Why Motilal's small-cap fund gave 25%-plus returns last year

Ajay Khandelwal, Fund Manager at Motilal Oswal Mutual Fund, began his career in IT but was soon drawn to the world of equity investing. While initially analysing large-cap companies, Khandelwal found small caps more interesting, believing they provide "excellent opportunities" across time periods.

Today, Khandelwal manages 13 funds at the AMC, including the Motilal Oswal Small Cap Fund, which delivered a remarkable 25.3 per cent return (as of March 25, 2025) over the past year, outstripping the category average of 10 per cent.

In this interview, Khandelwal sheds light on his small-cap fund's stellar performance. He also shares his investment philosophy, the three non-negotiables he considers before investing in small-cap stocks and how he navigates the volatility that comes with such investments.

What sparked your interest in equity markets, and why the small-cap segment specifically?

When you start your career, you are very inquisitive and want to learn new things. I worked in the IT industry, and when I moved to investments, I believed investment, or the equity markets, was fascinating. In this field, you learn new things daily, which is very engaging. It's not just the knowledge; even the human element comes into the picture because the market behaves irrationally. So, you're always on the edge, trying to learn and understand new things. The equity market is extremely exciting - specifically the small-cap segment. Interestingly, I started as an analyst and tracked large-cap sectors. Still, I built knowledge on small caps over a period, and I understood this is a much easier segment because stocks are under research. There are excellent opportunities across time frames. So, if you keep building knowledge, small caps are fairly rewarding.

How would you define your investment philosophy? What types of stocks or market trends excite you the most?

As an investor, I first look at sectors that are inherently more rewarding for investors. For example, investors will make more money in a sector that requires less capital if there is a similar growth opportunity of, say, 25 per cent available in two stocks. So, my first driver is the capital intensity of a sector.

Second, I examine the industry practices within that sector. For example, certain industries are inherently more focused on margin; the growth is more calibrated and the raw material supply chain is well defined. Such sectors tend to be more rewarding for investors. I think you will make money if you find areas where growth is better than the estimates. Challenges arise when a cyclical or capex-exiting industry turns around. Generally, this leads to an improvement in cash flow. The hard part is determining what industry growth cycle this is in and how your earnings estimates pan out. Only then can you discuss multiples because, in such a situation, the earnings generally deviate more than your estimates. So there, it becomes challenging for us to estimate the earnings. But by and large, if we can find a good, capital-efficient industry where you have earning tailwinds, our job is done.

But how do you go about picking stocks in the portfolio?

To give an example, what is the capital intensity of a sector? Suppose I need to build a plant, machinery or service, whether it requires a capital of Rs 100 crore or Rs 1,000 crore. How much revenue can I make on that capital, whether Rs 300 crore on Rs 100 crore or Rs 100 crore on Rs 100 crore? This indicates the actual revenue potential that can be generated by investing in that capital. Then comes what kind of margin you can deliver with that revenue. Whether it's a business with a 5, 10 or 15 per cent margin, its profitability is revealed.

The next step is to determine the working capital cycle. Does the company need to stock a lot of inventory, or do they have a large receivable? That tells you what the business's operating nature is. These things determine what kind of industry this is and what kind of challenges you can expect when things become difficult. So, we look for industries with the right asset turnover, working capital and a decent margin. Some industries may offer over 30 per cent margins temporarily, but these often decrease to 10-12 per cent in subsequent years. So, I typically do not like industries with too much volatility margin.

What are three non-negotiable qualities you look for in a small-cap company, and why are they critical?

In small-cap companies, management is critical. Often, the management in a small-cap company becomes too ambitious. We have seen their children joining the business and suddenly deploying money, which sometimes leads to wrong capital allocation. If something like this happens, then it's a challenge because small-cap valuations take a knock during difficult times. Thus, if there is a checkered past, it becomes challenging for those businesses to get a valuation. Therefore, I think a company's management pedigree, past behaviour, how it looks at capital and whether it understands the concept of capital allocation are critical.

Second, the business needs to eventually generate cash because no company can deliver sustained returns if it cannot generate positive cash flows.

Lastly, I don't engage in businesses where the supply side is seeing traction because, time and again, I have seen an ample supply coming into a sector, making it challenging for us to make money.

Small caps come with inherent volatility and limited information. How do you navigate these challenges to make confident investment decisions?

You learn to navigate over time because data frequency is not widely available. For example, you get monthly data for auto sales. Regarding small caps, we look at how the whole value chain operates. Let's say I am interested in the auto ancillary industry, where the end customer is primarily commercial vehicles. I would like to understand the performance of large commercial vehicles and review how the financiers are doing. We even look at how the transport companies are doing because if the entire value chain is seeing good traction, then I believe the visibility of the auto ancillary company will also capture those changes, which gives us confidence in the sector. Whether we like it or not, these small caps operate within a specific context. They depend on large caps, macros and other factors. However, by conducting our channel checks, which require frequent visits to understand the situation, we can gather data that provides confidence in the availability of small-cap businesses.

How do you differentiate between a temporary dip and a fundamental red flag that warrants exiting a position?

Sometimes, people don't trust enough early on, so they don't build numbers. But when a stock is discovered, suddenly, people start projecting numbers for the next 2-3 years. So, there are different ways to look at such scenarios. I believe that you have to be early in the cycle, but at the same time, you must be cautious once people start building numbers for the next three years and above. This is one area where I think analysts make mistakes, and as an investment manager, I have to be extremely careful.

Second, if there is a virtue or something unique in a business and they are delivering, and if something changes fundamentally, then I need to be cautious. Even if there is regulatory support for businesses or they have duty arbitrage or dependency on specific clients or certain kinds of geographies, and if those geographies are not doing well and things are not going to improve, then I need to make sure that my portfolio reflects my highest conviction earning ideas. Whenever any corporate governance mishap happens, we need to act immediately.

The Motilal Oswal Small Cap Fund delivered the highest returns in its category in the past year, outpacing the benchmark's negative 1 per cent. What strategies or stock picks drove this success?

We have been cautious and in small caps, and I am always mindful. We first need to construct a portfolio that can deliver better risk-adjusted returns. There are a couple of ways you can do it; the first is to have the correct weights in your portfolio. If you look at our portfolio, we are not too thinly stretched. At the same time, we do not have a very high concentration and are currently working on ensuring the correct allocation of our portfolio.

Second, in the last year, there have been a few instances where we needed to act and have cut down on our allocations when something untoward has happened. So, you need a liquid portfolio to take those kinds of actions. Otherwise, how would you handle being illiquid if any unfavourable circumstances arise? You cannot change your allocation. Therefore, we construct a portfolio with a market cap and liquidity that leans towards the higher end, enabling us to respond promptly in an emergency. These are some of the risk measures we follow closely. Finally, you must pick the right stock in the right sector and make changes accordingly. In all my previous organisations, I have followed the same strategy, so my efforts have remained consistent.

Also read: Why's Tata's small-cap fund excelling? Fund manager explains