Small-cap stocks have starred in the market rally over the past one year with the BSE Small-cap index notching up gains of 34 per cent against the Sensex’ gain of 24 per cent.

As those gains have been driven mainly by expanding valuations, rather than increasing profits of these companies, these stocks now trade at an unjustified premium over the blue-chips. The PE multiple of the BSE Small-cap index is at 23 times to the Sensex’ 17 times.

This appears a good time for investors in small-cap stocks to book profits on their portfolio and switch the proceeds into diversified funds with a good record. The HSBC Smallcap Fund, which concentrates on this market segment, has gained 45 per cent in the last one year, aided by this rally. The fund’s three-year record, however, remains uninspiring.

Investors may use this opportunity to book profits in the fund and switch into a diversified fund, to help shield the portfolio from any market correction that unfolds over the next one year. Small-caps are likely to decline much more than large caps, if this happens.

Performance

Launched just after the markets peaked out in early 2008, HSBC Smallcap Fund has beaten its benchmark the BSE Smallcap index, but trailed both the broader category of mid and small-cap funds and its direct peer over a three-year period. Its three-year annualised return of less than 1 per cent compares with the category average of about 9.5 per cent for small and mid-cap funds.

DSP BlackRock Microcap, a direct peer, has managed a 14 per cent annualised return in the same period.

This is despite the fund faring well in the recent market rally. HSBC Smallcap Fund has made a 45 per cent return in the last one year while DSP Blackrock Microcap has managed only 40 per cent.

The fund received a sharp setback during the 2011 market decline, losing nearly 47 per cent in value, at a time when the small/mid-cap category managed to contain losses to 26 per cent.

Portfolio

The portfolio suggests that the fund has adhered to a bottom-up strategy, buying and holding small-cap stocks trading at low valuations.

Some of its top bets such as Orient Paper, India Glycols and IFB Industries have paid off, delivering a more than 60 per cent return year-to-date. But other top choices such as Rane Holdings, Hitachi Home and Nucleus Software have delivered more modest returns.

The portfolio features quite a few stocks which carry a below Rs 500 crore market capitalisation, which tends to peg up the risks.

Companies from the micro-cap category may be much more susceptible to earnings risks from pricing pressures, debt problems and the ongoing slowdown than their larger peers.

However, to its credit, the fund has clearly preferred low PE stocks, and has managed to stick to this value-based approach even as the small-cap segment of the market has been getting quite over-heated.

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