t looks like all funds are hopping onto the small cap and mid cap bandwagon.

Don't know what that means? Read on.

Just for the record, here are the new kids on the block. Sundaram's Small and Medium Indian Leading Equities Fund (S.M.I.L.E) is one that closes on January 24. That's right! Today!

Then you have Kotak's mid-cap fund and Franklin India Flexi Cap (FIFCP). The former closes on January 28 and the latter, on February 9.

So what is small cap and mid cap?

In stock market parlance, companies are divided on the basis of large cap, mid cap and small cap (cap refers to market capitalisation).

The value of a share in the market at any point of time is called the price of the share or the market value of a stock. So the share with a face value of Rs 10 (the base price of each share that the company decides on), may be quoted at Rs 55 (higher than the face value), or even Rs 9 (lower than the face value).

If you multiply the number of shares in a company by its market value, the result is market capitalisation.

For instance, a company with 10 million shares of a face value Rs 10 and a market value of Rs 30 as on January 21, 2005, will have a market capitalisation of Rs 300 million as on that day.

Companies with a market cap of over Rs 1,500 crore (Rs 15 billion) are called large cap. Those between Rs 25 crore (Rs 250 million) and Rs 1,500 crore (Rs 15 billion) are mid cap and those less than Rs 25 crore (Rs 250 million) are small cap.

Why divide companies at all?

Indeed. A company is a company. Its stock is just that. So why the various categories?

i. It helps understand risk

Over time, small cap companies must grow into mid cap and, finally, large cap companies. That is the life cycle of a company (just like the caterpillar metamorphoses into a butterfly).

Investing in a small cap is riskier than investing in a mid cap. All mid cap companies reach that stage only after surviving the most risky part of their growth (the small cap stage). So investing in a mid cap company protects it against the wild gyrations that a small cap company passes through.

On this count, large cap stocks are regarded safer because they are well established, show good and stable earnings and will not go bankrupt easily. These companies have scaled the most risky curves in their life cycles.

Not so with small cap companies. Being much newer, smaller, with lesser cash, the risks are higher.

ii. Then again, higher the risk, higher the potential return

On the flip side, small cap companies have greater potential for growth because of their small size.

It is clearly easier for a small company to double its sales and profits in each of the next five years than it is to imagine, say, Hindustan Lever [Get Quote] (HLL) do so.

Sundaram Mutual Fund conducted a study of 395 companies of the BSE 500 index. It revealed that between 1997 and 2004, companies with smaller market capitalisations have grown their market caps faster compared to large cap companies!

iii. Stock market performance varies

It has been observed that if one divides companies on the basis of market capitalisations, there are some interesting trends.

There will be periods when small cap companies as a group tend to perform better in the stock market than large cap stocks and vice versa.

So while one segment is doing well, the other may dip. So having a mix of such companies helps to balance one's portfolio.

Should you opt for these funds?

These funds plan to invest most of the money in stocks of small and mid cap companies. They will close for subscription now but will reopen later when they can be purchased at the Net Asset Value (NAV). This is the price of each unit of a fund.

The funds are open for subscription at a time when the stock market is undergoing a correction. This refers to a relatively short-term drop in stock market prices and tends to happen when prices have been consistently rising for a period of time.

It helps the market cool down when things get too heated.

This provides an opportunity to enter small and mid caps at lower rates.

If you want to invest in small and mid caps on your own, you would be in no position to undertake a rigorous research of all these companies. And the research does not just include sifting through their balance sheets but also to visit their plants. Remember, some of them may just be fly-by-night operators that do not even have a proper office, let alone a factory or any other asset.

The fund will do all this research for you.

Considering the growth potential of Indian economy it is but likely that those small and midcap companies of today will be the large caps of tomorrow. In a booming economy, the small and large caps play a vital role.

The fund with a difference 

The Franklin India Flexi Cap Fund plays it safe by investing across all three segments: small, mid and large cap companies. No wonder they are calling it the Flexi Cap Fund!

In this way, they lower the risk of investing in just one particular type of company. Also, depending on how each category is faring, they can invest accordingly.

This strategy should help protect the fund against wild trends in the stock market that most analysts feel it will go through. It will help build a solid and stable portfolio of stocks that will outperform the markets through the upturn and downturn in economic business cycles.

The verdict

The stress of the above funds to invest in mid cap and small cap companies stems from the fact that these companies gave startling returns to investors in the previous years.

Wouldn't it have been nice if these companies had thought of this strategy at least a year ago to reap the maximum returns for their investors? Let bygones be bygones.

There is not much risk associated if investors pour their moolah into these small and mid cap funds. If they couldn't be a part of last year's mid cap story, they will surely redeem themselves by creating history this year.

To use an over used clich�, investors should never risk everything on one endeavour. Divide your money between these funds, with the bulk going into the FIFCP, followed by Kotak's mid cap fund.

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Illustration: Dominic Xavier