Today valuations of small cap stocks are at significant discount to large cap stocks

Small Cap stocks have come down considerably from their historic highs. What are your views on small cap stock valuations? Are there attractive investment opportunities in the small cap space now?

Small cap stocks have, in the last two years, borne the brunt of economic slowdown. They have seen downgrades in earnings and also P/E derating. As a result, they have significantly underperformed large cap stocks. Today, the valuation differential between small caps and large caps is very large and at levels similar to those seen in 2003, 2009 and 2013. We have seen that from those levels small caps have given handsome returns. We believe today the investment opportunity in small caps is very attractive.

You have launched the Small Cap Fund NFO, What will be the investment philosophy of this fund?

Similar to our other equity funds, we will use our fund house 'SQL investment philosophy' in managing the small cap fund also. Here 'S' stands for margin of safety, 'Q' for quality of the business and 'L' for Low leverage. At least 80% of the portfolio will be of ‘core’ stocks with decent businesses having an average Return on Equity of over 13% over the long term. Tactical bets shall not exceed 20% of the portfolio. The fund will be benchmark and sector agnostic. We will invest only in small cap stocks as defined by the AMFI criteria. We endeavour to have a diversified portfolio with no single stock having exposure of more than 3% of the AUM. In normal circumstances, we will be invested in excess of 90% in equities. However, if we feel valuations of small caps are turning frothy, we will book profits and increase our cash and short term debt levels upto 35%. This situation may arise after 3-4 years. We are also going to restrict the AUM to 1000crores.

Do you think that this is a good time for investors to allocate some money in their portfolios to small funds? Please explain why?

As stated earlier, we believe today valuations of small cap stocks are at significant discount to large cap stocks. We get such valuations when the economy is facing cyclical downturn and generally sentiment towards equities is weak. Historically, such times have proven to be the best times to invest in small cap stocks and the returns of small cap stocks from such levels have been very good. Today we face a similar situation, When economy improves, the small cap stocks rebound the most and tend to outperform large cap stocks by a wide margin. That is why we believe small caps will significantly outperform large cap stocks over the next 3-5 years and investors should allocate their moneys to small cap stocks taking the risk reward into consideration.

Small Cap funds as a category have underperformed large cap funds and midcap funds in the last 1, 2 years. Even on the basis of trailing 3 year returns small cap funds underperformed these two categories. How should investors, especially new mutual fund investors, approach small cap funds?

Small cap investing is a high risk high return play. The returns from small caps during bullish phases are spectacular but the decline during bearish phases can be massive. Hence, the time and the valuations at which an investor invests in small cap stocks is very important. This happens because small cap stocks are mostly impacted by the performance of broader economy. Today we believe the small cap segment offers an attractive entry point due to cyclical slowdown in economy and the severe underperformance of the last two years. Investors should tactically increase their allocation towards small cap stock to boost overall portfolio returns. We strongly believe small cap funds are meant for lumpsum investment at appropriate time and not for SIP investments. Since the category is highly volatile, SIPs even after 3-4 years can be negative so it is better to look at the opportune time & invest in lumpsum with a 3-5 year view. This kind of approach in small cap investing can be rewarding.

Mutual Fund Investments are subject to market risk, read all scheme related documents carefully.