Weekly Musings – NFO Pick (JM Small Cap Fund)

9 May 2024 , 10:48 AM

UNDERSTANDING THE SMALL CAP OPPORTUNITY

How big is the small cap opportunity for investors in India?  Technically there are about 5,000 stocks meeting the small cap definition, but most fund managers remove the micro caps and then the small cap numbers are much smaller. What is important is that the entire small cap space, which accounts for over 90% of the number of listed companies in India, make up less than 15% of the market cap of the BSE and NSE. But the real opportunity in small caps is in stock selection.

Why do we put so much focus on stock selection. Out of the 2,720 small-cap stocks in the year 2018, 2,686 stocks are still small caps and they have yielded 7% CAGR returns in the last 5 years. A total of 32 stocks have graduated from being small caps to mid-caps in these 5 years and they have given CAGR returns of 32% in these 5 years. Just 2 stocks have grown from small caps to large caps in these 5 years, giving CAGR returns of 57% in 5 years. So, the real opportunity in small cap funds is in the last two categories.

BIG DRAWDOWNS, BUT LIMITED COVERAGE OF SMALL CAPS

There are normally two contrasting factor that play on the small cap stocks; one is negative and the other is positive. On the down side, the drawdowns are much deeper in small cap stocks and the they also take a longer time to recover after a correction. For instance, in 11 out of the last 19 years between 2005 and 2023, the small caps have seen drawdowns in excess of -20%. In comparison, mid-caps saw draw downs on 8 occasions in this period and large caps on just 4 occasions. Also, if you look at the previous small cap corrections of 2008, 2011 and 2018; it is the small caps and the mid-caps that have taken a much longer time to recover, while the recovery period is much shorter in large caps.

However, there are also some positives in small caps. At times, it does look like a treasure hunt; and that is what it actually is. The probability of finding those big winners is quite small. However, the number of analysts covering small cap stocks is substantially lower than the analysts covering mid-caps and small cap stocks. Also, the average institutional holding in these small cap stocks is much lower than in mid-cap and large caps. That means; there are number of hidden gems in small caps, but you can never find so many hidden gems in large caps as the institutional tracking is too high.

HOW AN ACTIVE APPROACH CAN HELP IN SMALL CAPS

How is it that an active fund management approach through a small cap fund can be helpful? There are several reasons, and all are borne out by statistics.

• One way to look at the chances of success is to look at the probability of a small cap fund beating the index. Based on last 12 years data, the probability of small cap funds doing better than the index is as high as 92%.
• It is also the alpha that matters. Over the last 12 years since 2012, the average alpha (excess returns) generated by the small cap funds, over the Nifty Small Cap 250 TRI index is 6.4%.
• Small Cap funds do better in a crisis than the index. In the GFC, the active small cap fund fell by -69% against -76% for the small cap index. Similarly, in the COVID crisis, the active small cap fund fell -50%, compared to -60% for the small cap index.
• Small cap funds may not capture the full upside, but do a lot better on the downside. In a rising market, the up-capture of small cap fund is just 84% of the index, but in a falling market, the down-capture is just 63% of the index, which makes it an attractive bet.

Clearly, active fund management, not only works, but works effectively in case of small caps.

PERFORMANCE OF SMALL CAP FUNDS IN INDIA

Here is a quick look at how small cap funds in India have performed in India over different time frames like 1-year, 3-years, and 5-years. We have considered the direct returns in all the cases to avoid the distortion that total expense ratios (TER) brings about. Also, there are cases where the 3 year and 5 year returns may not exist, due to the recency of the fund. In such cases, the returns since inception have been substituted in that case. The rankings are based on 1-year returns.

Scheme Name	1-Year (%) Returns	3-Year (%) Returns	5-Year (%) Returns	Daily AUM (₹ in Crore)
Bandhan Small Cap Fund	78.59	32.25	39.69	5,037.81
Mahindra Manulife Small Cap Fund	74.27	54.13	54.13	4,006.20
ITI Small Cap Fund	70.78	26.36	26.79	1,951.80
Quant Small Cap Fund	70.41	39.08	40.75	20,204.34
Nippon India Small Cap Fund	60.47	35.63	32.33	50,631.99
Franklin India Smaller Companies	60.41	33.63	25.62	12,618.63
Invesco India Smallcap Fund	59.29	31.81	28.93	3,974.10
Bank of India Small Cap Fund	55.35	29.88	34.07	1,054.13
Sundaram Small Cap Fund	52.88	29.12	25.86	3,153.09
HSBC Small Cap Fund	52.46	33.38	27.12	14,596.23
Aditya Birla Sun Life Small Cap Fund	51.02	22.25	19.45	4,758.94
LIC MF Small Cap Fund	50.62	28.63	25.29	223.88
Edelweiss Small Cap Fund	50.49	30.52	30.84	3,353.62
HDFC Small Cap Fund	49.17	31.92	25.02	29,458.00
Tata Small Cap Fund	48.41	32.87	30.17	6,951.59
Union Small Cap Fund	48.13	25.88	27.10	1,401.36
DSP Small Cap Fund	48.08	27.44	26.48	14,025.47
ICICI Prudential Smallcap Fund	47.05	30.03	28.02	7,654.64
Kotak Small Cap Fund	43.85	25.10	28.98	14,847.10
Canara Robeco Small Cap Fund	43.74	29.91	29.77	10,040.07

Data Source: AMFI

At the outset, the JM Small Cap Fund NFO performance may not be entirely reflected by the averages we are talking about here. However, it will give a rough idea of how small cap funds in India have performed. There are a total of 24 small cap funds in India managing a total AUM of ₹2,62,987 Crore, and JM Small Cap Fund NFO comes at a time when fund houses have been generally cautious about small cap funds due to the recent SEBI strictures. Here are how the returns and the return dispersions worked across time frames.

• The return dispersion is relatively high in this case and that is largely because many of these stock holdings are fairly distributed across funds. Also, the timing of entry matters a lot in small cap funds. On a 1-year returns basis, small cap funds in India generated maximum returns of 78.59% and minimum returns of 39.89%, showing rather robust performance even in a worst case scenario. The average returns over a 1 year period are 53.34%, which is very impressive. However, it must be noted here that the small cap index itself has given more than 55% returns in the last 1 year, so this is not surprising.
• On a 3-year returns basis, small cap funds in India generated maximum returns of 54.13% and minimum returns of 15.43%, showing rather robust performance even in a worst case scenario. The average returns over a 1 year period are 30.14%, which is very impressive. However, it must be noted bulk of the returns on small cap fund have actually come about in the last one year only.
• On a 5-year returns basis, small cap funds in India generated maximum returns of 54.13% and minimum returns of 15.43%, showing rather robust performance even in a worst case scenario. The average returns over a 1 year period are 29.39%, which is very impressive. However, it must once again be noted here that the small cap index itself has given most of its returns in the last 1 year, which is why 1-year returns are so high.

The strategy has done very well over a shorter time frame, and over a longer time frame, even the worst case returns look to be quite impressive.

GLANCE AT THE JM SMALL CAP FUND NFO

Here are some details of the JM Small Cap Fund NFO you must know to decide on investing in the fund.

a. The NFO of JM Small Cap Fund opens for subscription on May 27, 2024 and will close on June 10, 2024. Being an open-ended equity scheme, the fund will offer buy and sale at NAV linked prices and will reopen for sale and repurchase within 10 days of NFO closure. While the fund has no lock-in period, it is best to hold such small cap funds for a period of 5 years or more to get full benefits of the small cap investment cycle.

b. On the Standard SEBI Risk-O-Meter, the JM Small Cap Fund will be ranked as a Very High Risk Fund. The high risk is due to the predominant exposure to equities that the JM Small Cap Fund will have. In addition, there is also the risk of entering into the fund when the market is at all-time high levels. Above all, the focus of the fund will be predominantly on the small cap theme, which is generally considered to be much riskier than diversified large cap equity funds.

c. The JM Small Cap Fund is about long term capital appreciation with the combination of alpha and the benefits of time. This theme has been observed to outperform other capitalization themes in India. However, one risk to be conscious of is that the small cap stocks, by default, tend to outperform in risking markets but underperform in falling markets. Over a longer holding period of over 5 years, such cycles get neutralized.

d. Investors can invest in the NFO of JM Small Cap Fund in minimum size of ₹5,000 and in multiples thereof. This also applies to switch-ins during the NFO while additional purchases will be of a lower amount. There will be an exit load of 1% on the fund if it is redeemed within 180 days of the allotment date. However, investors are advised to hold such funds for a minimum period of 5-7 years to get full benefits of small cap theme.

e. The JM Small Cap Fund does not give any guarantee on returns, being a pure small cap equity fund, the fund will maintain 80-100% exposure to equities, with predominant exposure to small cap stocks. The focus of the fund manager would be more to generate alpha on a consistent basis.

f. The JM Small Cap Fund NFO will offer the growth option as well as the IDCW (income distribution capital withdrawal) payout option. It will offer the facility to invest via the Regular Plan or through the Direct plan. The NAVs on redemption will be different for regular plans and dividend plans based on the TER imputed to the fund. The NAVs of growth plan and IDCW plan will differ to the extent of dividends declared.

g. The fund is best suited for investors with a higher risk appetite and ability to stay invested for 5-7 Investors in JM Small Cap Fund NFO must be prepared for the additional risk that small cap stocks entail due  to their focused business model and narrow client base. Small caps have outperformed Nifty over 1 year and 5 years. Such data may, however, not be indicative of future performance of JM Small Cap Fund.

h. The performance of the JM Small Cap Fund will be benchmarked to the underlying Nifty Small Cap 250 TRI. The TRI (total returns index) is more reflective as it includes the impact of dividends and capital movement. This benchmarking will evaluate how the fund is performing vis-à-vis the underlying benchmark. The fund managers for the JM Small Cap Fund will be Asit Bhandarkar and Chaitanya Choksi.

i. The JM Small Cap Fund will be classified as an equity fund for tax purposes; with its equity exposure decisively above 65%. The short term capital gains (held for less 1 year) will be taxed at 15% while long term capital gains (held for over 1 year), will be taxed at a flat rate of 10% beyond a minimum threshold exemption of ₹1 Lakh per financial year.

The JM Small Cap Fund NFO is an opportunity for investors to participate in the in smaller stocks with focused business models and the potential to become mid-caps and large caps in the future. Investors can look at this NFO, not only to add alpha to their satellite portfolio, but also to manage diversification of portfolio across sizes.