STeP into this well timed NFO
WF: Your presentation highlights relative poor analyst coverage among small caps as one of the alpha sources for fund managers. Given the huge amount of domestic money that has come into mid and small caps in the last 2 years (through MFs, PMS and AIFs), is inadequate research coverage still a competitive advantage?
Radhika: The smallcap universe is big, there are more than 500 stocks with more than Rs. 1,000 crore marketcap. Mutual funds have not covered the entire universe yet, which is visible from the data below that shows more than 600 smallcaps being covered by less than 5 analysts. Hence, we strongly believe inadequate research coverage in this space remains a strong edge to generate stock selection alpha in longer term.
WF: Your presentation makes an interesting point about incremental demand for small cap stocks. How much of this 1 lakh crores do you actually see going into small cap stocks and how much of this action may already have happened?
Radhika: SEBI categorisation played a huge role in this. With revised mandate of Largecap, Large & Midcap and Midcap funds the investment universe available has shrunk. Now only 100 stocks are largecap which are heavily covered by analysts, midcap universe has also shrunk to just 150 stocks. With this scenario, generating alpha by investing in largecaps and midcaps is becoming difficult due to lower information edge. Hence, we believe that the funds will see increased allocation into smallcaps in years ahead.
Currently, on an average, 5%, 8% and 11% of the corpus of Largecap, Large & Midcap and Multicap Funds respectively are invested in smallcaps. This will gradually increase and hence, there is enough scope for flows into smallcaps from these funds.
MF AUM as Dec 2018. Data Source – ACE MF
WF: Your presentation makes a good point about the correction in small caps (-28% in last 1 year) and the history of bounce-backs post such corrections. Some experts however argue that valuations have not yet corrected to below historical averages vs large caps. Should one brace for more pain before an eventual bounce back?
Radhika: The quality small cap stocks have fallen sharply from their peak, whereas the earnings of these businesses are steadily growing representing an investment case. Valuation has to be seen in context of underlying earnings and many stocks are continuously growing much faster than their largecap counterparts and hence, shall trade at a premium. We have seen valuations of such stocks dropping sharply due to price correction and they have become more attractive than before.
We have shown one such example in our presentation.
In the below example if you see, in last one year the stock has fallen by 25% while earnings have grown by 29% thereby reducing the P/E ratio of the stock from 22.4 to 13.1. Now with ROE of 16.9 and expected EPS growth of over 20.4%, valuation of this stock looks attractive.
In Edelweiss Small Cap Fund we will aim to identify such quality smallcap stocks and generate wealth over long term from such opportunities.
WF: What is the STEP facility that you are offering along with this NFO and how should distributors position this to their clients?
Radhika: Keeping in mind the volatility till the general elections, we have introduced “STeP” (Smart Trigger enabled Plan) which will help investors to stagger their investment in Edelweiss Small Cap Fund.
This unique facility – Smart Trigger enabled Plan* (STeP) helps to invest in a staggered manner and mitigates market timing risk. This feature is available only during the NFO period. Through the STeP facility investors can spread their investment in Edelweiss Small Cap Fund in 5 equal steps. With the Trigger enabled, under this feature 20% of the application money will be invested upfront in Edelweiss Small Cap Fund. The remaining 80% will be invested in Edelweiss Liquid Fund and will switch to Edelweiss Small Cap Fund in 4 equal monthly instalments on market dips.
Since smallcaps are volatile, we want investors to invest carefully and in a responsible way using the STeP facility during the NFO period.
Illustration of STeP:
WF: What are some the sectors/themes that seem most promising to your team in the small caps space?
Radhika: Although the fund will not take sector bias calls and the focus will be on stock picking, but there are few sectors which are unique to small-caps and looks promising going forward. Industrial/Infra, chemicals, staffing companies are few amongst them which are expected to grow fast in medium to long term horizon.
WF: Your portfolio allocation strategy talks about core, tactical, defensive and option. What is option? What weights will your team typically give to these 4 sub-strategies within the fund?
Radhika: Strategic, tactical, defensive and options are bucketing of the stocks. Bucketing is the last stage of our research process. This is done to understand the portfolio allocation and this is a derivative of our initial bottom-up research. Bucketing helps us to ensure consistency in performance.
WF: What should be the key investment argument for this fund that you would want distributors to communicate when discussing this fund with their clients?
Radhika: Since the Small Cap category has experienced a steep decline, their valuations are now looking a lot better than before. If one invests with cheaper starting valuations, it improves the odds of generating reasonably healthy returns in the long term.
Having said that, no one can predict the bottom and whoever wants to still take a cautious route, STeP facility is the way to go.
Also, when investors in general are too risk-tolerant, markets are more risky than the returns they can generate. And when investors are too risk-averse, markets can offer better returns than the risk they carry.
Many investors today have become risk-averse in small caps and probably the risk-reward is favourable for those who invest now.
For more information on Edelweiss Small Cap Fund, kindly click on the below link:
Mrs Radhika Gupta is the CEO - Edelweiss Asset Management Limited (EAML) and the views expressed above are her own.
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
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