Good businesses are available in the small-cap segment. There are plenty of well-managed companies run by good managements
Mid and small-caps have fallen like nine pins. The BSE MidCap index declined 13 percent in 2018 and three percent in 2019. The BSE SmallCap index lost seven percent in 2019, after decreasing in value by 24 percent the year before. DSP’s Small Cap Fund had sensed the high valuation in the small and mid-cap segment and shut its doors to new inflows. The scheme suffered and underperformed its peers. Moneycontrol’s Kayezad E. Adajania caught up with Vinit Sambre, Head of equities, DSP Mutual Fund to understand the lessons that the fund house has learnt in this extremely volatile period.
Q: What’s your outlook for small and mid-cap stocks for the year 2020?
A: I’d rather not predict outcomes for the short term. But I firmly believe that equity as an asset class is meant for long-term investments. It should be permanently there in our portfolios, especially mid and small-cap stocks. That is because the cycles for mid and small- cap companies tend to be longer than those for large-cap firms.
Just remember two things: In the short-run, large-cap stocks may seem less volatile than small and mid-cap shares. Second, small-cap stocks outperform the broader market when the economy does well. During a low phase in the economy, small-caps generally tend to underperform.
Q: So you’re saying that the economy is not doing well?
A: Correct. The economy hasn’t been doing well. A better and broader revival of the economy is essential for the small and mid-cap categories to do well. Good businesses are available in the small-cap segment. There are plenty of well-managed companies run by good managements that are aspirational and have a vision to grow their companies. But investors must also understand that we buy companies from a four, five or six-year horizon. The category is fraught with risks.
Q: What kind of companies do you aim to invest in, with respect to your mid & small-cap funds?
A: We have been true to label as far as our funds are concerned. In our DSP Small-Cap Fund, we have avoided buying large-caps, which technically we can up to 35 per cent and hence the average market capitalisation is a bit lower. On the other hand, in our DSP Mid-Cap Fund, we have around 20 per cent exposure to the large-cap category, which is leading to the average market capitalization being what it is. However, in both the categories, our selection process for companies remains similar, and we focus on good quality management that respects capital efficiency, which is measured in Return on Equity (ROE) terms. We like cash-generating companies. And their leverage should be low. We like companies that have shown a track record in these parameters, among other things. We also try and decipher if the company has competitive advantage to sustain over a long phase of time.
Q: So, you avoid early-stage companies?
A: Typically, we try and stay away from companies with a very short history. But we have invested in companies such as D-MART. For companies that are early in their life cycles, we go deep into our research, conduct rigorous channel checks, etc. to find out as much as we can about the company. Unless we get clarity, we don’t invest in them at all. But, last year, we took a decision to pick only those companies for our small and mid-cap funds that have a history. There could be a one-off exception.
Q: Do you think the re-classification of mutual fund categories that SEBI initiated in late-2017 contributed to the slide in the mid and small-cap segments?
A: I don’t think so. The category had become very expensive by the end of 2017, before the time SEBI’s re-classification norms had come out. Even if SEBI hadn’t initiated the re-classification exercise, a correction in this segment was long overdue, given that shares of all types of small and mid-sized companies (even those with inferior business models) were going up. We had called that a junk rally; it was scary because many companies’ share prices didn’t justify their underlying valuations. In fact, our small-cap fund (DSP Small Cap Fund) had already shut for further inflows. That was a signal from our side that markets were very expensive.
Q: In early 2017, DSP Small Cap Fund stopped all fresh inflows. It opened up its doors again in August 2018. Indian mutual funds have slowly now begun to shut doors in volatile markets. What was your experience from shutting your doors?
A: It was good because we did not collect money at higher levels. We felt that it is not right to invest investors’ hard earned money in the small-cap category at a time when we ourselves were not convinced. The small-cap funds category continued to get inflows. But new inflows did not earn higher returns and so the experience of investors that invested in this category after 2017 has not been great.
Q: But your corpus was close to Rs 4,500 crore, down from a high of nearly Rs 6,500 crore in this period. Besides, after closing the doors, your scheme’s performance has been a bit wobbly. What happened?
A: The performance has been challenging indeed, in these last two years. There are a couple of reasons.
First, we turned cautious a bit earlier (around January-February 2017) in the cycle. But the markets kept going up. That year, our fund underperformed (DSP Small Cap Fund gave 43 per cent returns as against the category average of 50 per cent). Some of our investments in sectors such as speciality chemicals, textiles, materials performed badly because they were facing down-cycles in their businesses. But in the last six-odd months, these sectors have done well and we have closed the gap. We prefer to ride the business cycle rather than churn our portfolios. The year 2019 was also a year when sectors such as textiles, building materials didn’t do well, which hurt us.
Q: DSP Small Cap is now open for inflows only through systematic investment plans. What is stopping you from accepting lumpsum amounts?
A: Valuations of relevant companies in the small and mid-cap space are still high, considering the slowdown in earnings. While we find some opportunities in the segment, we are not yet ready to receive a gush of inflows. There is still polarisation in the small and mid-cap space, though not as vivid as in the large-cap companies’ segment. The impact cost (or the divergence of price at which we could efficiently buy the desired quantity of our stocks) in the segment in general is still high. The economy is also yet to pick up.
If the segment corrects some more, we can then take in another Rs 500-700 crore that we think we’ll easily be able to deploy and then we will open the fund for lump-sum inflows.
Q: Why didn’t you tell existing investors to explicitly exit and switch to your other funds? Perhaps to your large-cap funds, which now seem to be recovering. Existing investors suffered, no?
A: If you go through our communication back then, we had clearly mentioned that the category had become very expensive. This is a good-enough indicator.
Q: True, but why not tell them “shift elsewhere,” instead of just saying “markets have become expensive”.
A: I understand. Look at it the other way. If you invest with a horizon for, say, 10 years, then there are plenty of opportunities. For example, Asian Paints was a small-sized company 30 years ago. Look at the company’s size today, its growth, earnings and how the company has come a long way, despite the onslaught of technology and lifestyle disruption.
Likewise, there have been many other opportunities. Just because markets are down or the economy hasn’t been doing too well, companies (mid and small sized) don’t just wind up their operations and walk away. There will be plenty of opportunities for those investors who stick around.But if investors must withdraw because they have expenses to meet or their goals have been achieved, they can withdraw their investments. And when they have the cash later to invest, they can come back.