Catch them young and watch them grow. They may be small now, but have the potential to be big some day. No, we are not talking of kids, we are referring to small and mid-cap stocks that are a rage with fund managers these days.

In the last couple of months, five mutual funds have launched their small and mid-cap funds. This shows that fund managers are betting big on small companies.

Investment flow

“Private equity investments coming into this country are going to small and medium sized companies. Private equity investors generally put their money in an unlisted company for three to five years after which they want to get those companies listed so that they can exit by selling their stocks for a huge gain,” said Navneet Munot, a fund manager with Birla Sun Life Mutual Fund.

“These equity investors want to ensure that the companies in which they have invested perform well,” he added.

Track record

Small and mid-cap stocks gave low returns in the last 12 months as they had a greater fall in May last year than large-cap stocks.

In May and June last year, small and mid-cap stocks lost over 40 per cent of their valuation. At present, these stocks are available at a significant discount compared with large caps. For example, a typical mid-cap scrip in the services sector is available at a 37 per cent discount to the price-earning (P/E) ratio (a measure of valuation of a stock) at which a large-cap is trading.

The discount is 60 per cent in banking, 32 per cent in capital goods, 21 per cent in cement and 25 per cent in consumer products.

However, small companies are expected to do better this year with an 8 per cent plus growth forecast.

Historically, large, mid and small-cap stocks follow distinct cycles within a broader market trend. For example, between February 2003 and February 2005, large-cap stocks traded at a higher P/E ratio than small and mid caps. Between February 2005 and June 2006, mid and small-cap stocks traded at a higher P/E ratio than large caps. Since June last year, large-caps are again trading at a higher P/E ratio.

Large-cap companies had a higher earnings growth in 2003-04. In 2004-05, small and mid-cap companies recorded a higher earnings growth.

How to pick?

However, it's difficult for a common investor to identify small companies that have the potential to grow in the next three to five years. Though small and mid-cap stocks abound on any bourse, most of them are best left untouched.

Mid and small-cap companies are usually new in their businesses and have lower market share, revenue and profit earnings. They have the potential to offer higher returns in earnings growth than large-cap companies. Historical data shows that price indices for small-cap stocks outperform those of large-caps over a period of three to five years (see chart).

However, picking the right stock is the key to winning investment.

Investors should, therefore, leave the responsibility of stock selection to professionals by opting for the mutual fund route. There are a number of existing small and mid-cap funds and five mutual fund houses — Kotak Mutual Fund, Sundaram BNP Paribas, DSP Merrill Lynch, JM Financial and Birla Sun Life Mutual Fund — have recently floated plans. Birla Sun Life’s new fund offer is still on.

In the last one year, small and mid-cap funds gave a return of 6.32 per cent against 5.95 per cent by diversified equity schemes. However, these funds could not keep pace with the sensex, which offered a return of 15.65 per cent.