Time and again, investors have been lured by high return potential of small-cap companies. This is because smaller companies have potential to give very high returns in a very short duration of time. There are instances when a small-cap company has given more than 10x returns within one year of time. Such huge returns are unheard of in any other segment of stock markets, viz. Large and Mid size companies. As we all know there are no free lunches in equity markets :) So, with a huge return potential, there is also an equal chance of losing your investment capital. Hence, most of the investment advisors reserve small-cap space for more aggressive and savvy investors.

Though we agree with this statement in-principle, we hate to deprive our investors with such a lucrative investment opportunity. The challenge for us was to find a way to give this opportunity to majority of our investors without increasing their portfolio risk substantially. So, we delved deeper into this subject and figured out that the following: "Risk can be reduced significantly by investing into smaller companies after they have corrected substantially from their recent peak". Further, instead of investing into few stocks, it is much better to invest into a small-cap mutual fund. A small-cap mutual fund typically invests into a portfolio of 60-80 high potential small sized companies. This way the investment gets diversified thereby reducing the investment risk.

When to invest in a small-cap mutual fund?

Now coming back to our analysis of investing into a small-cap mutual fund after the small-cap index has corrected substantially. What is the right level of correction to start investing in small-cap mutual funds? What should be the time duration of such investment? What is the underlying downside risk? To answer these questions, lets look at the following analysis performed by the FinAtoZ Research team:

We did some primary analysis and figured out that 30% correction from the peak is a reasonable level to start accumulating small-cap mutual fund. We analysed historical data of Nifty small-cap index and found that there are four such instances when it fell by more than 30%. If an investor invested into a small-cap mutual fund after a 30% fall from its recent peak, we saw that in all the four instances an investor made more than 18% annualized return within 5 years of investment. See table below: 

In three of the four instances, the returns were more than 20% annualized return within 5 years of investment. Further there were three instances (out of four) when the investor experienced high returns within 2 years of investment!!

What is the max.downside that you should to be prepared to see?

This is an interesting analysis. Even if one invests after the small-cap index has fallen by 30%, there is still a chance that the index may fall much more. In one of the four such instances, the small-cap index fell by 40% more before it recovered eventually. This is a significant downside risk for a conservative or moderate investor. Though eventually the investor made good returns, but in the interim he saw his hard earned money dip below its invested value. You would have to be mentally tough to see your investments go down below its invested value.

There is, however, a way to reduce this downside risk. This is by spreading your entry over a 3 to 6 month period using Systematic Transfer Plan (STP). This way the downside risk can be reduced by as much as 50%!! Or in other words, by deploying advanced investment strategies like STP, the downside risk can be reduced from 40% to around 20%. So, the investor should be ready to see his invested value go down by around 20% before making returns eventually.

Other important considerations!

In addition to analysis of historical data, it is also very important to understand the following factors: What are the current economic conditions? Are we at the top or bottom of economic cycle or somewhere in-between? What is the current geo-political context? etc.

These are very relevant considerations before timing your entry into small-cap space. As per data from trading economics, our manufacturing industry is at a capacity utilization of 81.8% which has risen continuously over the past 3 years. Combined with this, the GDP growth rates have been healthy too. As per our analysis, India looks poised to grow at an healthy rate over the next 2-4 year time-frame. If such a scenario pans out, Indian manufacturing companies already have a spare capacity of around 20%. This can be utilized to increase the production and thereby profit margins. This gives a clear indication that we are not at the peak of an economic cycle. When the economy corrects from its peak, the correction is likely to be deeper. But when the stock markets correct from in-between, the correction is not likely to be very high. 30% correction in small-cap is already pretty high for a market that is not considered to be at its peak.

There are other factors that can impact in the short run like General Election outcome, Indo-Pak tensions, US-China trade war etc. However, in our view, such things are part and parcel of the investment journey. They don't have much impact in the medium to long run.

Conclusion

As per our analysis, we do believe that this seems to be the right time to invest in small-cap mutual funds. In the current circumstances, 30%+ correction in a small-cap index gives a fantastic entry point for a savvy investor to invest for a 3-5 year time-frame. As we had advised in our earlier article on "tips to ride market volatility", we advise our investors to continue with their equity investments and look at an opportunity to invest more in the small-cap space. This is the time to speak to your financial advisor and get started on small-cap funds!!