Big daddy of small-cap funds says segment frothy, investors need to have 5-7 year horizon

No. We have always maintained over 65percent of our corpus in small-caps, which is companies with market-cap in the range of Rs 3000 to Rs 22,000 crore. We always keep some buffer, in large and midcaps, and cash, for liquidity. It’s pretty much the same now. It is time-tested, as we have managed this successfully for more than 10 years. We are confident and prepared for all kinds of market scenarios.

Your portfolio has more than 200 stocks. Is your strategy primarily one of risk mitigation, and return a secondary objective?

Our approach is to keep the portfolio well diversified. Beyond the top 250 companies, everything, about 400-500 firms, i.e., about 65 percent of the listed firms, are small-caps. There have been maybe 150, 200 IPOs in the last three years, a lot of which are small firms. So, the universe is large. Within that universe, we have exposure to 190 stocks, including large and midcaps.

Secondly, our approach is stock selection, bottom-up investing. We consciously make sure that the portfolio isn’t concentrated. That's why you see a larger range of stocks.

Third, we don’t take sector-based calls. Because of that, the churn is low and the holding period is long, three to five years. We pick up equity at sensible prices and hold. Even if we find a sector attractive, we try and distribute our bets across players to keep single-stock risk as low as we can.

Are you saying you pick sectors and spread your bets? Why do you say it’s bottom-up strategy then?

The sector is the starting point for everything. But the real thing is doing bottom-up research to understand which stocks to own, and what to avoid.
It's very difficult to play cycles in a small-caps because of challenges in changing portfolios frequently. So we do not play cycles, we tend to instead hold stocks for longer time periods.

We thus prefer to own a larger number of stocks, and for a longer period of time; that's how we build our portfolio. That way, the impact (of any one company not doing well) is also lesser because you bought less in the first place.

Your fund size is around Rs 45,000 crores. Even if you allocate 1 percent to a scrip, that’s a Rs 450 crore position, at 2 percent it’s Rs 900 crore. Does the market-cap profile of these stocks give you comfort to exit without significant impact cost?

Currently, over 68 percent of the portfolio is in the small-cap cap space. These are not the sub-Rs 3,000 crore market cap firms, as small-caps were classified 10-15 years back. Small caps today have market caps going up to Rs 18,000-20,000 crore.

The fact is that over 80 percent of the portfolio is invested in companies with market-cap of over Rs 5000 crores and around two-thirds is in companies with market-cap of more than Rs 10, 000 crore. In my view, at times the discussions around big and small positions are just narratives. These need to be evaluated in the context of prevailing market conditions.
Right now, beyond the top 250 companies, the rest are small caps. The second largest hotel company is a small cap. In that sense, the small cap universe is different from the common perception of a small cap firm.

What’s the market cap of the smallest company in your portfolio?

Between Rs 2,000 to 3,000 crore. The universe is between Rs 3,000 to 22,000 crore. That’s large. Ten years back, the large cap firms used to be Rs 10,000 crore plus. Today, that’s a small cap by definition.

I do agree that for small-cap funds, euphoric times like this are a challenge. Hence, we have made sure that investment is via SIPs (systematic investment plans). We stopped lump sum investment in smallcap funds in July 2023 to ensure that people come with a longish time-frame in mind. Besides, we have been cognisant that excessive flows can hurt existing investors.

The general perception is that unless you size up the bets, you are not optimising for returns, are you? With a portfolio of 200 companies, how much alpha can you generate?

This is a wrong perception. There is no guarantee that a focussed fund will generate alpha. Focussed portfolios of 10, 20 stocks need not be the holy grail. A well-diversified fund can also generate alpha.

The fact is, you have a 700 stock index, of which we own 200, of which 150 are small caps. So we own only about 20 percent of the small cap universe. We had 140 stocks even two years back.

There are two options when you pick stocks — buy new scrips, or concentrate on existing stocks, which impacts the size. We may not choose to do the latter unless prices correct sharply and we see value. Our team has the ability to cover a large universe. We cover about 475 companies, one of the largest coverages on the street. That’s what gives us the edge.

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How big is your research team?

We have about 28 members. The core research team has about 17 people, 80-90 percent of whom have about 15 years of experience covering stocks.

You said you focus on bottom-up. What’s your top criteria to pick small-cap stocks?

We pick the best managers. Companies should be run by very good quality management.

What a good management? Is that apparent in this category?

Yes, very much. Like I said, the second-largest and the third-largest hotel companies by market cap in India are small-caps, and part of our portfolio. Ninety percent of all engineering and manufacturing companies are in this space. So, this is a very large space if you see the portfolio, and these are businesses that will live beyond us.

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The traditional perception of smallcap is that it is some fragile company that will not exist. That is not the case. That would be the below-Rs 5,000 crore-8,000 crore market cap companies. But there is a whole universe of world-class businesses in this space. These offer both quality as well as longevity. Market-cap cut-off is low, but that does not mean a big compromise on quality.

Risk in the small caps is on account of volatility in both earnings and stock prices. Over a 20-year time frame, largecap and smallcap returns converge. But there is a stark difference in the returns from the mid-cap category between 2003-11 and from then onwards. The sharper you fall, the longer you take to comeback. Is the risk even worth it?

Every segment of the market carries asset-class risk. When you look at smallcap investing, it is different from largecap investing by nature, character, and asset classes. Hence, the returns have also been very different. Nobody can eliminate asset-class risk.

As for the performance and volatility, there was a very bad cycle from 2007 to 2013. If you remember that period of pre-elections and the challenges of high inflation, oil prices, and bankruptcy problems in large banks, the smallcap stocks were the most impacted at that time, and from there on, the return differentials are visibly behind. During that time, the large caps also fell, but not to the same degree.

So you are saying small-caps are now on firmer footing? But do you agree that valuation in this segment are frothy?

Given the way stocks have moved in the last six months, yes, it is certainly getting expensive. Stocks with market-caps less than Rs 7,000-8,000 crore are the ones becoming expensive because that's where stocks have been moving 40-50 percent in a month or so. There is froth and impact costs are high, which can impact investor experience in our fund, that’s why we stopped taking lump sums or larger-ticket investments. We are taking money in the SIP format. That's our way to deal with the situation.

Having said that, the market including this category has survived Covid-19 and demonetisation-correction. In my opinion, small caps are not as fragile as perceived to be. We have come a long way -- from 20 years ago when small-caps meant companies under Rs 3000 crore, today we are speaking of significantly larger companies. The reference is very different now. Companies with more than Rs 10,000 crore market caps are reasonably less fragile.

But why should market-cap be a reference point for fragility? Shouldn’t it be more fundamental factors like sales, profit, competitiveness etc?

Fair point. And there are few points that favour small-caps. Firstly, there is a market shift from unorganised to organised. Some of this benefit is coming to companies in this segment. Secondly, some of these companies are benefiting from a generational shift in the promoters running their businesses. We can see some companies with younger promoters or those that have seen transition looking at new ways of running the company. They are running it a lot more professionally.

The other thing is that today it is generally very difficult to not have the right taxation practices because of GST. This has brought about a meaningful level of governance in a lot of these entities. The good part is that a lot of these also have 10 to 20 year listed histories, which is very important because that means you are tested by the market at various points of time. So all this means, we do have a fairly good set of businesses.

But how do you deal with the volatility risk? Is it worth it?

But it does not mean you don't have the small-cap risk of volatility. So our advice always is that if you have anything less than a five-to-seven-year horizon, please don't come to small caps. Please come to small caps with a five-to-seven-year horizon. This has been our advice since the launch of the fund.

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You need to have a longer time frame for small-caps also because you need to overcome the cyclical impacts. Their margins are more volatile than large caps because, when there is pressure in large caps, they will pass it on to ancillary services. However, the challenges of the smallcap category remain on both sides. There is an impact cost when you buy as we all as when you sell. Nobody can eliminate category risk. You can only design it a little better. In our case, the position size management is one important way to deal with this risk.

What about the liability side? What’s the client concentration in your fund?

None. Top 10 investors by AUM cumulatively account for less than 1percent of the fund AUM and Top 50 investors cumulatively account for less than 2.5percent of the fund AUM. Our investor based is quite diversified. We will not be impacted by one large redemption. And as I said, with a mix of 30-32 percent in large-cap, mid-caps, and cash, we are very much liquid.

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