Weekly Musings – NFO Pick (Motilal Oswal Small Cap Fund)

4 Dec 2023 , 07:35 AM

SMALL CAP FUNDS – HOW THEY FIT IN

As the name suggests,  a small cap fund is invested in small cap stocks. In the past, small cap stocks had varying definitions. Eventually, SEBI has standardized the definitions of large caps, mid-caps, and small caps for the sake of mutual fund investing. For example, if the entire stocks on the stock exchange are indexed descending on market, then the top 100 will classify as large caps, the next 150 will classify as mid-caps and the any stock below the ranking of 251 by market cap will rank as small cap companies. That is the focus of the small cap fund. But, how does the profile and size of small cap stocks look like?

Currently, if you translate the above SEBI rule into numbers, then large caps would be the companies with a market cap of more than Rs49,700 crore. Stocks with market cap of between Rs17,400 crore and Rs49,700 crore would be classified as mid-cap companies. Stocks with a market cap of less than Rs17,400 crore will classify as small caps. In short, small caps are stocks with a maximum market cap of around $2.2 billion and anything below that will be a small cap. Obviously, you cannot go to the smallest common denominator so even the small cap universe is restricted to about 1,700 companies. Still, that is a rather wide choice and also a rather heterogeneous choice of stocks available to fund managers.

WHY SMALL CAP STOCKS AND FOR WHOM IS IT MEANT?

There are several unique features of small cap stocks which makes them special and value accretive. Firstly, it is company specific factors that drive small cap stocks. Unlike large caps and, to some extent mid-caps, the small caps are only marginally impacted by macro factor and industry level factors. Small caps are also less tracked, and hence the scope to find hidden gems are more. The average large cap stock has an average analyst coverage of 31, while mid-cap stocks have coverage of 18 analysts and small cap stocks is just 8 analysts. Small cap stocks also give exposure to sectors that large caps do not offer like specialty chemicals, defence, life sciences, consumer staples, gas utilities, electrical equipment etc. The variance of returns is also high in small caps. For example, if you look at the Small Cap 250 index, only 62 companies gave more than 20%, 17 companies yielded 10-20%, 28 companies yielded 0-10% and a total of 141 companies yielded negative returns. This heterogeneity not only makes it a bottom-up game but also improves the chances of identifying multi-baggers for the stock portfolio.

Whom will the small cap funds be ideal for? To begin with, these small cap funds entail a higher level of risk. Firstly, there is the risk of equities and secondly there is the risk of a thematic concentration in small cap stocks. That makes the portfolio riskier than a large cap portfolio, but also enhances the return potential. This is meant for investors who are willing to take that higher risk. As part of financial planning, investors need stability and alpha in their equity portfolio. The proportion of small cap stocks provides the alpha. Most small caps generate value for shareholders when they transform into mid-caps and then to large caps. However, that is a time consuming process and hence investors must be willing to take a time frame of 7-8 yeas for a small cap investment. Also, most small cap stocks need a tipping point to be able to discover their real value and the timing of such tipping points cannot be predicted with any sense of accuracy. 

WHAT YOU MUST KNOW ABOUT NIFTY 250 SMALL CAP INDEX

The Nifty Smallcap 250 is the index to which the Motilal Oswal Small Cap Fund will be benchmarked. Hence it is in order that we understand this index better to understand the nuances of the risk and return of these indices and how they performed.

1. The Nifty represents 250 companies ranked from 251 to 500 in the market cap rankings, so they will be the largest and most valuable among the small cap companies category. It is a free float market cap index where greater weight is assigned to public float than just the size of the market cap.

    

2. The Nifty Smallcap 250 Index has generated returns of 38.24% in the last year, 22.08% CAGR over last 5 years and 16.25% since inception on a CAGR basis. These are returns on price plus returns from dividends and other corporate actions.

    

3. The Nifty Smallcap 250 index has a standard deviation of 13.49% over 1 year, 19.74% over 5 years and 21.76% since inception. In short, this is a diverse index with a high degree of volatility, which obviously adds to the risk.

    

4. One good thing about the index is that it does not move too much in tandem with the Nifty index and hence becomes a good hedge. For instance, if you look at the Beta of the Nifty Smallcap 250 index with the Nifty, it is 0.79, while the correlation is just 0.78, which makes this index a good hedge against the Nifty.

    

5. In terms of sectoral representation, the top 8 sectors in the Nifty Smallcap 250 index comprise of BFSI (23.46%), Capital goods (15.95%), Healthcare (9.86%), IT (6.28%), Chemicals (5.17%), Consumers (4.94%), auto parts (4.41%), and FMCG (4.32%).

    

6. The top stocks by weightage in the Nifty Smallcap 250 index are Suzlon Energy, BSE Ltd, CDSL Ltd, MCX, Cyient KEI Industries, IDFC Ltd, Angel One, RBL Bank, and Sonata Software. These 10 stocks have more than 16% of the weight in the index.

    

7. Finally, what about valuation parameters. The Nifty Smallcap 250 index has a P/E of 25.63X, Price to Book (PBV) of 3.4X and Dividend yield of 0.95%. Compared to the Nifty, the valuations are steeper, but it is the divergence that makes this index attractive.

The index has been positioned as a high risk, high return asset class with low correlation to the Nifty index, giving it good diversification value. 

HIGHLIGHTS OF THE MOTILAL OSWAL SMALL CAP FUND NFO

Here are some key takeaways that investors should know about the NFO.

• The Motilal Oswal Small Cap Fund NFO opens for subscription on December 05, 2023 and closes on December 19, 2023. Ajay Khandelwal, Niket Shetty and Rakesh Shetty will be the fund managers. 

   

• It is an open ended mutual fund scheme which is classified as an equity mutual fund scheme under SEBI classification norms. Any equity fund runs the risks of market volatility, business cycles, portfolio quality and active management risk, which could be subject to perception of the fund manager. Small cap funds also have added size risk.

   

• The performance of Motilal Oswal Small Cap Fund will be benchmarked to the Nifty Smallcap 250 TRI index. The TRI index is total returns index, which not only factors the capital gains but also the dividends received by the components of the index.

   

• The objective of Motilal Oswal Small Cap Fund is to generate long term capital appreciation by holding and managing a diversified portfolio of small cap stocks. While it will spread across small cap stocks, there can be no assurance of returns.

   

• Lumpsum purchases in the NFO entail a minimum investment of Rs500 per application and in multiples of Rs500 thereafter. Once the fund opens for continuous purchase and redemption post the closure of the fund, the minimum application will be Rs500 per application. The SIP investment will also have a minimum base of Rs500.

   

• There will be no entry load on the fund. However, being a high-risk and long term equity small cap fund, the Motilal Oswal Small Cap Fund will impose an exit load of 1.00% if redeemed within 15 days of the allocation of such units. There will be no exit load after that. 

   

• The Motilal Oswal Small Cap Fund offers Regular Plans and Direct Plans to investors with the TER adjusted accordingly. In addition, the fund also offers investors the growth option, IDCW option and reinvestment option to its investors. Investors are required to evaluate the tax implications of the various options before opting for the same.

   

• While there are no lock-in restrictions, it is suggested that ideally the Motilal Small Cap fund should be held for a minimum period of 5-7 years, or more, to derive the full benefits of varying equity cycles and the full benefits of risk reduction through diversification. Small cap stocks need time to reach their tipping point.

It must be noted that in the case of equity funds, the dividends are taxable at the marginal rate of tax applicable to the particular investors. The capital gains are taxed at concessional rates of 15% for short term capital gains and 10% for long term capital gains (above a threshold of Rs1 lakh of capital gains).

UNDERSTANDING THE SMALL CAP FUND UNIVERSE IN INDIA

Here is a quick look at the other existing Small cap funds available in India at the current juncture. These fund have been ranked on their CAGR returns since inception.

Small Cap Fund  Scheme Name	NAV Direct (in ₹)	Returns  1-Year (%)	Return  3 Year (%)	Return Since  Launch (%)	Daily AUM  (₹ in crore)
Bandhan Small Cap Fund	32.72	43.65	32.42	36.98	3,224.83
Bank of India Small Cap Fund	40.77	38.02	37.57	32.95	819.51
Edelweiss Small Cap Fund	37.38	35.30	36.86	31.49	2,819.90
UTI Small Cap Fund	21.46	28.52	N.A.	29.63	3,452.50
Canara Robeco Small Cap Fund	33.99	25.94	37.13	29.07	8,695.36
Tata Small Cap Fund	34.01	30.18	37.95	27.40	6,298.31
Nippon India Small Cap Fund	145.64	39.34	41.97	26.68	41,018.84
Invesco India Smallcap Fund	32.91	38.69	36.15	26.37	3,260.09
SBI Small Cap Fund	157.42	20.83	28.66	25.78	22,902.75
Axis Small Cap Fund	94.50	29.33	32.19	25.15	17,771.45
ITI Small Cap Fund	22.18	42.39	26.68	23.40	1,839.97
HSBC Small Cap Fund	73.54	40.82	40.35	23.20	12,863.57
DSP Small Cap Fund	168.85	36.27	33.13	22.95	13,153.31
Franklin India Smaller Companies Fund	155.47	43.96	37.25	22.33	10,776.63
Kotak Small Cap Fund	242.44	28.15	32.70	20.90	13,474.81
HDFC Small Cap Fund	124.74	39.41	38.39	20.75	25,536.73
Sundaram Small Cap Fund	227.34	38.05	35.38	18.84	2,877.59
ICICI Prudential Smallcap Fund	78.82	30.54	35.78	18.47	6,669.85
Quant Small Cap Fund	211.55	39.67	46.20	18.22	11,110.20
Aditya Birla Sun Life Small Cap Fund	78.55	33.37	27.43	17.59	5,059.44
Union Small Cap Fund	44.81	37.88	35.23	17.14	1,258.01
LIC MF Small Cap Fund	25.66	23.85	33.65	15.73	183.06
PGIM India Small Cap Fund	13.65	16.87	N.A.	14.21	1,460.18

Data Source: AMFI

The above table shows the performance of the small cap funds available in India. These funds already manage a substantial AUM of Rs2,25,000 crore. Over a 1 year period, the average returns have been around 33.6%, while the average CAGR 3-year returns have been 35.4%. This makes them among the best performing fund categories in India. If you look at these funds from inception, the average returns are close to 23.7% CAGR. Clearly, small cap funds are a credible story and the Motilal Oswal Small Cap Fund is timed right to capitalize on a big growth vector. In the last few months, investors have been consistently choosing small cap funds and most of the secondary flows and even NFO flows are gravitating towards that segment. That is not really surprising, if you look at how this segment has performed in the past.