Quality micro-cap stocks remain in focus

Securities Exchange Board of India (SEBI) on Friday (September 11, 2020) issued a circular regarding the asset allocation in the multi-cap funds. The initial scheme categorization circular issued in October 2017 only wanted a multi-cap fund to maintain 65 per cent equity exposure with no other regulation on market cap allocation. Now, it has modified the asset allocation rules "in order to diversify the underlying investments of multi-cap funds across the large, mid and small cap companies and be true to label."

To understand better, multi-cap funds are seen as all-weather funds for their flexibility to invest across the capitalizations of the stock markets. The seamless transition from a large-cap heavy to mid and/or small-cap to take advantage of the opportunities is possible in these funds. The fund manager will also have the freedom and less restrictions in sticking to a profile other than to make greater returns to the investors. This is the largest category with about 20 per cent of the mutual funds (MF) industry similar to that of the large cap funds. From the investor perspective too, these funds offer better risk adjusted returns than that of the mid and/or small-cap funds due to their very nature of having a buffer through the large cap exposures.

Ever since, the reorganization of mutual funds through categorization came into effect, the mid and small-cap stocks have taken a dent with particularly the smaller caps coming off from their heady 2017 performance levels. The categorization forced the divestment of allocations that were not in sync with their objective or category and mid and small caps have taken by a big portion of the hit due to the subsequent sell-off. The Long-Term Capital Gains (LTCG) on equity and related investments only added fuel to this exodus.

In a move that seems like a redemption of the earlier step, has come up with classification on the 75 per cent of the equity investment with a minimum of 25 per cent each in large, mid and small cap coming into effect from February 2021. It's to be observed that due to the current conditions of global and domestic uncertainty, most of the funds, especially with the larger asset size have majority of the allocation to the large caps among their multi-cap funds. This is just an aberration and none of the managers would pile up the large caps if the mid and small-cap stocks are as lucrative.

Also, need to be considered is that most of the current multi-cap funds are benchmarked against BSE/Nifty-500 where the large-cap stocks constitute about 80 per cent of the total capitalization. So, naturally fund managers would more or less imitate the benchmark and is evident from their current asset allocations. The post-March rally has brought in new investors willing to make a quick gain by adding into the already discounted prices in the small cap. The slowing down economy and the lack of liquidity in the small cap space has resorted to flight to safety by the managers to stick to large caps.

Again, it is to be noted that quality micro-cap stocks have remained in favor of the investors and fund managers, irrespective of the market conditions albeit at a lower end currently due to the prevailing market and macro environment due to the pandemic. While the new circular gives about six months' time for the incumbents to mend to the restrictions imposed, there could be a lot of volatility in the performance especially with funds of larger sizes. A quick estimate puts that over Rs27,000 crore is to be added into the small-cap stocks by the existing multi-cap funds and an additional 13,000 cr to the mid-cap stocks, while bringing down over 34,000 cr from their large cap exposures.

This has the potential to create rallies in the mid and small cap while a bit of rationalization in the large cap. The existing investors in the mid and small-cap funds could gain from this and also of those with focused funds (with higher mid/small-cap exposures). The fund inflows also benefit the low float companies with better prospects of growth with an existing low debt and quality business. The new rules could lead to a new churn while also forcing to compromise on the quality due to the mandatory percentage allocation leading to underperformance in the category. While the Sebi's diversification agenda is clear, the execution is riddled with quality, liquidity and fund sizes. There's also a potential of some of the funds merging or classifying to another category according to their overall portfolio. The move also could make the existing small cap funds more concentrated and lead to different issues if a rally persists. A lot could happen in the next six months and investors should resist trying to time the market. Existing investors have to relook at their risk profile to realign the multi-cap allocation to the desired levels.

(The author is a co-founder of "Wealocity", a wealth management firm and could be reached at knk@wealocity.com)