Cash levels in smallcap mutual fund schemes swell as valuations turn lofty

The cash pile within smallcap mutual fund (MF) schemes has grown over the past few months amid a relentless rally in stocks in this space.

While fund managers usually don’t make cash calls, incessant inflows and valuation discomfort have forced their hand.

At the end of January, the top 10 schemes had over Rs 12,160 crore in cash, compared to Rs 8,700 crore in August 2023.

These top 10 schemes together have Rs 2 trillion in assets under management (AUM).

Cash accounted for 6.1 per cent of it as of the end of January, 60 basis points higher than the August level, according to an analysis of smallcap portfolios.

Between August and January, the National Stock Exchange Nifty Smallcap 100 has rallied 37 per cent.

Smallcap stocks have been trading at significantly higher valuations compared to their long-term averages.

The Nifty Smallcap 100 is now trading at a 12-month forward price-to-earnings (P/E) ratio of 22 compared to a 10-year average of 16.5.

The largecap space is comparatively better placed, with a P/E ratio of 20 vis-à-vis their 10-year average of 17.7.

This differential in valuation has also prompted fund managers to increase the largecap allocation in smallcap funds.

Smallcap schemes have the flexibility to invest up to 35 per cent of the portfolio in largecaps and midcaps.

“We have increased the allocation to largecaps and midcaps in the scheme to 7.01 per cent and 17.97 per cent, respectively, in January 2024, compared to 0.5 per cent and 4.2 per cent in September 2023 as the smallcap valuations stretched.

"Currently, the portfolio has a 75.02 per cent allocation to smallcaps,” said Anish Tawakley, deputy chief investment officer (CIO), equity, ICICI Prudential MF.

Shridatta Bhandwaldar, head-equities, Canara Robeco, added, “We have increased the largecap allocation.

"Nearly 15 per cent of the portfolio is now in largecaps and cash.

"We have also decreased the concentration in the scheme to manage the risks better.”

The surge in cash levels was even higher in the case of the top three schemes.

While the aggregate amount has gone up from Rs 3,900 crore to Rs 7,000 crore, the average cash level as a percentage of the total assets has surged from 5.5 per cent to 7.75 per cent.

In 2023, the benchmark S&P BSE Sensex and Nifty50 indices gained nearly 20 per cent each, while the Nifty Midcap 100 and the Nifty Smallcap 100 gained 46.6 per cent and 55.6 per cent, respectively.

The mouthwatering returns generated by smallcap stocks have led to more and more flows into smallcap schemes.

Last year, largecap and flexicap funds together collected Rs 4,500 crore, while smallcap funds raked in nearly Rs 40,000 crore.

“A large part of this smallcap and midcap (SMID) rally (approximately two-thirds) was liquidity-driven (supported by strong domestic flows), whereas, for the Nifty, this was led by earnings delivery.

"As a result, valuations for SMIDs are now stretched at over one standard deviation level, while, in comparison, Nifty continues to trade closer to its long-term average valuations.

"With heightened volatility in the first half of calendar year 2024, we continue to prefer largecaps over SMIDs,” said Arbind Maheswari, head of India equities, BofA Securities.

“The midcap and smallcap indices have nearly doubled in the past four years.

"Historical trends suggest that any segment tends to falter after a 25 per cent five-year compound annual growth rate.

"However, we are cautious only in sub-sectors that have seen a massive melt-up during the past six months,” said Neelesh Surana, CIO, Mirae Asset Investment Managers (India).

Given that some of these businesses are characterised by high cyclicality, asset heaviness, debt burden, lack of cash flow, low return on equity, and subpar management, there are concerns about the quality of the rally in this segment,” said Neelesh Surana, CIO, Mirae Asset Investment Managers (India).