What no one told you about the mind blowing mid and small cap returns

Lately, I have been receiving a lot of mails on whether this is the right time to invest in mid and small caps.

The reason why some of you think I might be able to predict is because of this earlier warning that I had given during January in my post –

Seat Belts, Condoms and the Indian Equity Investor

Now to be honest, I had no freaking clue that such a sharp mid and small cap fall was coming post that. If you read that article, I had just indicated that people were forgetting the risk part and focusing only on the returns which is not a great place to be. Inevitably when people forget risk and become aggressive something always goes wrong. The timing was luckily correct but that has nothing to do with my ability to forecast.

If the crash had come say 2 years later (which was of course possible) I would have looked really dumb. The tough part of risk is that you can only approximately and qualitatively evaluate the extent of risk but cannot exactly time the trigger which will cause it to play out.

So now that you know my capabilities to predict and that I was just plain lucky, let us delve into some interesting but often ignored aspects of the mid and small returns of the past 5 years.

Why is everyone interested in only Mid and Small Caps?

Have a look at the below table which indicates the past 5 year returns in Mid and Small cap funds

Source: Value Research

Now we are like..

Wow! That’s 25% returns every year for the last 5 years!

My bloody FD gives me 7-8% and that too the government puts a tax and takes a portion away!

It’s time for equities and let me jump into mid and small caps!

Hang on..Pause and take a deep breath

Let us revisit our mind voice again

“Wow! That’s 25% returns every year for the last 5 years!”

This conclusion from our impatient mind is the single most important reason why most of us end up having a bad experience in equities.

The real question to ask:

Is it really 25% every year?

Let us explore..

Just take a minute to go through the returns of each and every year which led to the 24-27% returns in mid and small cap funds.

Do you see the catch?

The mind blowing returns of mid and small cap returns were primarily driven by the returns in 2014 where they had outperformed every other category by a huge margin.

To put that in perspective, a return of 73% and 87% in single year contributes ~20% to 23% CAGR for all 3 year periods which include 2014. Similarly, the single year return contributes 12-13% CAGR for all 5 year periods which include 2014!

Now to make things clear, let us see what happened if you missed out on 2014 and started to invest only from 2015.

Oops! What happened to the mind blowing out performance?

The returns of mid and small cap category is almost in line with large and mid, multi cap and large cap category!

So the key here is that, to really have experienced the 25% returns on which you are being sold, you must have invested in 2013.

Back to 2013..

Let us rewind back to 2013,

At the index level, mid and small cap segment had been hammered.

The newspapers scared the shit out of you.

The past mid and small cap fund returns while not as bad as the index, weren’t great either (an FD would have given better returns – your mind voice would have argued).

Now do you seriously think you would have invested in mid and small cap segment just before the 2014 rise.

As expected, all of us were running out of equities leave alone mid and small caps in 2012-13 which in retrospect seems to be the best year to invest.

Past performance always needs to be put under context

This is the reality of equity investing.

The actual mid and small cap out performance came when everyone had given up and the past returns were pathetic.

Misled by the poor past returns, unfortunately most of us didn’t invest in mid and small caps when it really mattered.

This holds an important lesson for us as investors:

No investment style or approach will outperform at all points in time. The sooner we accept this, the better our investment experience would be.

Based on the changing market conditions, various investment styles usually find favor at different points in time.

Mid and small caps after several years of dismal performance had finally found favor in 2014 as the market conditions favored that particular style.

But as we all know, market conditions inevitably change and some other different style or approach will find favor. Last year was an example for this as mid and small caps have corrected while the large caps did well.

Thus, to predict the future winners, the real ask is to identify the future market conditions and not the past market conditions which led to the current winners.

Unfortunately, the future market condition has several possibilities (what ifs) and no one knows, which of the market conditions will really play out, when it will play out and how long it will play out.

Let us take the example of mid and small cap segment.

In 2014, the returns were primarily driven by valuation multiples expanding as BJP won the elections and there were huge expectations of reforms.

In 2017, the returns were again primarily driven by valuation multiples expanding as demonetization led to money moving away from real estate and gold to equities.

Now honestly it is not possible to have predicted both these events.

So what do we do?

Now while we cannot predict the future market conditions, not everything is lost.

Instead of trying to predict the future market conditions, we can evaluate for signs of where we are in the cycle (partly art, partly science) and take a call on when to increase our exposure to mid and small caps.

Usually bad past returns, scary headlines, weak earnings growth over the past few years, no investor interest and attractive valuations are a good starting point to evaluate a particular investment style. The vice versa case holds good as well!

The mid and small cap category ticked all of the above in 2013 –

1. Valuations were very attractive
2. Earnings growth was yet to play out
3. Headlines were scary
4. Investor interest was zilch
5. Past returns were bad

We were somewhere close to the bottom of the mid cap cycle and this was the time to be aggressive.

A lot of fund managers such as Kenneth Andrade , Sankaran Naren, Krishnakumar etc were able to identify this cycle.

In fact in the mid of 2013 at my organization we had asked our clients to invest in mid and small caps and had invested in a lot of the closed ended series which came at that point in time.

We knew the “Why” but not the “When”.

We were lucky that the call immediately played out and looked like we were extremely smart. But who knows, in an alternate version of history BJP may have not won the election and the mid cap rally could have been delayed. The trigger might have been something completely different. But since we had the odds in our favor we just had to patiently wait for a positive trigger to strike.

However post that we started reducing our allocation starting mid of 2015 as valuations were becoming unattractive (at least according to us). Unfortunately it took 3 years for our call to play out. And we looked extremely dumb till 9 months back.

This is the tough part of investing.

In the short run, there are hundreds of parameters which impact the markets and decide the investment environment. However in the long run, eventually it boils down to valuations and earnings growth.

Summing it up

So the whole idea is to keep this in mind and..

• Diversify across various styles – large, mid and small + value/growth/quality + international/domestic etc. Across shorter time frames inevitably there will be few styles which will find favor and will keep alternating. In the long run, the returns across proven investment styles will mostly work out to be close to each other and will provide you with a comfortable journey.
• Do not take exposure to various investment styles or approaches purely based on high past returns
• Keep looking out for risk (read as pockets of overvaluation) and start reducing exposure
• Valuations, earnings growth expectation, investor sentiments, flows can be used to calibrate the proportion of investments to these various investment styles or approaches

As for what to do with mid and small caps, that’s a topic for another day.

Happy investing!

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