It is important for investors to keep in mind that even within equities, the risk and return profile changes in line with the size of the company (as defined by way of its market capitalization). Typically, large-cap companies (top 100 companies by way of market capitalization as defined by DSP BlackRock Mutual Fund) are considered to be less riskier than the small and microcap companies. However, the return profile of these categories also varies with small and micro-caps typically tending to outperform large-caps in the long run.
In the last three years, we have seen the small and microcap category perform exceptionally well. The category also attracted a lot of investor interest and money. While we continue to have a positive view on the category over the longer term, we are worried about valuations in the near term. Investors need to be cautious and are advised to follow the asset allocation strategy well.
I would ask them to keep the following factors in mind before investing in this category.
It is a big virtue, especially in case of small and microcap stocks. It has been observed that it takes three to four years for these companies to show superior performance. It is essential that investors should have a long-term horizon in mind if they are to invest in these stocks.
Long-term track record :
It is important to look at the long-term track record (5 -10 years) of small and microcap funds. Funds outperforming the benchmark both during bull and bear phases of the market should be generally preferred.
Risk assessment :
Small and micro-caps are fraught with higher risk and just because the price have linearly risen for the few years does not make the category less risky. In fact, it raises the risk if not followed by a similar rise in earnings. The category is expected to remain volatile and investors should carefully assess the companies/funds.
Focus on quality :
One should not lose track of quality in any market cycle. It has been observed that during bull market investors tend to go down the quality chain in search of higher alpha. This trend could prove quite risky if the market starts correcting and it can potentially wipe-out a significant portion of capital invested.
Investment philosophy :
Investors should be comfortable with the investment philosophy of the funds they are looking at and it should be in line with their portfolio objectives. This aspect is of particular importance during periods of heightened volatility when investor patience can be severely tested and it will also help them stay invested to truly benefit in the long term.
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