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Why mid and small-caps are poised for a good run in 2023

The sharp decline in returns from small-cap funds over the past one year should not deter investors. A revival in the property cycle, consumer spending post-Covid-19 and a repair of household balance sheets is good news.

January 11, 2023 / 11:27 AM IST

As 2023 begins, it is perhaps useful to gaze back and look for trends in equity and category returns. An investor hopes that such trends may help in building a strategy for the next three years.

The last three years were quite eventful. From a longer perspective, how have the mid- and small-cap segments fared relative to large caps over differing lengths of times?

Mid-cap and small-cap funds are more volatile than large-cap funds, but they should be part of your portfolio Mid-cap and small-cap funds are more volatile than large-cap funds, but they should be part of your portfolio

Past performance can deter future outperformance

Mid-caps have clearly delivered better returns over the long term. This relative outperformance holds true even on a risk-adjusted basis. This illustrates the need for an investor, especially a young one, to have a healthy exposure to mid-caps in her portfolio.

Also Read: Rewind 2022: The best and worst of sector and theme funds. Who won, who lost?

The wrinkle in the argument is that the long-term numbers mask short-term cycles. The relative performance of mid-caps (vs large caps) goes through a cyclical pattern. Varying time duration and magnitude of the cyclical swings around the trend line make it difficult to fit a precise pattern. Both data and common sense indicate that neither outperformance nor underperformance around the trend line should be expected for a long duration.

In this context, the recent three-year outperformance of mid-caps does impose a handicap on this segment for the next one year or so. The three-year return of the Midcap index is 23 percent vs 15 percent for the large cap index. Due to this recent outperformance, the midcap index is unlikely to outperform the large-cap index in the coming year.

Is the risk worthwhile? For sure, yes…

Looking beyond statistical inferences, what about the changing landscape of the economy? Revival in the property cycle and a possible recovery in the capex cycle point towards an acceleration in national growth over the near term.

The improving asset quality of retail and high-yield credit indicates that the repair of balance sheets of households that were impacted by Covid disruptions is near completion. This should bring growth back to private discretionary spending. Lest we forget the powerful, emerging opportunity of China +1 in manufacturing.

This coupled with the targeted Production-Linked Incentive (PLI) schemes should lead to much better growth from the manufacturing sector compared to what the last decade has offered. On the detractor side is the fact that many Western economies face a recession in 2023 that will drag down our export growth.

On the balance, the factors that are positive for growth seem to be much stronger. Given the aggressive pace of rate hikes, even the well-anticipated recession may not survive beyond 2023. Why is accelerating growth so important? Accelerating growth implies, in general, stronger corporate earnings, more frequent earnings upgrades, higher risk appetite among investors. All these factors are conducive for the out-performance of midcaps.

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So, the coast is not clear for mid-caps to outperform yet. Impending recession in developed markets and a recent outperformance vs large caps are handicaps that require some time to digest. After this, the more powerful enabling factors mentioned earlier should kick in.

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The next 2-4 quarters offer time for investors to build an adequate midcap exposure to ride this acceleration in growth.

Should you invest in small-cap funds?

The data about small caps leads to a few observations. The small-cap index returns do not seem to compensate the investor for the higher attendant risk, even over a long timeframe. Besides, many seasoned small-cap mutual fund schemes have delivered meaningful alpha over the index returns. These two observations indicate that the role of active management has a higher degree of relevance in small caps segment.

Also Read: Should you invest in small & mid-cap funds that are passively-managed?

At the category level, the sharp underperformance of small caps over the five-year and one-year periods makes its current position quite favourable in the relative performance cycle. This and the more appealing valuation of small caps implies that when the earning cycle rebounds, this category is primed to generate meaningful outperformance.
Janakiraman R is Senior Vice-President & Portfolio Manager, Emerging Markets Equity - India, Franklin Templeton.
first published: Jan 9, 2023 09:35 am