Title: “Small Cap Sector: Outperforming Strategies & Top Picks”
Content:
Small-cap funds have been outperforming other categories lately, with impressive returns over the past year. They yielded a remarkable 28% return, surpassing large-caps at 18% and mid-caps at 22%. Data from Morningstar India shows that even considering a three-year performance, small-cap funds continue to shine with an annual gain of 39%, compared to 21% for large-cap funds.
The driving force behind this trend is the market’s inclination towards the manufacturing segment, well-represented within the small-cap space, contributing to significant outperformance.
Kalpen Parekh, the managing director and CEO of DSP Mutual Fund, brings attention to an interesting insight. He points out that since 2008, the small-cap index has yielded returns comparable to government bonds, both around 6.3%. However, he emphasizes the importance of selecting the right small-cap stocks and timing one’s investments properly. While small caps can be lucrative wealth creators, it is crucial to avoid the wrong choices, as the difference in returns between the small-cap index and bonds narrows to just 2% when considering the period from the peak of 2010 until now.
Over the last three years, small-cap companies have shown remarkable growth, around 20%, presenting unique investment opportunities not commonly found in the large-cap space.
Record Inflows and Challenges:
Small-cap funds are currently experiencing record inflows due to their strong performance. However, this influx of funds is presenting challenges. While investors are eager to invest, limited ideas and investment opportunities in the small-cap space make diversification more difficult. Additionally, the small-cap segment is less liquid, leading to the potential concentration of risk.
Small-cap funds have proven to be volatile, even though some stocks in this space have delivered high returns. These funds have thrived on high-conviction bets made by experienced fund managers.
Experts advise investors to consider a long-term investment horizon of more than 10 years, given that the sector is currently deemed expensive.
Top-performing Small Cap Funds:
HDFC Small Cap Fund: Leading the pack with remarkable returns of nearly 39.44% over the one-year period.
Franklin India Smaller Companies: Following closely with an average return of 36.05%.
Nippon India Small Cap: Exhibiting strong performance with a return of 35%.
HSBC Small Cap: Showing robust returns of 31%.
DSP Small Cap Fund: Delivering a return of 28.44%.
Investment Strategy and Success Factors:
The success of these small-cap funds can be attributed to investments in key companies like KEI Industries, Carborundum, Brigade Enterprises, Sonata Software, and Apar Industries before 2020. These strategic investments have played a pivotal role in delivering substantial returns for the funds.
Investment Philosophy at DSP Small Cap Fund:
Resham Jain, the fund manager at DSP Mutual Fund, has been managing DSP Small Cap Fund since March 2018. Their investment strategy revolves around thinking like an owner of the business and participating in the journey alongside the company. This approach is reflected in their portfolio turnover ratio, which has consistently remained between 15% and 20%, indicating a long-term investment horizon.
Key Criteria for Investment:
The fund focuses on companies with strong business models, managed by credible and capable managers, and available at reasonable valuations.
They seek out companies with the potential to grow faster than nominal GDP and generate returns on equity higher than 16%.
The fund managers consider various factors such as growth, returns ratio, management quality, earnings stability, cyclicality, and optional drivers while evaluating valuations.
The higher the consistency in growth and return on equity, the more favorable the business is perceived.
Navigating Business Cycles:
Jain acknowledges that most businesses go through cycles, which can bring volatility to stock prices. During downturns, if the fund managers believe the impact on the company’s performance is temporary, they take the opportunity to build larger positions. Although this phase may not generate immediate returns, it can prove beneficial over the medium term. On the other hand, during upcycles, fund managers book profits and trim exposure to capitalize on favorable market conditions.
DSP Small Cap Fund’s Top Performers:
Suprajit Engineering: With a portfolio weightage of 3.54%, this stock delivered an impressive return of 22.31% in one year.
Ratnamani Metals & Tubes: Accounting for 2.76% of the portfolio, this stock displayed outstanding growth with a return of 56% in one year.
La Opala RG Ltd: Representing 2.40% of the portfolio, this stock outperformed with an impressive return of 62.25% in one year.
These top-performing stocks contributed significantly to the overall returns of the DSP Small Cap Fund before 2020.
Nippon India Small Cap Fund’s Top Performers:
Nippon India Small Cap Fund achieved an impressive return of 43.5% over the past year. Its top five stocks, acquired before 2020, were:
Tube Investments of India
KPIT Technologies
Credit Access Grameen
Apar Industries
Zydus Wellness
Diversified Investment Strategy:
Samir Rachh, the fund manager – equity at Nippon India Mutual Fund, highlights their approach to investing. They are not limited to any specific style of investing, instead focusing on creating a well-diversified portfolio of stocks across different investment styles and sectors. The fund incorporates a mix of growth, value, and GARP (growth at a reasonable price) stocks. This diversified strategy enables them to offer better risk-adjusted returns to investors.
By holding onto their winning positions for a longer time and maintaining exposure to a variety of sectors and investment themes, they can remain active in the market even if some of their investments do not perform as expected. This flexibility and diversification contribute to their ability to navigate market fluctuations and aim for a well-rounded and successful portfolio.
Stock Selection Criteria at Nippon India Small Cap Fund:
The fund manager considers two crucial criteria – the quality of the promoter and the quality of the business. These factors are of utmost importance in his stock selection process. Rachh believes that businesses inevitably experience ups and downs, and the quality of management plays a crucial role in maximizing opportunities during the upside and effectively navigating challenges during the downside. The quality of the business is also a significant determinant, as even exceptional management cannot compensate for poor business quality.
ICICI Prudential’s Small Cap Fund: Three-Bucket Approach:
ICICI Prudential’s small-cap fund adopts a unique strategy, dividing the entire small-cap universe into three distinct buckets:
Bucket A – Quality Compounding: This group includes companies with characteristics that exhibit “quality compounding.” These are businesses with strong fundamentals and the potential for consistent and sustainable growth over the long term.
Bucket B – Normalcy Candidates: Stocks falling into this category are termed “normalcy candidates.” These are companies with current earnings below their normal levels but are expected to normalize within the next two to three years.
Bucket C – Wealth Destroyers: This group comprises “wealth destroyers,” which are companies that the fund manager intends to avoid to minimize potential mistakes