caps and mid-caps can be lucrative, provided one has the required patience. In investment, patience is a big virtue.

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