India's growth story lies in mid and small caps: Yogesh Patil of LIC MF

• Mid and small cap stocks are the best representatives of a growing and changing India says LIC MF's equity head.
• ‘Some small caps are overly valued, but investors with a three-year horizon can make money’.

Fear of froth has hit two of the most rewarding classes of stocks since last month — mid and small caps. Yogesh Patil, head of equity at LIC Mutual Fund advises investors to keep a slightly long-term horizon, pick stocks carefully and hold on to good companies to generate solid returns.

In an interview with Business Insider India, Patil said mid and small cap stocks can’t be ignored as they are best representative of a growing and changing India. “Nifty is not representative of the Indian economy. Core manufacturing is not present in the index, which too largely veers towards engineering, procurement and construction (EPC),” he says.

On the other hand, many industry-leading companies in power, capital goods and manufacturing space are classified as mid and small-cap companies. Like CG Power, Hitachi, GE T&D, Bharaj Bijli etc. Blue Dart too, despite being an industry leader in air cargo, is a small-cap company.

“A lot of industry-leading companies in auto ancillaries are mid and small cap companies,” Patil says. A lot of consumption themes like travel-related business be it portals, luggage companies, or hotels are also covered in mid and small cap indices.

Vocal for local

Between 2002-08, there was a huge capex cycle driven by the power sector. However, back then, companies were importing equipment from abroad. This time around the benefits are flowing to Indian manufacturers.

“Most of the capex is driven by power (renewable and coal), followed by defence, railways, data centres and Production Linked Incentive-related capex,” he adds

Small caps also represent turbine companies, apart from railways, defence companies and other themes like PLI schemes. The government’s thrust on local manufacturing is adding to the order books of these companies.

“Indian companies’ addressable market has increased globally and domestically. After Covid, many people want to change vendors due to China+1 or cultural issues,” says Patil.

While few of the top listed companies are making investments, mid and small cap stocks have been making capex investments. As per a report by the Bank of Baroda, the investment announcements in the manufacturing sector have made investment announcements to the tune of ₹11 lakh crore in FY24, with chemicals leading the growth. The electricity sector’s announcements are at ₹8.98 crore and services are at ₹6.6 lakh crore with transport services making up for a lot of it.

Are valuations frothy?

Due to strong fundamentals, a lot of investors are betting on mid and small cap stocks. Even after the recent fall, the Nifty 500 has given 40% returns in the last one year. Nifty Small Cap 100 also gave 76% returns. The bull run that markets in general saw in 2023, has seen good retail investor participation, both directly and indirectly (via mutual funds).

The exuberance has brought back fears of over-valuation and these stocks running ahead of consensus. Small cap stocks in particular are amongst the first to fall, and slow to recoup, unlike their ‘bigger peers’. Low liquidity and free float hit these stocks.

“Some small caps are highly valued but show promising growth. Investors with a three-year horizon can make money, One needs to choose the bucket and pick stocks. It’s not exactly beta, you need to generate alpha,” says Patil.

Investing in small and mid caps is a volatile journey, and investors must not be swayed by short-term returns, he advises. He also says that rewards lie in risk-taking ability. Investors who are willing to risk more can earn more.

‘MF investors are not panicking’

Mutual fund investors have been bullish on mid and small cap schemes. As of FY24 until February, mutual funds net inflow into mid and small cap funds were over ₹21,000 crores and ₹40,000 crores respectively, as per the Association of Mutual Funds in India (AMFI).

In mid-March, markets regulator SEBI asked mutual fund houses to come up with a policy to protect investor interests. The idea behind AMFI's stress test, initiated by SEBI, is to instil resilience within mutual funds against various adverse scenarios.

The stress test tells if a certain class of funds are going through very high valuations, and if their valuations fall, how will fund managers sell the portfolio to pay off the investors. Subsequent to releasing stress test data, most mutual funds tweaked exit load rules to discourage early redemptions. An exit load is the fee charged by mutual funds when investors leave a scheme.

In spite of these developments, MF investors are holding still, insists Patil. "Over the past decade, a vast majority of mutual fund investors have reaped significant benefits. Enhanced transparency and strict regulations have bolstered investor confidence in mutual fund investments, prompting increased participation in this financial vehicle,” he says.

Moreso, with more women participation in the workforce, there is ‘room’ within household budgets for equity investments and there is a long-term case of mutual funds and equities, the market expert says.

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