Taking advantage of smallcaps and midcaps!

Generally speaking, when it comes to small caps versus mid caps versus large caps, overall market movement dictates whether or not the the large caps will fare better than the the other two groups. To put is simply- when the overall markets do well, small caps and mid caps will do better than large caps, and vice versa when markets fall.

The reason has to do with how stocks are priced. A large cap stock is going to be better priced than a mid cap stock, and a mid cap will be better priced than a small cap stock. Therefore, when overall markets are going up- the small cap stock is more prone to be price sensitive than a large cap stock. In terms of correlation, if we assume that the Sensex is the barometer for the market- than a group of large cap stocks will move in high correlation with the Sensex because they are more accurately priced. Due to the higher accuracy of pricing, the large cap will move in tandem with the index.

The small cap, however, is going to be less correlated with the index. But when the index surges up, the small cap will surge up higher due to the fact that investors will continue to incorrectly price it, but will price it in accordance with the movement of the index. If the index moves 20% upward, small caps can be expected to move more than 20% as investors will feel that it is underpriced (and in return, cause the small cap to perhaps become overpriced).

There is also the element of risk involved with buy small caps versus large caps. Due to the uncertainty of small caps, the risk is higher- which leads to greater rewards when the stock moves up.

In 2013, the markets moved up approximately 9%. But this is basically in line with inflation, so overall the markets did not move up in 2013. You can make an argument that investing in the capital markets in 2013 was a net zero gain. Since small caps have risk associated with them, they will not perform as well as large caps (which make up the Sensex). Therefore, the BSE Small Cap Index went down 11%, while the BSE mid-cap lost 6%. This makes sense, as the risk/reward ratio is higher on small cap stocks versus mid cap stocks.

The rally in blue chip stocks had to do with the fact that, since the elections, the markets have surged 30+%. The biggest contributors towards the move were the blue chip stocks. If you look at the overall market capitalization of the BSE, while the BSE crossed 100 lakh Crore in market capitalization recently, SME's (small to medium sized enterprises) only crossed 10,000 Crore in market capitalization. In contrast, the top 30 companies on the BSE in terms of market capitalization make up close to 50 lakh Crore themselves, which is 500 times the value of the SME's.

So, in a nutshell, the blue chips are the ones that drive the value of the Sensex and the markets. The markets, in return, did extremely well in 2014 due to the new government coming into powerful and unleashing a vary array of reforms aimed at garnering economic growth. Additionally, the macro economics have been fundamentally sound in 2014, with a growing GDP, low inflation, and a high influx of FII investment flows. These all add up to a surge in market prices in blue chips stocks, the foundation of the Indian economy.

What is the outlook for small and mid-cap stocks in 2015?

There is a strong correlation between small/mid caps and the overall economy. Since we are in the middle of a bull run where markets are expected to perform well over the next few years, we can definitely expect small and mid caps to take advantage of the bull run. Investors will also look to diversify their portfolio by including small and mid caps into their portfolios, which only leads to higher liquidity among these stocks. All in all, as long as the market continues to surge forward, small and mid caps can be expected to fare better than blue chips (just like 2014).
[su_spacer]
So- in a nushell, don't shy away from small-cap and mid-cap stocks if the opportunity is right!
[su_spacer]
Cheers,
-RKSV