Since the last six months, Small Caps have been on a rally, with the Nifty SmallCap Index gaining almost 33 percent from Rs 9,672.55 in March 2023 and the BSE SmallCap Index gaining nearly 35 percent from Rs 28,149.58 in April 2023. While there is a debate on whether investing in SmallCaps is the way to go ahead, here are five reasons why Chirag Mehta, Chief Investment Officer, Quantum MF says this is the right time to invest in small caps.
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Mehta was speaking on the sidelines of an event to announce Quantum AMC’s Small Cap Fund.
- Compared to the number of mid- and largecap stocks, Chirag Mehta, Chief Investment Officer, Quantum MF, says that the number of small caps is much larger, and includes companies with “good ideas and good budding themes, that we can get in on early and benefit as they compound over a long period of time.” The smallcap space currently includes more than 85 percent of the listed companies.
- Talking about why one should look at smallcaps along with mid and largecaps, Mehta explained that largecaps are skewed towards certain sectors, such as finance, and oil and gas. While smallcaps are also skewed, they’re not as skewed as largecaps and include sectors the government is trying to grow, such as agriculture, tourism, transport, etc.
For example, Mehta says, “India has one of the highest logistics costs. If we have to grow, we need to bring it down. And that can only happen if the sector scales up, bringing down warehousing and transportation costs. So, there'll be a lot of momentum in these new sectors in the smallcap space.”
3. Another reason for focussing on smallcaps is ‘information asymmetry’ as the space is under-researched, says Mehta, with only a fourth of the brokers covering, smallcaps. “There is an opportunity to identify unexplored companies and get in early.”
4. Compared to mid- and largecaps, smallcaps are also under-owned by institutions, mutual funds, insurance firms, etc. Mehta says smallcaps have good growth potential as out of about Rs 20–22 lakh crore that’s deployed in equity mutual funds, only Rs 1.8 lakh crore, or less than 10 percent, is in smallcaps. Mehta says a 10-15 percent allocation in smallcap mutual funds would be desirable.
5. Smallcaps also offer opportunities for PE re-rating, he adds. For returns, Mehta says, there are two levers — earnings growth and PE rating and smallcaps have the advantage of being able to offer both. When a company consistently delivers and showcases its potential for growth, Mehta explains that investors themselves start saying that the company has the potential to trade at a higher PE. This is especially true for smallcaps as they are still relatively unexplored, hence do not have the valuation that they should command, Mehta adds.
6. The ability to disrupt is also a big plus. “These are innovative companies which have disrupted something. They are generating cash flows and have a steady business model; therefore, they have created a moat for themselves, for their innovation. As they get in early on that space, they can be the first mover and therefore command a larger pie of the business,” Mehta points out.
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Understanding risks
Mehta says that they (Quantum) also understand the risks in the space. One is the ability of small caps to attract the kind of talent that can innovate. Second, capital may be scarce because the companies are newer and smaller. The third is the challenge of governance.
“You can identify the right businesses, but if the promoter or the management is not good, you may not get adequate returns,” he says. Mehta adds that at Quantum, they have an internal `integrity screen’ which analyses the management based on various criteria.
“When it comes to portfolio construction, there’s the risk of liquidity, the risk of ending up owning a large chunk of a small firm, which can hamper the long term performance of a smallcap fund. That’s where we think we can be disciplined and deliver a good portfolio to investors,” he adds.
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