This fund manager believes 2025 could be the right year to look at small caps

There are three main reasons for considering small caps. First, if you look at the Nifty Small Cap 100 index, it has been around for almost 20 years, and its performance has been impressive. Over the past 20 years, small caps have delivered an internal rate of return (IRR) of 16.5-17%, while several active funds in India have added significant alpha to this. Small caps are one of the few asset classes that have delivered high double-digit compounding returns for over 20 years. While they may not deliver huge gains in just one year, taking a 4-5 year view, small caps have been one of the best wealth creation tools.

I personally invest in small caps for my daughter’s future, as I believe that over a 10-15 year period, the compounding effect in small caps can be substantial. For example, while the Nifty 30-year return is around 11-12%, the small cap index has delivered 17% over 20 years. Although small caps may experience 20% drawdowns every 4-5 years, these corrections are expected. We also believe that 2025 could be a good year to start building a small cap portfolio, with returns materialising in the next 3-5 years. The current correction is an opportunity to enter at more favourable levels.

By the last week of December, while large caps were down by 10-12% from their 2024 peak, small caps were down only 5%. However, in the first 10-11 days of January, small caps corrected by 8-9%. Now, we have seen a correction of 13-14% across market caps. A 15-20% correction from the peak is typical for markets every 4-5 years and we are not overly concerned about this. While we may experience 5-10% additional correction, we see this as a normal part of market cycles. We will use this opportunity to build a strong portfolio that can deliver value over the next 4-5 years. The market may take some time to recover fully, but we are confident that small caps will deliver strong long-term returns.

There’s always concern about extreme volatility, especially in small caps. With the current market volatility, are there any risk mitigation strategies in place to address this?

Volatility is certainly a concern, but we expect the market to be volatile in the next few months. We have several key events, including the Indian budget in February, RBI monetary policy, and the new President taking office in United States. These could create market volatility, and we plan to take advantage of this volatility.

In the short term, we may adjust our portfolio to have an allocation of 20-25% in large and mid-caps in our small cap fund especially during periods of volatility. As market conditions improve, we’ll gradually shift to fully to small caps. This tactical allocation allows us to manage risks while taking advantage of value opportunities in small caps.

Are there any particular newer segments or sectors you are focusing on for investments?

Today, India’s economy is much more diverse than it was pre-Covid, and we can focus on emerging themes. We are targeting sectors such as contract research and manufacturing, chemicals, renewable energy (solar and wind power), and the shift to battery vehicles. Additionally, financial savings, including AMCs, wealth management, depositories, and exchanges, are exciting areas.

Small caps tend to deliver better earnings growth than large caps. Over the past 5 years, the Nifty has had 18% earnings growth, while small caps have grown by 27%. While the broader market may experience a softer year in FY25, we believe small caps could continue to see earnings growth of around 15-20%. Our approach is to pick 45-50 stocks with high earnings growth, solid return on equity, and reasonable valuations. This gives us a diversified, high-quality portfolio across multiple sectors.

Considering that there are already several small cap funds in the market, how will your strategy be different from others?

Our strategy stands out in a few key areas. We have a strong track record in the Indian market, having grown from zero to Rs 2 lakh crore in assets over the past 15 years. When we first launched our fund in 2008, many people were sceptical, but we have since added significant value through careful risk management and stock picking.

We also have the right team in place. Just five years ago, we had 6 analysts covering 200 stocks. Now, we have 12 analysts and 5 fund managers covering 600 stocks, including 200 small cap stocks. This expanded team allows us to focus on bottom-up stock selection and gives us a competitive edge in identifying value in the small cap space. Our strategy is to build a strong foundation by starting with a smaller fund size and gradually growing it over time.

What is your outlook for the market in 2025?

For FY26, we expect earnings growth of 11-12% for Nifty 50 companies, which is in line with the long-term average. We anticipate that the market will revert to this historical trend of 11-12% earnings growth. As an active fund manager, we aim to add alpha through selective stock picking and risk management. The overall market may see softer earnings growth in FY25, but we expect a bounce back in FY26 and believe there will be plenty of opportunities for small caps to outperform, especially as we focus on high-growth sectors and stocks with reasonable valuations. The long-term outlook remains positive, and we are optimistic about the potential of small caps.

Disclaimer: The views and investment tips expressed by investment experts on Moneycontrol.com are their own and not those of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.