If you’ve been keeping a close eye on the stock market, you’ve likely noticed the remarkable performance of small-cap stocks. Over the past year, small-cap equity mutual funds have consistently outperformed, claiming top spots in various performance charts, including longer-term periods like 3 and 5 years. Enter Baroda BNP Paribas MF with its latest offering, the ‘Baroda BNP Paribas Small Cap Fund,’ marking the 23rd actively-managed scheme in this category. The last year has witnessed a surge in index fund launches tied to small-cap indices. The new fund offer period remains open until October 20, 2023. So, what sets apart the Baroda BNP Paribas Small Cap Fund? Is investing in small-caps a wise move right now? What sets this new offering’s strategy apart? Let’s delve into a comprehensive review.

Small-Caps: A Glance at Their Past Performance

Small-cap stocks have certainly shone brightly in recent times. Whether you look at returns over 1 year, 3 years, 5 years, or even a decade, small-caps have consistently outperformed large-caps, as evidenced by the Compound Annual Growth Rate (CAGR) of the Nifty Smallcap 250 compared to the Nifty 50. However, it’s important to note that small-caps often exhibit polarized returns, with significant variations between the top and bottom performers in the Nifty Small Cap 250 index. Therefore, selecting the right stocks is crucial in the small-cap segment.

Given that small-cap companies are relatively smaller in size, they have the potential for substantial growth. Beyond the 250 listed companies (with the top 100 as large-cap and the next 150 as mid-cap) in terms of market capitalization, the small-cap universe offers a wide array of choices across various companies, sectors, and business models.

Valuation Considerations

Typically, stock returns depend on a combination of earnings growth and valuation re-rating. Currently, as a group, small-caps (Nifty Small Cap 250) trade at a trailing Price-to-Earnings (P/E) ratio of 24.5 times, which is higher than the 22.2 times for large-caps (Nifty 50). According to Baroda BNP Paribas, small-cap valuations are in line with their historical averages and have room for further growth. Additionally, the forward P/E ratio for small-caps is similar to that of large-caps. Regarding earnings growth, small-caps are expected to exhibit higher Earnings Per Share (EPS) growth compared to large-caps, which is not surprising, given their need to justify higher valuations with robust growth.

Baroda BNP Paribas points to historical data, indicating that small-cap boom cycles typically last around 660 days, with an average absolute growth of 179 per cent across four cycles. According to the Asset Management Company (AMC), the current cycle has spanned 182 days, with small-caps already experiencing a 33 per cent increase, suggesting potential for further growth.

Investment Strategy

The Baroda BNP Paribas Small Cap Fund will allocate over 65 per cent of its net assets to small-cap companies, in adherence to its mandate. Existing small-cap funds currently hold around 80 per cent in small-caps, with 15 per cent in mid-caps and the remainder in large-caps. Notably, DSP Small Cap, ICICI Pru Smallcap, and Tata Small Cap have the highest allocations to small-cap stocks.

Consistent with Baroda BNP Paribas’ BMV philosophy, the fund’s focus will be on selecting companies with strong fundamentals, quality business models, and a reputable management team.

The fund will not be confined to any specific sector, adopting a sector-agnostic approach. In the current small-cap fund landscape, sectors such as industrial products, consumer durables, banks, auto components, and finance tend to receive significant allocations. Pinpointing a specific style followed by funds in this category can be challenging. Nevertheless, it appears that some funds lean towards cyclical sectors in their portfolios.

Key Considerations

First, it’s worth noting that existing small-cap funds employ various methods to mitigate risks and address valuation concerns. For instance, funds like Nippon India Small Cap, Bandhan Emerging Businesses, and ABSL Small Cap maintain portfolios consisting of 100 to 200 stocks to ensure diversification. In contrast, PGIM India Small Cap, LIC MF Small Cap, and SBI Small Cap have fewer holdings, typically ranging from 50 to 60 stocks. It will be essential to closely examine how Baroda BNP Paribas Small Cap structures its stock portfolio.

Second, it’s advisable not to invest money in small-cap funds if you anticipate needing to withdraw it within the next 10 years. Over shorter time frames, such as one, three, or five years, the likelihood of achieving subpar returns is relatively high. Given that markets rarely provide advance warnings of corrections or bear phases, it’s prudent for first-time investors to opt for the Systematic Investment Plan (SIP) route when investing in this category.

Third, historical analysis indicates that investing in small-cap funds after significant market declines, rather than during bull markets, can lead to better returns. While predicting market tops or bottoms is challenging, entering the small-cap space after a substantial market (Sensex) decline, typically around 20 per cent or 30 per cent, has historically yielded favorable results.

Our Take

Entering the small-cap fund arena at market peaks can pose risks. Small-cap funds are known for their volatile performance, swinging between periods of exceptional returns and underwhelming results. Therefore, it’s crucial to ensure that your small-cap investments, including SIPs, align with your overall equity portfolio and risk tolerance. Resist the temptation to overweight this category during bullish market phases.

We typically prefer funds with a track record spanning an entire market cycle, encompassing both bull and bear phases. Given that the Baroda BNP Paribas Small Cap Fund is a new entrant and untested, it may be prudent to await the development of its performance history.