India's largest small cap fund's manager believes there is more juice left in small-cap stocks

We identified some sectors such as chemicals and information technology at the right time. For instance, about a decade ago, chemical stocks were available at price-to-earnings multiple of four times. And, when China had begun cutting back on polluting industries when they were hosting the Olympics, we saw a shift in sourcing from India by global customers. This worked well for us. Soon after that, there was a re-rating of India’s chemical sector – many became multi-baggers.

So, it is important to be able to identify changes in the factors that influence earnings, be they macroeconomic, policy, management or governance.

The biggest challenge is the poor liquidity in small-cap stocks. As a fund manager, it is tough to enter and exit stocks quickly and frequently. Else, this increases the impact cost and investor returns go down. So every time the market moves up or down, we cannot participate.

We have a strong research team. Further, investing in small-caps entails managing several risks related to the company, sector, market and liquidity. Therefore, we have a well-diversified portfolio of about 120 stocks, across themes and investment styles to offset these risks. The fund manager must be patient in realising returns from small-cap stocks.

We do not have any automatic triggers. Our exit strategies are built around the initial hypothesis with which we first bought the stock. If this changes or there are governance issues or, if the stock price runs way ahead of fundamentals, we may trim our exposure to manage the sector or stock-specific risk. However, we do not allow a single stock’s weightage to cross 6 percent of the portfolio.

In India, we have some well-managed engineering companies. Unfortunately, due to the collapse of capital expenditure (capex) cycle, all these years, most of them have had challenging times. However, I feel that corporate India is showing some willingness to spend money on capex now. Some industrial companies have consciously worked on developing export markets.

Stock prices are still below their January 2018 levels. So, it is a combination of good value and growth prospects. A capex cycle revival usually takes time; but once the cycle starts, it continues for a long time.

Yes, I agree that there has been a stellar rally in small-caps. However, investors must also know that bull markets can have corrections. If you book profits, you must also pay taxes. Further, it is not easy to time the exit and again buy a stock, especially in this category, where liquidity is low. Hence, a long term approach is good.

I personally think that there is a lot of money to be made for long-term investors in India. The coming decade will be better economically for India, compared to the last decade. Unless, there is a specific goal in mind that has to be realised and you need to take money off the table, I suggest staying invested.

Generally speaking, a 15 per cent allocation to small-caps within equities is good. If an investor can live through some corrections, this category can generate good alpha over benchmarks.