"The Space is Overcrowded, but We are Positive." | Value Research We spoke to Vinit Sambre, Fund Manager, DSP BlackRock on micro caps and how he manages Micro Cap Fund

"The Space is Overcrowded, but We are Positive."

We spoke to Vinit Sambre, Fund Manager, DSP BlackRock on micro caps and how he manages Micro Cap Fund

Micro-cap stocks have been much sought after in this bull market and DSP BlackRock Micro Cap Fund has thus emerged as a chart topper. But isn't the segment overheated right now? We spoke to Vinit Sambre, Fund Manager, DSP BlackRock on micro caps and how he manages Micro Cap Fund.

The Space is Overcrowded, but We are Positive Vinit Sambre, Fund Manager, DSP BlackRock

Most people invest in small caps thinking that they can find the next Infosys or Asian Paints, but this doesn't really happen that way. The survival rate among small-cap stocks is really low over the long term. So how do you handle the issue of low survival rate? Or do you have to churn your portfolio very often?
You are absolutely right about small companies and the risks associated with them. Survival risk is in the most extreme case, but we have also seen other risks in terms of mismanagement and misappropriation of funds. Hence, it is of utmost importance to follow a detailed investment process so as to reduce these risks, while ensuring that the investment performs well over a period of time.

Given the above factors, we chose to follow a very detailed investment process while selecting stock ideas for Micro Cap Fund. We look for a great management with good capability and credibility and promising businesses. We also look for companies which have fared well in the past cycles and are currently underperforming due to a downturn in the cycle. Consistent and decent ROCE over the past decade or so and incremental ROCE generation are also the factors we consider.

All these factors make sure that non-performing companies are eliminated from our shortlist. We also focus on selecting ideas with a long-term view and hence the churn in the portfolio is quite low.

What about governance issues? When some of these small caps are hit by governance issues, the share price can really take a big beating.
As mentioned earlier, we are cautious about this. We place a lot of emphasis on the track record of the management and promoters. We look at the company's financial history of the last ten years and verify various aspects, including cash-flow mismatches. We assess capital allocation strategies of the management and see if they have yielded better ROCE. If these factors are in place, we follow up with the management to get a sense of where the business is heading. This discipline is more important in a bull market because every business and every company looks extremely promising and everyone is giving out rosy guidance. One more thing to watch out for is the frequency with which a company raises money through equity. To us, high frequency of equity raising does not paint a positive picture.

Typically fund houses in India don't track more than 150 or 200 stocks in total. So how big is the universe from which you pick stocks for this fund?
As per DSP Blackrock, the definition of micro cap is all the companies ranked below the top 300 by way of market capitalisation. Hence, technically, we have all these companies as the investment universe to choose from. As a house, we actively cover around 270-300 companies (including large caps).

The valuation of the BSE SmallCap index is at 35 times today. Don't you think these small-cap valuations today are quite expensive?
Last year, small caps as a category outperformed massively as compared to mid caps and large caps. Hence, we see this deviation in valuations. In the past, valuations of small caps used to be at a discount of 18-20 per cent to those of large caps. Now they are at a premium. We feel that the problem is with the denominator as earnings for many small-cap companies are at depressed levels. Companies are operating at sub-optimal capacities currently and once the cycle turns, utilisation levels will improve, leading to strong earnings growth. The earnings momentum for such companies will be extraordinarily high. When one factors this into the P/E, the ratio will suddenly tend to look very different. So at the index level, valuations are surely in a higher range, but when one analyses stock by stock, we see a lot of potential going ahead. Further the correction in the last two months has been quite healthy and has provided some buying opportunities.

Micro Cap Fund follows a bottom- up stock selection approach and the focus is on identifying companies which can outperform the peers. We feel identifying the right company within each sector is very critical as two companies within the same sector can have a wide variation in their performance. Having said that, there are some sectors that offer good visibility like healthcare, financials and materials, which we prefer. We avoid giving high weights to stocks which are highly cyclical in nature.

There have been quite a few micro-cap fund launches recently. So, is there too much money chasing the same investment opportunities?
Yes, that is happening and this is one of the reasons why we saw such hyper valuation. But the current correction phase has helped from the overall portfolio perspective. Secondly, each fund manager works with a different mindset, which leads to both buying and selling opportunities. Yes, the space has got crowded but we are not complaining.

Is there a certain fund size beyond which you will find it hard to find opportunities in a small-cap/micro-cap fund?
Yes, such cases become more prominent when huge inflows come in a very short span of time. We witnessed that last year and took a decision to restrict the inflows into the fund when we touched ₹1,500 crore in size.

How are the earnings panning out for small-cap companies? There's a lot of research done on Nifty, Sensex earnings. But for small-cap companies, how does the aggregate picture look?
We have not looked at the aggregate picture but for the stocks we own in the Micro Cap Fund we have seen the top-line growth slowing due to overall lower demand growth. Falling commodity prices are also leading to lower realisations. However, the companies have managed their EBIDTA margins well on account of benefit of lower raw material prices. Some companies have also seen inventory losses due to the fall in commodity prices. We see this reversing when the commodity cycle stabilises or turns.

How do you manage liquidity risks? Many fund houses don't even invest in a stock with less than a certain market cap because they feel that can't liquidate it.
As per the mandate of Micro Cap Fund we need to have minimum 65 per cent of our investment in micro-cap companies, which we do. With a view to manage liquidity, we have about 4-5 per cent as cash and around 30-35 per cent in small- and mid-cap companies. We do not own large-cap stocks for managing liquidity as the current mix is working well.

You also mentioned you have a lower churn. What is the portfolio turnover of the fund?
The portfolio turnover in the last 12 months is around 0.29 times as on April 2015. The same was 0.42 times in April 2014 and 0.55 times in April 2013.

What's your view on the overall market? Do you think this profit booking will continue for some time or is it just a temporary?
We hold a positive view of the market for the next three-five years, given the spate of changes we saw on the political front last year. Definitely some nervousness has set in due to delay in implementation of major policies and reforms. This was further aggravated by the FII taxation issues and poor results but we feel that these are temporary phenomena. The government seems to be on the right track and may take a while to set the house in order. Once the momentum picks up we will surely see strong performance for many years to come. The current correction in that sense provides a good entry point for investors with a long-term horizon.

This interview appeared in the July 2015 Issue of Mutual Fund Insight.

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