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Big/Mid/Small Cap: Know the difference and how that affects your investing!
November 25, 2009

S. Krishnakumar, Fund Manager, Sundaram BNP Paribas Asset Management discusses the style followed for stock selection in small-cap and mid-cap funds.


Author : Dhanashri Rane



Untitled Document

Numerous mutual fund schemes are segregated in terms of their market capitalisation. But how is a large-cap fund different from a multi-cap or a small-cap fund? Is the investment philosophy unique to a mid-cap fund or it is uniform across all funds?

In this article, we understand the concept of market capitalisation and speak to S. Krishnakumar, Fund Manager from Sundaram BNP Paribas Asset Management to know the method generally followed by fund managers to pick up stocks listed on the exchanges.

Key Points

  • Large companies are fewer and bigger in India. Hence, the 50th stock and below in terms of capitalisation can be the cut-off to enter mid-cap space in the market
  • The risks in terms of liquidity and impact cost increases as we move down the capitalisation curve
  • For a mid-cap fund or small-cap fund, you must ask for the weighted average market-cap of the portfolio before making an investment decision and use that as the basis to judge the profile and positioning of the fund

Story of Market Capitalisation

Market capitalisation of a company = Stock price X Number of outstanding shares.

Basically, market capitalisation (cap) is a way to classify companies in equity market according to their size. The market cap at any given point of time shows whether the company is either a large-cap or a mid-cap or a small-cap. With the rise in stock price and issue of additional shares into the market, the market capitalisation of a company goes up. As the market cap increases, the liquidity of the stock in the market also increases.

In the late 70s, Rolf Banz and Mark Reinganum, published a study that the companies with smaller capitalisation on an average gave more returns than the companies having larger capitalisation, even after adjusting for risk. This finding, also known as ‘the size effect’, has evolved into a style for managing funds.

The Bombay Stock Exchange (BSE) introduced ‘BSE Mid-Cap’ index and ‘BSE Small-Cap’ index on 11 April 2005 to represent and keep track of companies having size smaller than the 30 stocks listed on BSE Sensex. These indices denote the ups and downs in the mid-cap and small-cap sector.

 

INDICES

Market Capitalisation

 

No. of stocks listed on the index

 

P/E Ratio

52 Week

(Rs. crore)

%  to Total Market Cap

High

Low

SENSEX

2,474,918.30

45.01

30

20.83

17,493.17

8,047.17

MIDCAP

878,751.11

15.98

234

17.75

6,709.56

2,547.91

SMLCAP

291,490.97

5.3

474

16.33

7,883.50

2,864.24

Source: BSE India, 28 October 2009

 

iFAST: How do you classify a stock since there is no exact definition of a mid-cap stock in India?

S. Krishnakumar (SK): Different fund houses have adopted varying definitions to classify mid- and small-cap stocks. Also, the classification depends on when they have adopted the definition, considering the fact that markets have risen significantly from levels of 2003.

Definition for regulatory purpose: Sundaram BNP Paribas Mutual Fund has defined mid-cap and small-cap stocks under Securities Exchange Board of India (SEBI) regulation in the scheme information document as:

Mid-cap stocks:  The stocks that have a market cap of less than that of the 50th stock by value in the S & P CNX 500^.

Small-cap stocks: The stocks that have a market-cap of less than that of the 100th stock by value in the S & P CNX 500.

For instance, the cut-off for a mid-cap stock and small-cap stock is Rs. 18,925 crore (Sesa Goa) and Rs. 6,952 crore (Divi’s Labs) respectively as on 31 July 2009.

We were one of the early fund houses to fix the threshold and with the rise in equity values, these limits appear to intrude into large-cap territory. These threshold levels lead to market cap levels that are also not intuitively understood to be mid-cap or small-cap stocks.

The elegant approach to understanding the capitalisation curve: You could sort the stocks by market cap and take the cumulative market cap at the level of each stock. Stocks that are covered in the list till cumulative market cap reaches 70% can be treated as large-cap whereas the stocks that occupy the 71% to 90% band can be treated as mid-cap. Finally, the stocks between 91% and 100% in cumulative market cap list would make small-cap or micro-cap. However, this approach does not work well in India, as the large companies are fewer and bigger and you would end up with the 50th stock as the cut-off for entering the mid-cap space in the market.

Risks: The risks in terms of liquidity and impact cost (i.e., the cost of executing a transaction on the exchange) increases as we move down the capitalisation curve as well as other factors such as volatile price movements and lack of transparency.

 

iFAST: What approach is followed by Sundaram BNP Paribas Mutual Fund for mid-cap and small-cap funds?

SK: The weighted average market cap of the portfolio is obtained by multiplying the market cap of each stock and the weight of the stock, and then adding the numbers obtained for the stocks in the portfolio.

Weighted Average Market Cap = ∑ (Market cap of each stock X Weight of the stock)

The median market cap is that of the stock that is present at the mid-point in the portfolio. For example, if the portfolio has 45 stocks, the median market cap will be the value of the company that occupies the 23rd slot when all the exposures are arranged in the order of market cap.

The weighted average market cap of the portfolio of Sundaram BNP Paribas Select Mid Cap was Rs. 6,916 crore as of July 31 2009 and the median market cap was Rs 3,957 crore. The weighted average market cap of the fund’s portfolio is about 65 per cent lower than the cut-off of the threshold stock (50th by market cap) and the median market-cap is lower by 80 per cent.

We believe this market-cap profile indicates the true mid-cap orientation of the fund. The weighted average market cap profile of the portfolio has consistently been lower as compared to the cut off limit of the 50th stock by 60% to 70% since launch. This fact highlights the style integrity maintained by the fund manager across market phases over a seven-year period. The weighted average market cap of Sundaram BNP Paribas Select Mid Cap is closer to the threshold of the 100th stock by market-cap in the S & P CNX 500 Index. This also appears to be an intuitively and logically appealing point for a stock to be considered as a mid-cap play.

The weighted average market cap of the portfolio of Sundaram BNP Paribas Select Small Cap was Rs. 1,473 crore as on 31 July 2009 and the median market cap was Rs 1,010 crore. The weighted average market cap is lower by about 80 per cent than the cut-off of the threshold stock (100th by market cap) and the median market-cap is lower by 85 per cent. The market profile of the fund appears to provide a clearer picture of what should be considered small-cap territory.

This numbers are averages and so there will be distribution of stocks on either side.

 

iFAST: How is a multi-cap fund different from a mid-cap or small-cap fund?

SK: From an investment perspective, if you wish to invest in a mid-cap fund or small-cap fund, you must ask for the weighted average market-cap of the portfolio before making a decision and use that as the basis to judge the profile and positioning of the fund.

For a multi-cap fund such as Sundaram BNP Paribas S.M.I.L.E Fund that invests between 70% and 90% in mid-cap and small-cap stocks, the weighted average market cap would be distorted by the large-cap exposure. In such cases, investors should try and understand the weighted average market cap of the mid- and small-cap component and the large-cap component separately. Therefore, for multi-cap funds, the median market cap of the portfolio should be considered additionally.

The median market cap tells you how far down the capitalisation curve the fund manager has gone in choosing stocks for the portfolio. If the median market cap is significantly low, it indicates a more aggressive style of the fund. For instance, in the case of Sundaram BNP Paribas S.M.I.L.E Fund, the weighted average market-cap of the portfolio is Rs 14,916 crore (due to allocation of about 15% to large-cap stocks) and median market cap is Rs 3,147 crore. This means half the stocks in the portfolio have a market cap of less than Rs 3,146 crore which indicates that at least half the stocks have a market cap lower than that of the median.

 

Conclusion

Apart from market capitalisation, investors need to bear in mind their individual investment goals, risk tolerance levels, financial health and your understanding of the security. Hence, to take an exposure to a small-cap or a mid-cap sector through an equity fund is advisable.

 

^ The S&P CNX 500 is India’s first broad-based benchmark of the Indian capital market. The S&P CNX 500 represents about 92.57% of total market capitalisation and about 91.17% of the total turnover on the NSE as on Sept 30, 2009. S&P CNX 500 is computed using market capitalisation weighted method, wherein the level of the index reflects the total market value of all the stocks in the index relative to a particular base period. The method also takes into account constituent changes in the index and importantly corporate actions such as stock splits, rights, etc without affecting the index value.


iFAST and/or its content and research team’s licensed representatives may own or have positions in the mutual funds of any of the Asset Management Company mentioned or referred to in the article, and may from time to time add or dispose of, or be materially interested in any such. This article is not to be construed as an offer or solicitation for the subscription, purchase or sale of any mutual fund. No investment decision should be taken without first viewing a mutual fund's offer document/scheme additional information/scheme information document. Any advice herein is made on a general basis and does not take into account the specific investment objectives of the specific person or group of persons. Investors should seek for professional investment, tax, and legal advice before making an investment or any other decision. Past performance and any forecast is not necessarily indicative of the future or likely performance of the mutual fund. The value of mutual funds and the income from them may fall as well as rise. Opinions expressed herein are subject to change without notice. Please read our disclaimer in the website.

 


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