“It is not accurate to generalize and say that smallcaps are expensive,” he says, adding that in many high-growth segments the options are exclusively or predominantly in smallcaps or midcaps.
Edited excerpts from a chat:
You have just launched a smallcap fund. Isn’t the timing inappropriate when there has been a lot of concerns around valuation, particularly in the smallcap space?
I do not see investors or our distributors expressing concern on small-caps. Small-cap stocks are a stock-picker’s paradise, and investors have consistently made money in the past 4-5 years. Mutual fund industry is seeing continued flows into mid and small-caps. The other segment that is seeing flows are thematic funds – even these have significant allocation to mid and small-caps. It will take a sustained fall in small-caps for investors to impact flows to this segment.On valuations, the P/E ratio of the small-cap index (Nifty Small Cap 250) is similar to that of the large-cap (Nifty 100) index, at around 19-20x on two-year forward earnings (excluded loss-making companies in the aggregates). However, the projected earnings growth for small-caps is higher, at 18% for the next couple of years versus 8-10% for large-caps. So, growth-adjusted valuations are not that expensive for small-caps.
Moreover, with a canvas of around 800 small-cap stocks (taking an arbitrary cut-off of Rs. 2,000 crore market cap as the minimum size and removing the top 100 large and next 150 mid caps), it is not accurate to generalize and say that small-caps are expensive. Yes, many stocks have become expensive but not all the 800 stocks – there is still ample scope for stock picking – we are targeting a portfolio of around 60 stocks. Also remember that we have even more choices if we go below Rs 2,000 crore in market cap.
India is a growth market, and small-cap companies are often in the highest growth trajectory within their lifecycle after the high-risk start-up phase. In the micro-cap or small-cap stage, the focus of the companies is primarily on growth and the length of the growth runway can be very long – offering the potential to become multibaggers.In many high-growth segments the options are exclusively or predominantly in small-caps or mid-caps. For example, there is no large-cap stock in the hotel sector, consumer durables segment etc. There are only 2 large-cap chemical stocks versus 60 small-cap, 2 real estate large-cap versus 30 small-cap. There are many such sectors where there are 10x the number of choices in small-caps versus large-caps.
Moreover, the investable universe of small-caps has significantly expanded. In 2020, the number of small-caps with market capitalization of more than Rs 2000 crore was about 220 – today the number is around 800, an increase of 4x. The largest small-cap used to be around Rs 7000 crore in market capitalization – today it is around Rs 30,000 crore. Moreover, the weight of small and mid-caps in the market has gone up from 20% 15 years ago to 40% – they have become too significant to ignore. Small-caps and mid-caps are about $1 trillion each – quite large even by global standards.
How careful are you going to be while picking stocks in the smallcap space at this stage?
Management and promoter quality are of paramount importance to us. In the case of small caps we may need to be extra careful in due diligence and in checking the background of the promoters. Another tool to mitigate risk is to diversify the portfolio adequately and not have more than 4-5% exposure to one stock in the small cap fund. Similarly, we also take care of sector concentration. Regular follow-ups and management meets are an integral part of our research and portfolio management process.
There is one notion in the market that the buzz in smallcap space has been largely led by domestic liquidity. Do you agree?
After many years of growth and rising income levels, we have reached that stage where the domestic savings pool is now large enough to counter the foreign flows. Earlier when FIIs used to buy or sell they used to impact the markets. This is no longer the case. This is a natural evolution, and we have seen this earlier in the western world and then in countries like Taiwan, Korea, Japan, China etc where the local investor does not really bother about foreign flows on a daily basis. Moreover, foreign flows tend to focus on the large cap benchmark stocks as they have limited research bandwidth, and most flows are anyway through passive funds which track the large cap benchmarks. On the other hand, the Indian retail investor and institutions have more bandwidth and are familiar and comfortable with mid and small caps. In India, the proliferation of PMS schemes and AIFs has also led to domestic flows to smallcaps.
Which pockets of the market are a no-entry zone for you at this stage?
There are no no-go segments for us but in general I am not structurally very bullish on commodities and global-economy linked stocks like IT, metals, energy, mining. Certain sectors fall by the wayside as we may not be tracking them actively like shipping, aviation etc. For us the no-go stocks are where we do not have faith in management or promoter credibility.
The market is worried about a shift in FII money to China and the fallout of the war in the Middle East. How big are these two issues for you?
The “flow of money to China” debate is pretty much settled after the events of last week. Equity investors have not made money in China in the past 25 years – the period in which China went through its greatest period of growth and became a global manufacturing powerhouse. If one didn’t make money then, how do you expect to make money when it is struggling for growth and the government is taking knee-jerk, desperate measures to stoke growth and consumption. Demographics are against China and in favour of India. So structurally, India should continue to attract flows. It is too risky to bet against India.
The wars in the Middle East and Ukraine are risk factors for sure, but so far commodities have remained subdued due to the slowdown in Europe and China. A few years ago, oil would have spiked up significantly in such a scenario but with the US turning net exporter and China consumption not growing (impact of slowdown and renewables capacities)
Do you think that the market, at an index level, can correct 5-10% before any dips get eventually bought into?
The market has been quite rational and has been discounting news and events. Many sectors like chemicals, banks, finance companies, IT have corrected significantly in the past 24 months, and these have paved the way for other sector leaders like capital goods, auto, real estate, defence etc. So while we see the indices near all-time highs, not all stocks and sectors are actually at highs. There is always scope for active management and I am not a big fan of waiting for a ‘big’ correction to deploy funds. Moreover, the retail investors are even more positive than me – out of the current 17 crore demat accounts 14.5 crore have been created in the past 9 years. These 14.5 crore accounts have not seen a single negative calendar year return, so they are conditioned to buy on any dip – big or small and that is what we are seeing in the market.
Which sectors do you find enough opportunity as a long-term investor?
The sectors we like fall into three broad themes: rising income levels, physical asset creation and technological disruption. Rising income levels means that premium item consumption growth will be higher. This means segments like premium vehicles, premium real estate, jewellery, consumer durables, hotels, airlines etc. It also means segments that cater to financial savings will grow faster – insurance, wealth management, asset management, broking, exchanges, depositories, registrars etc. Physical asset creation includes sectors like real estate, capital goods, construction, infrastructure, power, defence, railways. Technological disruption includes all the new-age companies in the B2B and B2C space, which use technology to create new business models or to disrupt existing ones.
A number of stocks from hot themes like PSUs, defence and capex have underperformed the market. Where do you think these themes are going to end?
We continue to be positive on defence and capex themes as these are structural long-term stories. We had tactically reduced exposure in the last three months as some stocks had gone up too much too fast but we would like to add back to the exposure as the long term story is still intact. PSUs are a very diverse bunch of stocks across all sectors like energy, oil and gas, metals, banking, defence, capital goods, mining etc. Each stock has very unique fundamentals and we look at these on their individual merits. So there is no one overall view for PSU stocks.