They are like chocolates. Sinfully tempting with high returns, yet bad for financial fitness in large doses. And as connoisseurs can’t keep their hands off a box of Belgian chocolate truffles, so can’t astute fund managers stay away from the best of small companies.

Unfortunately, bingeing on them means taking on a huge risk. With a market capatilisation of less than Rs 967 crore, small-caps are the most dynamic set of stocks. When the economy expands, they gain the most, but when the markets slide, they are the worst sufferers. This is why small-caps never constitute the core of mutual fund holdings.

They have a limited presence, but play an important role in adding zing to the fund portfolios. The good news is that with the Indian economy on a roll-the International Monetary Fund forecasts a GDP growth of 9.4% in 2010-small companies are expected to return to their high-income days. This explains why mutual funds have been aggressively adding to their pile of small-cap stocks.

In June 2010, 3.2% of the mutual fund industry’s assets were deployed in the BSE Smallcap Index stocks. Exactly one year ago, in June 2009, the number stood at 2%. As with other categories, we went scouting for the top 10 small-cap picks by mutual funds. Till 31 May 2010, they had deployed a staggering Rs 4,317 crore in this segment. About 20% of this amount was invested in what we call the 10 most wanted smallcaps.

The most prominent companies in the list include McNally Bharat Engineering, ICRA, a ratings agency, PSL, India’s largest manufacturer of long pipes, and Page Industries, the exclusive licensee of Jockey in India, Sri Lanka, Bangladesh and Nepal. Others that made the cut are Voltamp Transformers, Hindustan Dorr-Oliver, KSB Pumps and Gujarat Alkalies (see Most Wanted Small-Caps).

As the followers of the stock market will realise, all these companies are well-known in their niche markets and there is no surprise entry. Leading the pack is McNally Bharat Engineering, which attracted the attention of maximum fund managers. Twenty-four funds invested Rs 120 crore in this stock.

The Kolkata-based company is one of the leading engineering, procurement and construction (EPC) Smallcap turnkey solutions provider for power, steel and infrastructure companies. As the government stresses on infrastructure and private investment in the sector rises, EPC companies, especially McNally Bharat Engineering, are expected to earn big money. A report by Angel Broking estimates that the business for EPC companies will be worth about Rs 51,600 crore in the next five years. With this perspective, analysts estimate the company’s sales and profits to grow by over 28% in the next two years.

By the end of March 2010, the company had an order backlog of Rs 5,150 crore. Notably, the order inflow in 2005-9 rose at an average rate of 48% per year. To identify the small-caps in which funds have increased investment in the past one year, we conducted a separate analysis that threw up the seven most consistently bought small-caps. Surprisingly, only three companies-McNally Bharat Engineering, Page Industries and Hindustan Dorr-Oliver-figured in both the lists. This means that the funds are betting more on companies like Taj GVK Hotels & Resorts and Phillips Carbon Black, though in absolute value they fall short of, say, Gujarat Alkalies or KSB Pumps.

One of the most promising picks from the list of consistently bought small-caps is Phillips Carbon Black. It is the leading producer of carbon black, a key raw material for tyre manufacturers. Propelled by high automobile sales and rising replacement demand, tyre manufacturers are enjoying a surge in sales. To keep up with it, Phillips Carbon Black is expanding its domestic manufacturing capacity and is setting up a greenfield project in Vietnam.

The Mumbai-based research house, IIFL, expects the company to register a 33% growth in revenues this year and believes that the stock is priced attractively at 4.3 times the estimated EPS of Rs 51.8 (for 2010-11). Little wonder then that six mutual funds invested in the company between May 2009 and May 2010. Emulating the investment pattern of mutual funds is a good strategy. However, it becomes tricky in the case of small-caps because the decisions of fund managers are based on short-term objectives. This is in conflict with the long-term outlook advised to investors.

Also, funds can change their exposure much faster, a distinct advantage for investing in small-caps as their prices change rapidly. Hence, the best strategy is to buy just a couple of small companies with robust business models. McNally Bharat Engineering, ICRA and Page Industries are good bets as their core businesses have great potential and they are trading at low valuations.

A final word of caution: do not be tempted to feast on small-caps just because some of them have given stellar returns. Recall the 2008 debacle and you will realise that small-caps face the maximum price erosion during a bear phase. In that year, the BSE Smallcap Index lost 73%, much more than the 52% fall in the Sensex. So partake of small-caps in limited portions. For your staple investments, stick to the boring largeand mid-cap stocks. After all, only chocolate for three meals doesn’t fulfill your nutritional requirements.