We are fixated with what Reliance or Nifty is doing but smallcaps have managed to slowly outperform the benchmark indices. Is it because they were most beaten down or do you think the time has come when the attractiveness of smallcaps is looking meaningful from here?
The smallcaps or the midcaps have been underperforming for the last two years overall as compared to the largecaps and particularly in this fall as well. Post-Covid, we saw that the smallcaps particularly had seen much severe correction in that fall. So I think there is some amount of catch up linked to how the markets have been behaving right now.
I heard Nikunj talk about how there is a total disregard to what is happening on the economy side as far as the market moves are concerned. I think whatever euphoria we are seeing overall in the markets has also actually flown into the smallcaps right now. We have seen some amount of catch up in terms of the valuation gap which got created because of the outperformance of largecaps but overall because the smallcaps particularly were underperforming for a while in terms of pure valuation norms, the smallcaps today are trading at certain amount of discount to their overall average versus the largecap. So from that perspective, probably the category looks slightly better in terms of the valuation mix.
But let me give you the overall perspective. My overall thought process is that this year is particularly likely to remain challenging. We are slightly more cautious overall on the market given the fact that people might not have factored in all the negatives which one will have to see going forward. Most important will be the first quarter numbers as they come out and I do not know how much of that is well digested by the market participants.
Beyond that, we were already reeling under a low growth even before Covid as an economy. So even if some amount of normalisation is taking place, what we have to think about is we have to see much better growth numbers if we have to think about better growth versus what we were decelerating. So I think there are a lot of factors which makes the current environment a bit challenging at least for the next one, one-and-a-half years till the time we see normalisation and better growth taking shape.
As far as the smallcap category is concerned, for the smallcaps to structurally do well, it needs structural strength in the economy and that is only possible if we take into consideration pretty long period into investment horizon; so three to four years is what one should have in mind before getting into smallcaps. These moves may be more short term in nature catching up with the performance as compared to the largecaps and the midcaps and hopefully if we cross the hurdles for the next few quarters, that is where one could take some longer term beyond the smallcaps.
What do you buy in smallcaps then?
If you look at our portfolio in terms of the current segments where we are overweight on, it is not the near term and this has been the case for a while now. But fortunately, these segments are also the segments which are doing well. So the likes of pharmaceuticals, agri-related businesses, speciality chemicals, some gold finance companies and some of the low-ticket consumer discretionary categories are relatively some of the categories which are less impacted in the current environment. We hope that in the next one year or so, these are the categories which are likely to do relatively better.
Big is getting bigger; whether it is Reliance or HDFC Bank or Microsoft or an Apple. Are markets telling you that right now they are not worried about midcap valuations because typically when a reboot like this happens big and efficient companies which have better cost of capital, which are better automated, are the ones who will make a comeback?
That is the case across the board. When we fundamentally look at companies across the market capitalisation range, this is a core parameter which we have to focus on. And please remember there are so many categories in India where you do not have a largecap to play on; so be it the agri businesses, speciality chemical businesses or few others building materials as a category, I would say within some of these categories, one has to look for high performing companies. Within these categories, we have to focus on sector leaders because like you mentioned, the large keeps growing larger.
We are generally of the same opinion that companies which are running efficiently and companies which have leadership profiles across the categories are the ones that have a huge opportunity to play for many years forward. I think those companies across the board are likely to do well. So I think I agree with you but those types of companies are present across the board.
Midcaps corrected last time in 2008 and the bull market started in 2013-14. It took five to six years for midcap stocks to come back. Assuming that the cycles are short-lived because even in the largecap stocks, the cycles are very short lived now because of technology and algorithms. Do you think it could take at least three years for the midcap cycle to start again?
If we look at the moves and compare them since 2017, I think it was the peak of the market and specifically the midcaps and the smallcaps. It had been three years of underperformance already as far as the category is concerned. So I would say that there is a low base which got created and it takes longer time. I am of the same belief that investment into smallcaps and midcaps particularly is a game of patience. It is not appropriate for all types of investors to participate. It is not advocated for people who do not have appetite for digesting volatility or do not have patience.
But it is very difficult to say that it will take three years or four years because in 2008, our microcap fund (it used to be microcap fund earlier which is now small cap for five years or six years) actually hardly gave any returns and the seventh year is the year when it just shot up. So I think it takes a while to generate returns. The only thing that we look for is the companies into consideration. They need to have potential for growth. If they are promising us that these companies are going to grow 2x, 3x, 4x in terms of the size from where they are and are run efficiently, we would say that at some point in time, the price has to catch up, which is where the return generation or the value accretion has to happen.
From an investor point of view, what are the kind of investors who should be looking at smallcaps or this kind of funds? What kind of investor would benefit from investing in smallcaps?
Clearly there are a lot of aspiring young investors; enterprising and wanting to participate in India’s great enterprising talent because we have seen many smallcaps actually qualitatively grow from what they were when we had invested. And I think this is a true story of Indian capitalism where if someone is really willing to participate in such companies, this is a category meant for those. There are a lot of investors who seek private equity funding and they are willing to wait for a much longer period because those stocks are not listed just because these stocks are listed. They have a price point to look at every day which causes a lot of volatility in their minds and that temperament is then not aligned.
So I would say when they are looking at smallcap as a category, they need to have a lot of patience in their mind to remain invested and not get worried about the near-term volatility of the category. So I would say there are a lot of enterprising investors with a good risk appetite. The category is really meant for those types of investors and there are really satisfying gains to be made out of the categories and that is my core belief.
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