I want to understand the kind of liberty you have to strategize when you are picking up smallcap stocks compared to what you do in a largecap fund where you have like top large cap companies to select from. Talking about the current scenario in the market, what is that one thing that you are focusing on in terms of innovation and a different strategy in your smallcap fund?
The space is very exciting and once you start looking at a longer term picture, as India moves from a $3 trillion to $5 trillion economy and the per capita GDP moves from $2,200 to say to $5,000-6,000, new categories will be created, whether it be home improvement, durables, infra, real estate, recreation and so and so forth.
A large number of these are represented by smallcaps and midcaps. If you take the top 100 stocks which are classified as largecaps, 55- 60% of their revenue are dollar denominated or derive their revenues from outside India. But when you look at the smallcap and the midcap space and the smallcap is defined as 250th and below, there is a large universe of stocks to choose from. A large part of them are domestic plays.
If you are bullish on India from a medium to long term and you believe that the $3-trillion economy is moving to $5 trillion and $7 trillion over a period of time, this is the space you cannot ignore because a lot of businesses will become larger in size. We saw that in the mid 80s and early 90s that the IT bellwethers today were smallcaps in a way in sums of size and later on became midcaps and later on became largecaps.
I believe this sector is very exciting but also with the caveat that it has its own volatility. Other experts have talked about the need for patience in this category because there are periods which will show you negative returns also. As an investor, one gets perturbed during those times and if you believe that you will get a quick buck, probably this segment will disappoint you.
Also, the second most important point about the sector, where professional investors and money managers can add value with a good team is that the top 100 stocks are well discovered and well tracked by the research analysts but as you move down the market cap curve, the number of research analysts covering that stock actually reduces and below 250th market cap, there are companies where only one or two research analysts on the street covers that stock.
So if your research team is good, they can do deep research – Scuttlebutt analysis. You can add a lot of value over a period of time. But do not forget that the data is not very encouraging from an overall wealth creation perspective, in a sense that in the last 20 years, only 5% of the smallcaps have been able to transform into large caps and that is where the real money is made.
Our strategy is to try and have filters where you can make less mistakes because making less mistakes is the key to investing in smallcaps . The more mistakes you make, probably the lesser the returns would be and in smaller caps because they are smaller in size you need to be extra careful with the management quality, with the return on capital, balance sheet and cash flows.
Our mantra is a Gorilla to King Kong strategy. Have 50-60 gorillas in your portfolio, which pass your filter in terms of management quality, return on capital, balance sheet and cash flows and you do not know while investing which one will become King Kong. But if you are right on the investing side, making less mistakes, be rest assured that out of the 60-70, a few will become King Kong and add the returns to your portfolio over a period of time.
Hence over a 10-year CAGR, this category has not disappointed. In this category, even the last fund has done better than Nifty in a way or maybe equal to Nifty. So one needs to have patience. One needs to be temperamentally okay seeing the troughs when 2018-19 happened, 2011 happened and 2013 happened. There have been many instances like that. If you are patient enough, you will probably be rewarded and it is a good way to diversify your portfolios over a period of time. If you are bullish on India, you cannot ignore the midcap and smallcap space.
Currently looking at the market condition and the uncertainty involved, how are you reading these companies? What are the sectors that you really want to focus on?
One mega trend which we are riding on is the entire manufacturing revival in the country. Over the last one-one and a half years since Covid, we have been positive because structurally, a lot of changes have happened. One is that the geopolitical order in the world has changed since Covid. A lot of companies – be it European-based or US-based – wants to diversify part of the supply chain across industries and India is coming as a good location and destination for that.
The second one is that the balance sheets of corporate India have deleveraged considerably. As we speak, the debt to equity of the top 500 companies in India is down to 0.7.
Third, the profitability of the companies have moved. There has been a shift from unorganised to organised and these are structural changes. We believe that a manufacturing revival is happening right in front of us. A large part to play that manufacturing revival lies within the midcap and smallcap space – whether it is capital goods, consumables which is used in production like abrasive bearings, consumer durables, chemicals or cement, a large part of that pack on manufacturing side is represented by midcaps and smallcaps.
I see a great opportunity over the next three-five years from that theme perspective. The second one which we are positive on is the entire revival of residential real estate. Again, that entire category can be played only by small and midcaps. And we believe that bottom-up stock picking is the key in this area.
In this space also, many home improvement companies whether it be tiles, pipe, electronics, maybe plywood, all those things will lie in this theme as a part of the entire home revival. And I think there are other more themes like, the entire pharma space, some of the mid and smallcap IT companies and auto ancillaries.
Auto ancillaries is a promising space. We have seen many companies move from small to midcaps over the last 15-20 years and become sizable in nature. This is another important part which can be played through smallcaps. I think there are various narratives and opportunities out there from a three-five year perspective. But finally, it boils down to bottom-up selection, selecting the best businesses and management which will compound your earnings and wealth over a period of time.
Does your time horizon need to be long? I am talking about a fund. People want to invest in stocks that could be a different strategy altogether. But typically in a fund, if you are holding it for more than five years, does one need to have an exit strategy because that is easier to understand for a largecap category? What would be the criteria to decide on your exit in a particular small cap fund?
Time and again, we have seen the space goes through undervaluation and overvaluation. People talk about earnings yield. Earnings yield is nothing but 1/PE. And whenever you see a very sharp compression in earnings yield between largecaps and smallcaps. That is a great signal that smallcaps are overvalued.
The second one which we use as a contrarian signal and it acts as a great sentimental signal is the value 100 participation curve. What it means is when there is greed on the street, nobody wants to invest in largecaps. Everybody wants mid, small, micro and as a result, out of the total Rs 100 which is traded on exchange, only Rs 50 to 55 is traded in largecap, the rest is traded in mid and smallcaps. The opposite is true when there is fear on the Street.
Everybody wants largecap stocks. Nobody wants to invest in mid and smallcaps. We have seen various time periods especially the last one with Covid, everybody wants to hide themselves in the largecaps and that ratio moves to 75-80%. We have seen that whenever there is fear and 75-80% is the ratio of value to 100 participation.
Investing in midcaps and smallcaps at that point of time is extremely rewarding. In the next 12 to 18 months, the kind of alpha which you make over Nifty is amazing. Opposite is again true when there is greed on the street and the ratio comes down to 50-55% and you invest at that point of time, the next 12 months is disappointing. So one needs to see these market cycles when you need to take a call on exit or maybe look at aggressively investing in this category.
This category gives great returns over a period of time but one has to be patient and make sure that when there is fear on the street, when everybody is hating mid and smallcaps, that is the real time to go and invest your capital. We have seen time and again over the last 20 years how this segment could be rewarding for investors which have a longer term horizon.
We have seen in our funds as well that in 2018, 2019 and then moving into Covid, the SIP returns for the three-five years had actually become negative and how in two years the entire fortune changed. So if you were impatient and you moved out during Covid, probably you did not see that benefit coming in.
I say that this segment comes with its own risk, its own volatility and beware of that before you invest in this segment. But if you have a longer term horizon and especially in a country like India, where there are niche businesses, there are great opportunities as we scale from $3 trillion to $5 trillion and then to $7 trillion, there will be many businesses which will become larger in size. But you need to be an extremely good bottomup stock picker.
You will make mistakes but that should be smaller as in this segment, there is a very high probability of you ending up with stocks which can lead to permanent loss of capital.
