With small-cap stocks doing so well at the bourses, mutual fund houses have unveiled a flurry of new fund offers to capitalise on the growing investor demand. Direct investments in small-caps are much more risky than going for a portfolio managed by a trained expert in case of a small-cap fund. But, with over two dozen existing small-cap funds available, does it make sense to bet on a greenhorn? Motilal Oswal Mutual Fund certainly thinks a new fund can do better. Here is all you wanted to know about Motilal Oswal Small Cap NFO, which closes tomorrow (December 19).

Why small-caps now

There are a few reasons why one could consider investing in small-cap stocks now, even though they have run up quite a bit.

One, small-caps are witnessing earnings buoyancy. For instance, Nifty Small Cap 250 index earnings (EPS) have compounded by 12.7 per cent (CAGR) in FY2019-2023 period. This is expected to continue, unless there is a major downturn. Many small-caps have a higher exposure to domestic market and this could shield against global slowdown while help grow earnings as long as Indian GDP growth is good.

Two, small-cap stocks today have healthier balance sheets, backed by steady improvement in financial performance. Net debt to equity ratio for the index mentioned above has more than halved from 0.76 in FY15 to 0.30 in FY23. Also, many small-caps could benefit most from the next rate-cut cycle.

Three, small-caps are trading at reasonable valuations, says Motilal Oswal MF. There is no final word on valuations. Hence, you either believe or don’t.

Take note
We don’t think you should consider investing in small-caps solely because there is a strong trend of retail investment flows. Retail investment flows are not a good leading indicator. Historically, retail flows have come in at the fag end of a small-cap rally, leading to a boom-bust scenario. This is why roaring bull markets are bad times to make your first investments in small-cap funds. When the inevitable correction arrives, the tendency to panic and switch out, or stop SIPs, can be high. So, if you invest in small-cap funds, do it with 10-year plus horizon and in SIP mode.
Motilal Oswal strategy

Index funds and ETFS based on small-cap indices offer a passive way of enjoying market success. Some interesting small-cap index funds have been launched recently.

But we believe actively-managed small-cap funds offer a better options, although they can under-perform sometimes. Management quality is particularly crucial in the context of small-cap stocks/funds. Strong corporate governance practices are extremely vital in case of small-cap stocks, especially in the Indian context where small-caps are extremely under-researched. Hence, active small-cap funds are preferable, even though some poor funds will always be around.

Motilal Oswal MF offers a few advantages as a house on small-cap investing.

1. It has a long and decent track record of wealth creation by early investing in small-caps. Recent small-cap picks (2022/2023) such as Suzlon, PG Electroplast, Gokaldas Exports, Trent, Religare, BSE, Angel One, Zomato, Kalyan Jewellers etc. have done well.

2. It has expertise in terms of assessing quality of business and management, a key factor for small-cap investing.

3. Motilal Oswal MF is renowned for its higher skin in the game in funds. The promoter of AMC makes fairly large commitments for equity funds. This can serve as a confidence-boosting measure, but doesn’t guarantee any financial reward.

4. Selecting small-cap stocks in India is a very different ballgame from choosing mega or mid-caps. Small-caps require a bottom-up approach with an ear to the ground on governance and management moves. Funds with a specialist manager are better. Motilal Oswal MF’s Ajay Khandelwal appears to fit the bill in this regard, given his mid and small-cap experience. Also, Motilal Oswal AMC’s fund and alternative investment products have a good record in small-caps.

In terms of strategy, Motilal Oswal Small Cap Fund shall adopt a high-conviction portfolio of small-caps with around 30 stocks. Individual stock exposure shall range from 1.5 per cent to 4.5 per cent. About 70-80 per cent of overall portfolio will be in small-caps.

The portfolio will essentially follow AMC’s QGLP philosophy – i.e. invest in Quality businesses with reasonable Growth potential and with sufficient Longevity of that growth potential at a fair Price. The fund aspires to practice a low-churn, buy and hold approach to investing. The portfolio strategy shall be benchmark agnostic with a portfolio of high conviction stock ideas across sectors and market segments. The fund may also invest in IPO bound companies.

Our take

Motilal Oswal MF over the years, with some degree of consistency, has done well with its high-conviction portfolio strategy. While earnings growth is important for the fund-house, it has also shown streaks of valuation-consciouness. The latter aspect is important in current market scanerio. Management of drawdowns, a regular feature in small-caps, is very important.

If you wish for greater exposure outside our top-rated picks such as Nippon India Small Cap, Quant Small Cap and SBI Small Cap, you can consider SIPs in Motilal Oswal Small Cap fund. If not, adopt a wait-and-watch approach till the new fund builds a track record.