'Small-cap index gave 20%+ returns over last 3 and 5 years'

Summary: Small caps faced significant correction last year. However, Motilal Oswal’s Fund Manager is relatively unfazed by the slowdown, as he believes it is a temporary phase. He also shares why his small-cap fund is well-positioned to see an improvement in performance in this exclusive interview.

After a standout 2024, India’s small-cap segment ran into a far more uncertain 2025. Concerns around rupee stability, tariffs and supply chains weighed on sentiment and dragged returns lower. But for Motilal Oswal’s Ajay Khandelwal, a weak year does not amount to a structural slowdown. Over the past three and five years, the small-cap index has still delivered over 20 per cent returns, even as earnings growth has nearly tripled.

Currently a fund manager at Motilal Oswal Asset Management Company, Khandelwal oversees five schemes, including the Motilal Oswal Small Cap Fund. In this interview, he explains the fund house’s investment philosophy, centred on its QGLP (Quality, Growth, Longevity, Price) framework, outlines why the small-cap fund’s portfolio remains well positioned despite a modest dip in performance and discusses the sectors he is consciously avoiding.

What feels most different about the equity market today compared to a year ago, in terms of earnings trends and sector leadership?

We started the calendar year 2025 with a lot of uncertainty. From January to March, if you think about it, many things happened. The RBI’s stance was more focused on rupee stability, and as a result, liquidity became a concern in the markets. From our channel checks, we understood that businesses were going through a difficult phase.

During the year, some of these uncertainties persisted around tariffs and supply chains, and now even commodity prices, especially non-ferrous, are affected. The way they have been behaving has created additional margin challenges. These are some of the factors that, I think, have dragged more than anticipated.

But I would like to add something here, especially on small caps. One year of negative returns is not worrisome in the larger context. Over the last seven or eight years, the small-cap category has seen deleveraging of almost 30 per cent, while earnings growth has nearly tripled.

So, for small caps, if the balance sheet is healthy and growth is strong, a one-year discrepancy is more like a pause, especially given that the small-cap index still delivered a CAGR of more than 20 per cent over the last three and five years. This year has been challenging, yet markets have been resilient.

Within that broader environment, what is most different about the way small-cap companies are behaving right now,  in terms of demand, pricing power, order visibility or balance-sheet discipline?

When we spoke to various companies, the behaviour was quite different. For example, in industries facing clear headwinds, even if companies are willing to sacrifice margins or increase advertising spend, it does not necessarily lead to improved performance, because structural industry challenges limit what they can do. Whereas in industries where we are seeing growth, if companies are willing to sacrifice some margins, they can actually see growth improve. So different industries are behaving in different ways.

I would also add that even among the 2024-25 winners, we are seeing some change. For example, electrical and engineering companies did very well in 2024-25, but this year we are seeing a different set of challenges. Clients are delaying inspections, which is delaying dispatches. There have also been some regulatory changes, for example, around excise and customs duties on certain commodities, which are again causing delays in execution.

In some cases, regulatory processes have become more specific or stringent, and clients are facing challenges on that front as well. So, these are some of the changes that have played out this year.

What exactly is the fund house's investment style or strategy?

I will tell you how we think about it. We look at earnings growth and revisions to earnings growth. Because what happens is that if you expect 20 per cent earnings growth and the stock delivers 20 per cent, the stock often just stays where it is. The real returns come when there is a shift in earnings expectations, and that is what you then see reflected in stock prices over the following year or two.

Our focus is on predicting earnings growth, specifically identifying where we see potential earnings upgrades while maintaining the portfolio's quality at a high level. We follow what we call QGLP: Q stands for Quality, L for Longevity (the continuity of growth), G for Growth and P for Price, to pay the right price. Our understanding of price differs slightly from how the market often views it.

Our focus is on finding good-quality companies that are winning market share, defending their margins, growing through their own cash accruals and improving their competitive position without diluting the portfolio quality. That is why we avoid commodities, cyclicals and PSUs. By avoiding that noise, we can deliver more consistent outcomes. This, in short, is what investors should keep in mind about our approach.

In 2024, the Motilal Oswal Small Cap Fund outperformed its benchmark by around 20 percentage points, but in 2025, it is down by about 5 per cent. What has driven this reversal in performance?

Talking about the small-cap fund, the index has fallen more than that, so we have outperformed the index. But if you look at the overall portfolio return, as I mentioned earlier, in small caps, around 65-67 per cent of the stocks have delivered positive returns, while about 25-30 per cent have delivered negative returns. However, the drawdowns in that one-third of stocks have been much sharper, for example, in Engineering and Capital Goods. In contrast, the outperforming stocks have not outperformed by the same magnitude. So, if some stocks are down 30 per cent, the ones that are up may only be up 10-15 per cent, which mathematically pulls the overall return down.

The portfolio returns look like negative 5 per cent, largely due to the high base from last year. But overall, we have outperformed the index, and what matters more to us is how the portfolio is positioned to navigate near-term volatility and to deliver higher earnings next year.

We have a mix of businesses, with some now commissioning capex, so we believe earnings growth will accelerate. At the same time, we have added some beaten-down IT and financial names that we believe will turn over in the next three to six months. So we have made these changes to capture the earnings upside over the next year.

Also, across companies with ROE above 12 per cent and a market cap above Rs 1,000 crore, almost 35 per cent of small-cap companies have delivered negative returns this year. So, there is now a good pool of high-quality companies available at more reasonable prices, and we are actively exploring those ideas and building the portfolio accordingly. So, we are well placed from a portfolio construction perspective.

How does your approach to selecting and sizing small-cap stocks differ when you are managing a dedicated small-cap fund versus when you are allocating to small caps within multi-cap or large & mid-cap strategies?

I will answer this from a fund manager’s perspective. In small caps, we are very conscious of risk, both business and stock-price volatility. So, in a dedicated small-cap fund, we try to balance near-term earnings visibility with medium-term growth. I pay close attention to near-term earnings because if I buy a small-cap stock and there are near-term headwinds, it can underperform meaningfully.

In multi-cap or large & mid-cap strategies, around 70-75 per cent of the portfolio is in large and mid caps, where earnings are more stable and predictable. So there, we are more comfortable with near-term volatility or even short-term earnings softness in a small-cap position, because the rest of the portfolio provides stability. Thus, from a portfolio-construction perspective, that is the key difference in how we select and size small-cap stocks across different strategies.

Which types of small-cap businesses are you consciously avoiding today, even if valuations look attractive on the surface?

We are avoiding businesses with deteriorating balance sheets because that is the most important risk factor in small caps. If you see stress on the balance sheet, that becomes a serious problem very quickly.

We are also avoiding cyclicals, such as Metals. Over the last three months, some of these stocks have risen by 50 to 100 per cent, but nothing has changed structurally; there is no new industrial use or step-change in demand. So we are still avoiding sectors with highly volatile earnings and those outside our core competence.

We are also avoiding low-growth businesses. Valuations may look more benign than the broader market, but if growth is absent, the stock will typically just remain where it is. Hence, valuation alone is not enough; growth has to be there as well. These are the two or three key parameters we look at.

Are there any sectors where you see balance sheets as particularly weak?

In the small-cap space, overall leverage has come down, but in some pockets, we are seeing working-capital stress. That is where the problem usually starts.

Wherever gross margins are low, raw material costs make up a larger share of the cost structure. And over the last three to six months, raw material prices have risen sharply, which we believe will strain working capital in those businesses.

We are also seeing receivables increase in some sectors, suggesting that customers are deferring payments and execution is being delayed. That can lead to inventory build-up and further stress on cash flows. Electrical and Engineering equipment is one area where we are seeing these kinds of challenges.

Another example is parts of the Chemicals sector, where companies have undertaken large capex, but monetisation has not happened as expected. Spreads are being compressed because raw material prices have risen while selling prices have not kept pace. So these companies now have higher debt on their balance sheets and lower cash generation than they had planned. These are the sectors where we are currently more cautious than the broader market.

Also read: Why did Mirae's small-cap fund outperform in a tough 2025?