Weekly Musings – NFO Pick (Baroda BNP Paribas Small Cap Fund)

15 Oct 2023 , 10:33 AM

UNDERSTANDING SMALL CAP INVESTING

In the latest weekly coverage on mutual fund NFOs, we cover the Baroda BNP Paribas Small Cap Fund. As the name suggests, the Baroda BNP Paribas Small Cap Fund will be an intensely active fund with a focus on alpha; which is another name for generating excess returns above what the market is expecting from the fund. The focus of any small cap fund (and the Baroda BNP Paribas Small Cap Fund is no different) is to identify stocks that are small in size but high on quality and allow them time to grow and become large caps. 

Many of the highly profitable large caps of today were small caps and mid-caps at one point of time. The story of small cap investing is about catching them young and watching them grow. The idea of small cap fund investing is not about index-plus returns, but substantial outperformance over the index through a properly diversified portfolio of predominantly small cap stocks.

HOW WILL THE FUND DECIDE THE INVESTMENT STRATEGY?

Obviously, as the name suggests, the portfolio of Baroda BNP Paribas Small Cap Fund would be sharply inclined towards the small cap stocks. However, there are two interesting things to understand here. Firstly, how will the asset allocation look like and secondly, how are small caps defined in the massive universe of over 5,000 stocks listed on the NSE and the BSE combined. But, first let us focus on the asset allocation that the Baroda BNP Paribas Small Cap Fund proposes to have.

Type of Instruments	Minimum Allocation	Maximum Allocation	Risk  Profile
Equity & Equity related instruments of small cap companies	65%	100%	High
Equity and equity related instruments of mid-cap and large cap companies	0%	35%	High
Debt and Money Market instruments	0%	35%	Low to Medium
Units issued by REITs & INVITs	0%	10%	Medium to High
Units of Mutual Fund Schemes	0%	10%	Medium to High

The above table is just the theoretical framework that the Baroda BNP Small Cap Fund will follow. However, under SEBI regulations, any small cap fund has to mandatorily maintain at least 65% of their corpus in small cap stocks, but it has the leeway to decided what to do with the other 35%. However, the general practice is that around 75% to 80% of the corpus would generally get invested in small cap stocks. Another 10-15% gets invested in mid-cap and large cap stocks and just about 5% is maintained as liquid assets. This kind of an asset allocation ensures that the risk is reduced at an overall level, but at the same time the alpha goals of the small cap fund are not compromised.

That brings us to the next question; how are small cap stocks defined? SEBI has standardized the definition of stock classification based on a ranking model and not on a market cap model. As per the SEBI rule, the entire list of companies is ranked descending on the market cap. In case of multiple listing of stocks on NSE and BSE, the exchange with higher volumes is taken in account. Once the ranking is done, the classification is as under:

• The top 100 companies by market cap would qualify as large companies.

   

• The 101st to 250th companies by market cap would qualify as mid-cap companies

   

• The 251st and below companies by market are ranked as small cap stocks; which will be the subject of focus for Baroda BNP Small Cap Fund.

To make this list current and to reflect the changing times, SEBI reviews this list on a half yearly basis and makes changes to the classification where warranted. In addition, the fund can also invest up to 50% of assets in derivative instruments too.

DOES SMALL CAP INVESTING REALLY GENERATE WEALTH?

It is good to talk about alpha and historic returns, but does the idea of investing in small cap funds actually outperform the generic stock indices over a period of time. We first need to understand when the small cap stocks do well. For instance, when there is a massive sell-off in the market, like the kind of sell-off we saw in 2008 or 2013 or even in 2020, the small cap stocks tend to underperform. Where these small cap funds actually outperform is when the markets are overall in an uptrend and the optimism on the economy is high. 

We first need to understand what this market cycle from bottom to peak is all about. A typical bottom to peak cycle in India has lasted for about 660 days on an average. The table below captures how the small cap index has done vis-à-vis the large cap index during each of these cycles. That data is captured in the table below.

Market Cycle (bottom to peak)	Tenure of  Cycle	Large cap  Returns	Small Cap  Returns
Cycle 1	579 days	141%	197%
Cycle 2	740 days	128%	180%
Cycle 3	661 days	42%	93%
Cycle 4	666 days	143%	247%
Cycle 5	182 days	12%	33%

The last cycle (Cycle 5) is the cycle that is currently on. If you consider that an average bottom to peak cycle has 660 days, then we should ideally have a lot more of upside alpha to be generated in this cycle by the small cap stocks. That is where the Baroda BNP Smal Cap Fund is positioned. The above table shows that in each of the bottom to peak cycles in the past, it is the small cap stocks that have decisively outperformed the large cap funds. However, one can argue that no investor catches the bottom and top of the cycle precisely, so we look at a more passive approach. How the large can and small cap indices have generated CAGR returns over different holding periods.

Holding Tenure (CAGR Returns)	Nifty Small Cap 250 TRI Index	Nifty 50 (Large Cap TRI index
Last 1 year	29%	10%
Last 3 years	36%	21%
Last 5 years	15%	12%
Last 10 years	21%	15%
Last 18 years	16%	14%

The table below is a lot more convincing analysis of how small caps tend to outperform the large caps. We have considered a range of holding time frames and used CAGR returns to smooth out the time period volatility. Clearly, the small cap index has outperformed the large cap across all time frames. The margin may vary, but the outperformance is clear. That is the basis of the narrative for the Baroda BNP Paribas Small Cap Fund NFO.

WHO SHOULD INVEST IN BARODA BNP PARIBAS SMALL CAP FUND

Obviously, when you invest in any small cap fund, investors must be wary of the higher risk that it entails. In fact, there are 3 risks here. Firstly, there is the risk of equities as an asset class. Secondly, being an active fund, there is also the risk of fund manager discretion. Lastly, small cap stocks have business models that are more concentrated in terms of business spread and clients. This makes them more vulnerably and risky. Here are some key points to note before investing in the Baroda BNP Paribas Small Cap Fund.

• Investors holding portfolios that are predominantly large cap or mid-cap can look at the Baroda BNP Paribas Small Cap Fund NFO for diversification of their risk. This is addition to the alpha that it is expected to generate.

   

• This fund is ideal for long term investors with a time frame of 5 years or more. Many small cap companies need to time to build markets and scale and be observed by the markets. Hence, a long term investment horizon is a must.

   

• Lastly, this fund is intrinsically riskier than a large cap fund or even a mid-cap fund due to the unique nature of small cap stocks. That means, apart from the longer time frame, investors must also brace themselves for a higher risk appetite.

In short, if you have a higher risk appetite, a longer time frame and the urge to diversify your portfolio based on capitalization, the Baroda BNP Paribas Small Cap Fund can be the right choice for you.

HIGHLIGHTS OF BARODA BNP PARIBAS SMALL CAP FUND NFO

The Baroda BNP Paribas Small Cap Fund NFO is a small cap stock based alpha generating fund. Here are the key highlights of the Baroda BNP Paribas Small Cap Fund.

• The Baroda BNP Paribas Small Cap Fund NFO opened for subscription on October 06, 2023 and will close for subscription on October 20, 2023, both days inclusive. Investors have the whole of next week if they choose to apply for the NFO.

   

• It is an open ended actively managed equity fund with a focus on small cap stocks as per the SEBI definition. As per the latest SEBI listing, small cap stocks are those with a market cap of Rs17,385 crore and lesser.

   

• The Baroda BNP Paribas Small Cap Fund is an active fund benchmarked to the Nifty Small Cap 250 TR index. It is high risk and high return fund that seeks to invest in well-researched small cap stock ideas that can generate alpha in the long term.

   

• There are no entry loads in India as per SEBI regulations but it will impose an exit load of 1% if more than 10% of the investment is redeemed within 1 year. NFO subscriptions can be made in minimum lumpsum parcels of Rs5,000 and multiples of Rs1 thereafter. 

   

• The Baroda BNP Paribas Small Cap Fund will offer regular plans and direct plans. Each of these plans will also offer the growth option, the IDCW payout option and the IDCW reinvestment option.

   

• The Baroda BNP Paribas Small Cap Fund will be managed by fund managers, Shiv Chanani and Miten Vora. For purposes of taxation, it will be treated as an equity fund.

The Baroda BNP Paribas Small Cap Fund is meant for the savvy investor looking at small cap based diversification and willing to wait longer period with higher risk appetite.

UNDERSTANDING THE UNIVERSE OF SMALL CAP FUNDS IN INDIA

It is essential to have a quick understanding of the small cap universe in India in terms of median returns and AUM. That is captured in the table below.

Scheme  Name	NAV  Direct	Return 1 Year  (%) Direct	Return 3 Year  (%) Direct	Return Since  Launch Direct	Daily  AUM (Cr.)
Bandhan Emerging Fund	30.55	36.43	34.27	35.98	2,236.12
Bank of India Small Cap Fund	37.90	31.01	38.88	31.99	716.34
Edelweiss Small Cap Fund	34.80	30.18	39.77	30.52	2,512.67
Canara Robeco Small Cap Fund	32.32	24.36	39.88	28.62	8,012.38
UTI Small Cap Fund	20.24	24.59		28.53	3,224.01
Tata Small Cap Fund	32.65	33.46	42.43	27.18	6,236.66
Nippon India Small Cap Fund	137.22	37.53	45.79	26.35	38,144.21
SBI Small Cap Fund	151.99	19.60	34.22	25.73	21,620.23
Axis Small Cap Fund	89.27	26.39	34.62	24.81	16,555.56
Invesco India Smallcap Fund	29.69	30.79	36.67	24.55	2,853.55
HSBC Small Cap Fund	68.48	35.65	43.54	22.64	11,831.68
DSP Small Cap Fund	159.13	31.11	36.11	22.59	12,318.65
Franklin Smaller Companies	144.24	40.60	40.91	21.79	9,973.88
ITI Small Cap Fund	20.41	35.49	28.55	21.56	1,684.63
Kotak Small Cap Fund	229.68	23.16	37.78	20.58	12,595.25
HDFC Small Cap Fund	118.92	41.27	41.94	20.50	23,753.69
Sundaram Small Cap Fund	212.08	33.15	37.82	18.33	2,710.20
ICICI Prudential Smallcap Fund	75.39	30.41	39.96	18.23	6,182.37
Quant Small Cap Fund	197.58	41.42	47.16	17.72	9,476.06
Aditya Birla Sun Life Small Cap	75.05	30.47	32.22	17.33	4,716.50
Union Small Cap Fund	42.31	27.02	35.84	16.68	1,142.14
LIC MF Small Cap Fund	24.54	22.02	36.73	15.27	171.12
PGIM India Small Cap Fund	12.84	13.53		11.99	1,706.81

Data Source: AMFI

The above table broadly corresponds to what we have seen in the NFO note. The small cap fund universe has been growing rapidly and its current AUM has crossed the Rs2 trillion mark. If you look at small cap funds as a universe, these funds have generated average CAGR returns of 23% since inception. That is a good base case for the Baroda BNP Paribas Small Cap Fund NFO.