Time to Nibble On Mid- and Small-Caps

By Umang Papneja, Senior Managing Partner, IIFL Investment Managers

The simple answer to “When to invest?” is “Now”. However, the answer to “Where to invest?” is a lot more complicated. The recent risk aversion in the credit space and the sell-off in the mid- & small-cap space have thrown up some interesting opportunities. We believe it is a good time to start looking at some allocations in the beaten-down spaces of credit, mid-caps and small-caps while gaining large-cap exposure through structured products.

When it comes to investing in equity markets, the signal turns green when the price paidjustifies the value received. Mid- and smallcaps are slowly entering that sweet spot where they are available at compelling valuations. While the overall mid- and small-cap valuations are still not very cheap and hover around one standard deviation above mean, the recent steep correction has opened pockets of opportunity in several companies. When we look at the 101st company to the 500th one, we observe that 30 % of these companies are trading below trailing P/E of 15. This percentage was as low as 12 % on 31st January 2018, indicating that a larger number of companies in the space are now available at cheaper valuations. Additionally, the ratio of price to book of Midcap vs Nifty has also shifted towards the mean and is far away from the excesses that it was trading earlier. Our in-house proprietary market-cap allocation model suggests that investors should consider allocating 20% and 10% of their investment portfolio to midcaps and small caps, respectively. They should start allocating monies to portfolio managers who are good stock pickers with a nimble corpus. This will allow them the flexibility to create a fresh portfolio based on the current opportunities and generate alpha. Increasing coverage of large-cap stocks, decreasing market inefficiencies and the higher expense ratio of mutual funds are making it challenging for large-cap fund managers to generate alpha.

Last year we saw passive strategies gain traction as investors allocated more and more money to such investments. We believe that the core allocation to large-cap stocks should be done through passive strategies like large cap ETFs and principal-protected structured products, which can provide participation on the upside and capital protection on the downside with low credit risk. These products can be structured in such a way that they can capture the upside potential of Nifty and protect the downside by ensuring capital protection at the end of the tenure through investments in AAA-rated issuers backed by strong promoters.

Over the last six months, heightened volatility in the fixed income markets has had a strong impact on the type and quantum of fixed income allocations. A host of credit events led to a liquidity crunch and a subsequent widening of spreads. However, this extreme risk aversion has created an opportunity to invest in the markets with extremely good risk-reward ratio. Today a lot of companies as well as promoters, are offering higher yields with stronger covenants and securities. These structured deals are available in the private credit space since mutual funds and NBFCs are not participating actively in this space right now. These transactions are 400-500 bps above what they were six months ago. We believe that it is a good time for investors to start allocating some money to well-structured credit funds and also standalone deals as managers can negotiate for a higher yield with strong collaterals and securities in place.

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Economic Times