In terms of unique folios, small-cap funds concluded the year with a gain of more than 1 crore folios in the financial year, from 81 lakh folios in April 2022. Notably, the number of folio additions remained consistent in the December-April period. (Source – AMFI & Primemfdatabase.com)
Smallcap valuations are attractive compared with larger peers. Smallcap Index is trading at a discount to largecap index. It was trading at a premium to the largecap index during the euphoria of 2007 and 2017. People who invested in smallcap stocks back then suffered losses or accrued sub-par returns. The current valuations of small-caps seem reasonable. Investors with an investment horizon of five years should expect decent returns in these stocks.
However, small-caps were never a blanket buy nor they would be. The space throws interesting opportunities from time to time for those hunting for alpha creation. Long-term themes like play on rising disposable income, the shift from unorganised to organised, China-plus-one etc are available in the small-cap space. Contrary to some beliefs that small-caps do not have an established track record, there are multiple companies with a history of more than a decade and enjoying a dominant position in their respective segments. The disclosures and shareholder interactions (quarterly earnings calls) have materially gone up for small-cap companies over the last decade. The combination of being small in a large addressable market with a leadership position offers a great hunting ground for investors seeking alpha.
That said, small-cap stocks do come with several risks, as small-cap companies tend to be more volatile in financial performance and have a higher risk of failure than larger, more established peers. That is why while smallcap stays the alpha centre of the market, it is also the area that requires a stricter bottom-up approach to investing.
India has always been a hotbed for entrepreneurs and, hence, finding small-cap firms that hold a dominant position in niche categories is not difficult. Since the companies are in the early stages of their growth and have the potential to expand rapidly, they may or may not be discovered by the market fully, and offer significant return opportunities for investors who get in early.Data showed the smallcap mutual fund category outperformed other investing categories in the past year. Investors, however, should understand the risk associated with investing in small-cap schemes.The investment objective should be to generate long-term capital appreciation from a portfolio that predominantly invests in equity and equity-related stocks of small-cap companies. The focus should be on reasonably-priced businesses with medium-term earnings power, regardless of whether they are value or growth stocks. The capex theme, real estate and its ancillaries and automobiles within the consumer discretionary side look good. Gross capital formation in India has been an important driver of employment and GDP growth.
The private industrial capex and investment in real estate has consistently come down from 22% to ~14% and 37% to 27% respectively (as % of gross capital formation). The revival is expected. Housing sales have picked up post Covid-19 and inventory levels have reduced. The derivative impact could be seen in building material companies such as those linked to cement, pipes, wood panel, tile and sanitaryware segments. A lot of such opportunities are available in small and midcap space. Private manufacturing capex is at an early stage of its cycle thanks to government impetus in the form of production-linked incentive (PLI) schemes while banks are in a better position to lend thanks to healthy corporate balance-sheets.
On the consumer discretionary side, while pent-up or revenge demand has been witnessed on the urban side, rural areas are yet to recover from cyclical lows. It could be a dark horse in times to come. This may benefit the automobile sector.
Investors should select a fund house which has had a track record of picking well-managed businesses with scalable opportunities and a superior return on capital employed, ensuring that its investments are sustainable and profitable.
(Sahil Shah is Fund Manager – Equities, at Edelweiss Mutual Fund)
