The nuances of investing in small caps

By Morningstar |  11-01-16 | 
 

Anand Radhakrishnan, CIO - Equities, Franklin Templeton Mutual Fund, shares his views during a panel discussion at the Morningstar Investment Conference held in Mumbai.

How do foreign investors view the mid- and small-cap space in India?

From their perspective, it is a very tough space to play. Typically, the money they want to invest in India is larger than the size of opportunities available in this listed space. Consequently, they have been very tentative till now.

If you look at the ownership of foreign investors in India, more than 40% of the total of $300 billion is in the top 20 or 25 stocks. So it is a very concentrated holding on the large companies.

In the realm of public equities, the foreigners would stick with liquid large-cap or large mid-cap names and are kind of reluctant to move down the cap curve.

So the moves of small caps is more indicative of the bullishness of domestic investors. But of late, yes, they have been looking at the space and I think some of the investors are displaying a willingness to take a concentrated mid- and small-cap exposure to the Indian space. Having said that, it is worth noting that it is in a very early kind of a stage unlike private equity which is very well established for investments in smaller-sized firms.

When you move down the cap curve, what sort of research support needs to be built up?

It's a very challenging space for managing large quantum of assets, because the depth of due diligence which is readily available from the market is low unlike the other larger caps where you get 25 different views on a company. So even if you miss one or two negative points or a positive point, someone will point it out to you. Therefore, the chance that you will be better informed is higher.

In the small-cap space, the ability to build bandwidth, both from a research as well as a portfolio management perspective, is pretty tough. That's the reason why we have been a little bit circumspect and don't put too much of money there.

And also since research is not readily available, it has to be done internally. One needs to develop an entire framework to do that. It's not easy.

Small cap companies are owner-managed versus professionally-managed. They may not have well diversified boards or independent board advisory, corporate governance may be inadequate, and in some cases they may not even have proper auditors.

There are multiple challenges when researching such companies and unless you have a checklist that you can consciously tick, or not, the chances that you will end up with a few lemons in your portfolio are pretty high.

Go back five or seven years and look at the mid and small cap portfolios then. Check the kind of stocks held then and see how many of them had the longevity and sustenance to sustain over these years. See how many of them are still in portfolios. Many would have fallen by the wayside because the percentage of failures or obsolescence or of the investor getting it wrong is pretty high.

So, it's a very big challenge and as the number of assets increase, AMCs are also continuously investing in bandwidth to ensure that they do a reasonably decent job out of it.

Depending on the fund manager, the portfolios can be fairly concentrated or entirely diversified. What are your thoughts on getting the next multi-bagger while providing diversification to curb volatility?

One style is to harvest in a wider space to arrive at some winners. You need to, therefore, try a larger number of ideas and over a period of time, once the contours of a winner emerge, double or triple your weights. But the initial starting point is that you start wide.

Another style is having upfront conviction on ideas and betting strong on them. The flip side is that you may miss a few ideas along the way because you don't pick up as many ideas as possible. But if a few of the ideas that are picked and betted upon strongly work, then the portfolio does well.

Both the strategies are valid. There is no need to take sides. It's left to the individual fund manager style.

Some have 70-75 stocks in their portfolio, others 40-45. It all depends on the bandwidth, research ideas and how deep the convictions run. Also, how one plans to diversify the risks which cannot be fathomed upfront; there are multiple factors that play into it.

I would, therefore, say that there is validity in both the kind of approaches.

You mention volatility. When looking at the risks of investing in mid and small caps, people only look at the volatility of stock prices. They do not look at it as an uncertainty of outcome itself. For instance, if you buy a mid- or a small-cap company, it can be five times the price at which you bought or one-fifth the price.

In India everyone believes intuitively that they are very good at picking these 5 and 10 baggers, because the ones which have dropped to one-fifth are pushed under the carpet. It's psychologically not comforting to look at your losers.

They have these asymmetric expectations that they will make loads of money in the tail end of the market which accounts for 10% of the market cap of the country. They somehow think that there is a tremendous wealth going to be created, which is a little bit ambitious.

What would be your advice to IFAs on how they should be positioning their clients’ portfolios?

I have two messages.

One is put clients' interest first. Do what is good for them and eventually you will grow with your clients.

Secondly, Sir John Templeton said focus on post-tax real returns. In India we focus a lot on nominal returns. If RBI is indeed successful in its inflation objective of 4%+ or -2% and the world is anyway reeling under zero inflation or a deflationary circumstance, it is quite alright to have lower expectations on nominal returns. If the economy is growing at 5%, 6% or 7% and then inflation is at 4% or even less, return expectations are still pretty high when investors walk into equity funds.

Focus on real post-tax returns, which is I think is going to be very different over the next five years than it was in the last five. Not in terms of real returns, but in terms of nominal returns.

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