This extremely important for investors to understand the market for small and medium cap companies, particularly when it comes to investing in this segment through the instrument of mutual funds.

There are 3245 listed small-cap companies in India, 160 mid-cap ones, and only 73 large-cap ones. Most of these stocks represent small and medium companies, which the government is eager to assist and help in their recovery from the ill-effects of the pandemic.

Investors need to analyse carefully what is feasible in terms of research into these companies and what should be left alone. Investing in smaller companies are equivalent to what is called a ‘percentage shot’ in cricket.

So investors need to have a strong desire and the right attitude to manage the percentages. Succeed at a higher percentage, and fail at a lower percentage. Be prepared for the occasional bust and know precisely how to recognise it, when to acknowledge it to oneself and let go. Just as importantly, be really, really prepared for the gigantic winners and own them all the way till they become mid-caps or even large-caps.

If investments are made only in large, well-understood, and over-analysed companies, then investors could do well with them and yet never really have a winner. Make no mistake, this more stable investing is important and must be there in every portfolio but it will not deliver any outsize impact. I mean it’s possible to invest for years in large-caps and have returns that are kind-of-okay. Smaller companies provide that extra boost which many investors want.

Why Mutual Funds?

As an individual, can you mount any meaningful research on 3000+ companies? Can any one of us even begin to understand the business of any but a handful of companies, let alone acquire enough understanding and insight to be confident enough for investing in a company? For large companies, it’s not difficult to keep tabs on 70-odd ones because there is so much pre-digested knowledge available.

That’s where mutual funds come in. Fund companies are in the business of tracking a large number of companies and running investment portfolios that are composed of a balanced set of chosen stocks. A portfolio is not just a collection but a structure where different stocks of different risk, sectoral and business profiles play a complementary role. This is something entirely out of the purview of an individual investor and yet something which is easily available as a service from a mutual fund. For getting your share of small cap returns, there is no serious alternative.

Which Mutual Funds?

There are 24 small-cap mutual funds in India.  Their track records, in length and quality, vary greatly. The oldest was launched more than two decades ago while the youngest just four months back. There are three small-cap funds that we believe are the best choices for investors. These are Franklin India Smaller Companies Fund, HDFC Small Cap Fund and SBI Small Cap Fund.

In our system, these are classified as ‘Aggressive Growth’ funds, which is exactly what I’ve described above as being the goal of small-cap investing. Of course, like all equity funds, one must invest in any of these in a lump sum. A Systematic Investment Plan (SIP) is the only way one should invest in asset types of high variability.

I’m sure you’ll agree that while smaller companies are a great opportunity for boosting long-term returns, their variability means that they should not play an outsize role in your whole scheme things.

Let me elaborate. Individuals who invest in equities must exploit the outsized returns that are available in small-cap and mid-cap stocks. I’m not saying that they should invest only in ALL small and mid-cap stocks--that would be too risky--but that these stocks should be a significant chunk of their equity investments. For most of us, the best way--perhaps the only way--to do this effectively is to invest through mutual funds.

Let’s understand both parts of this story. For investors, the rewards from equity investing come from dealing with the variability in business’ performance and stock prices. It means that to make money, there are two important factors. There should be variability and you should be able to deal with it. The first is supplied by the nature of equities and the second, in this case, by choosing the right kind of mutual fund.

Why Variability Is Key

Instinctively, all of us know very well that it’s the variability of equities that make them great an investment opportunity. Some stocks will do better than others, some will do worse. Some stocks will do better in the future than they are doing now and again, some will do worse. That makes stocks risky, but this is precisely what also makes them potentially profitable. The payoff comes from investing well, which is a way of saying investing in stocks that will do better in the future. Preferably, a lot better.

Understand that risk and returns go together. There’s no great payoff waiting for you for making great choices for asset types that have no risk.

Why Small

So let’s talk about size. From almost any perspective, size is one of the most fundamentally important characteristics of a company. Whether it is for formulating investment strategies, launching mutual funds or creating market indices, grouping companies by size is the most common way of classifying stocks. And with good reason too.

Smaller companies are inherently different from larger ones. They are riskier because they are not as well-understood as bigger ones. There is relatively little research attention paid to them, so the truth about their prospects is not widely known.

However, this is actually only a small part of the story. There is genuinely a very high degree of uncertainty about smaller companies’ future. Many of them will never amount to anything. Many will fail and disappear. Even with the best of intentions, even with the best of research resources, even the best of analysts will make mistakes at a higher rate than they will with larger companies.

That’s all part of the game and is never going to change. However, it’s precisely because of this uncertainty and this risk, smaller companies that turn out to be winners give outsize returns. The two aspects--high risk and outsize returns--are two sides of the same coin. What we have to do, as analysts and investors, is two different things.

The author is CEO of Value Research