Reaping the benefits of a well-timed fund launch
CIO – Equity
WF: The BSE Small Cap Index grew 4 fold between Aug 2013 and Jan 2018 (from 5,300 to 20,000) and has since corrected to around 14.400 by end Nov 2018 – around 28%. Is this to be viewed as a healthy correction in a longer term bull market in small caps or does this signify that the bull market is over, given the steepness of the correction?
Taher Badshah: It is a healthy correction. When we look at the small cap index, we should not lose sight of the overall markets, and the larger benchmark indices are a decent comparison. In 2013, the smallcap index was a discount to the large cap index and during the course of 2014-2018, it rose to a significant premium. Post the correction since the beginning of this calendar year, the premium has reduced to virtually zero percent for the midcaps and maybe 5-10 percent premium is what remains now for the small cap index.
If we look at from a relative stand point instead of looking at absolutes, the small caps and mid caps don't enjoy a meaningful premium over the large caps. Given the general improvement of the macro conditions in the country and the expectation that India should be able to grow and outperform compared to other markets, some of this premium in the small cap and mid cap space would remain justified simply because midcaps and small caps are more domestic oriented businesses. They are more linked to the domestic economy and if the domestic economy is to grow, it would benefit the small caps and midcaps more than the large caps which over the years have developed a global approach. The correction is a very healthy one. Therefore, incrementally as we stand today, we are a lot more confident about the mid and small cap space than we were a year ago.
WF: Times of macro stress usually impact small and mid cap companies more than large caps. Why, in this context, did you choose to launch a small cap fund in October 2018 – when negative newsflow on macro stress was highest?
Taher Badshah: Around that time, we were seeing a fairly decent amount of deterioration. Quite a number of macro parameters including currency, commodity prices, fiscal accounts, current accounts, interest rates were relatively looking adverse and a bit weaker than what they were some time back. They were weakest in July, August and September but the market seems to have adequately punished the mid and small caps.
With mid and small caps, you are typically dealing with young businesses and management, which have yet to develop enough scale. The balance sheet may not have fully stabilized or been proven and therefore, carry inherent risks. The best protection against the volatility of small caps and mid caps from an investing point of view is from valuations.
If you were to buy small and mid caps at comfortable valuations, you will be a lot better off than buying them at significant premiums or buying them in momentum. By August 2018, the premiums already collapsed from 60%-70% to around 20% for small caps. We saw further carnage in the market in the month of September, and October post the IL&FS issue and other concerns, which emerged in the market at that time and the premiums had further collapsed to almost zero. Therefore, from a valuation's standpoint, we felt that this is the best time for mid and small caps as an opportunity especially if one has 2-3-year perspective. That essentially compelled us to launch our small-cap fund in October.
WF: How is the earnings story panning out among small caps?
Taher Badshah: If we take the BSE small cap 250 index during this whole crash, we found that out of the 250 companies, about 80 percent had done reasonably well from a fundamental standpoint. The 2 year revenue and 5 year revenue growth were in the vicinity of 12%-15% which is decent. We had delivered well from a fundamental perspective but despite that, most of these companies had fallen with the same intensity. The market did not differentiate between the good, bad and the ugly.
Almost all the small-cap stocks had received the same kind of treatment and there was therefore, room for differentiation. It was a good opportunity for bottom up stock picking and constructing a decent compact portfolio wherein we could identify companies where the fundamentals were strong and valuation multiples has fallen in the indiscriminate selling.
A year ago, it was very difficult to find small cap and mid cap ideas as everything was so expensive. Once they corrected, we were at the other extreme where there were a plethora of opportunities and plenty of good quality, decent business. They are not cheap like in 2013, but they are a lot more reasonable than what they were at the beginning of the year or a year back.
WF: What are the themes and sectors that you are overweight on and why, in the initial portfolio you have cast for your new small cap fund?
Taher Badshah: Although the focus is bottom-up stories, at an aggregate, we find ourselves well placed in consumption, industrial, technology, financials and oil & gas. These were the primary sectors where we found opportunity. We are about 65% invested in the small-cap fund as of now.
WF: The small caps cycle usually peaks at the top of an economic and market cycle while underperforming during large portions of the earlier stages of the cycle. In that context, where in the cycle do you see us now?
Taher Badshah: From a macro and earnings cycle, we are closer to the lows of the cycle. If you look at the aggregate profits to GDP, we are at a relatively cyclical low of 2%-2.5% versus a peak of 7%-8% in 2007-2008, and our average has been about 4%. So we are well below average from the point of view of the profit cycle and perspective of the growth cycle.
From a GDP growth perspective, we may be at 7-7.5, and we would have peaked at maybe 9 or so, but when we look at it from a profit cycle, it is a lot lesser and if we look at it from a perspective of capacity utilization, what used to be 80% is now more like 73, 74. It went down to as low as 69. We are off the lows, but we are well below the mid cycle. We are likely to see next 2-3 years of expansion before we start thinking of a cycle top.
WF: Given the significant amount of money that has come in recent years into mid and small cap funds and PMS products, can it be said that PE multiples of small caps stocks have perhaps got permanently re-rated upwards compared to historical averages, due to heightened institutional interest that will remain in them?
Taher Badshah: There is a fundamental aspect to it as well, and that has been more prominent over the last 10 years. Many of the larger companies saw limitations, and this has happened post the global crisis. Many of the larger companies have chosen not to meaningfully invest in India and that kind of restricts the growth outlook for large caps whereas the many of the mid and small caps have been investing and trying to increase their presence in their respective industries.
From a growth perspective, that makes small and mid caps interesting. Expectations of growth from small and mid caps led to institutional investor interest and more money flowing in. Many of the companies have undergone an interesting journey; some businesses have gained significant size and scale – making them very interesting from an investment perspective. That anyway is one of the biggest attractions of small caps – the opportunity to ride their entire growth wave from small to mid and then potentially even to large cap. We see a lot of such interesting opportunities in the small caps space today.
So I think there are some good reasons for sustained domestic institutional interest in the small caps space, and I think there are strong reasons for this interest to continue in the years ahead.
The views are expressed by Mr. Taher Badshah, Chief Investment Officer, Equities, at Invesco Asset Management (India) Private Limited. The sectors referred herein should not be construed as recommendations from Invesco Asset Management (India) Pvt. Ltd. The Portfolio may or may not have any present or future positions in these sectors or in any other schemes offered by Invesco Mutual Fund. The views and opinions contained herein are for informational purposes only and should not be construed as an investment advice or recommendation to any party or solicitation to buy, sell or hold any security or to adopt any investment strategy. The reference to the Scheme mentioned herein is only in context with the question asked and should not be construed as an investment advice or recommendation to any party or solicitation to buy, sell or hold any Scheme or to adopt any investment strategy. The views and opinions are rendered as of the date and may change without notice. The recipient should exercise due caution and/or seek appropriate professional advice before making any decision or entering any financial obligation based on information, statement or opinion which is expressed herein. Invesco Mutual Fund/ Invesco Asset Management (India) Private Limited does not warrant the completeness or accuracy of the information disclosed in this section and disclaims all liabilities, losses and damages arising out of the use of this information.
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