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'Mid and small caps are getting attractive'

After a steep correction in 2018, many mid and small caps are available at attractive valuations. They are also poised to benefit from the India growth story, says Krishna Sanghavi of Canara Robeco Mutual Fund

'Mid and small caps are getting attractive'

What has resulted in the outperformance by Canara Robeco Equity Diversified Fund in the last one year?
The fund has benefited from stock selection (preference for companies with healthy balance sheets and/or higher certainty in earnings), sectoral allocation (structural over cyclical growth) and preference for large caps over mid and small caps, considering the overvaluation of mid- and small-cap stocks at the beginning of the year.

Sector selection was more towards domestic consumption space, which is a structural positive for India, given the demography. Accordingly, the fund held higher weights in quality companies in FMCG, discretionary and retail banks. In addition, companies in sectors with dollar-linked earnings, like IT and private oil and gas, also helped in the outperformance.

How do you select stocks for this fund?
The fund has a preference towards businesses which have some form of competitive advantage, display high earnings visibility, generate high free cash flows and have quality management. At the same time, the fund also evaluates and invests in companies where there is any change in business environment/management that can act as a catalyst for unlocking intrinsic value. We also see the reasonableness of valuations.

When do you sell a stock?
We usually sell stocks for either of the two reasons: material change in the corporate governance/management or business environment that impacts earnings outlook and valuations becoming expensive. In the latter case, however, we prefer to reduce the stock weights rather than completely exit as the underlying business view on the company is intact.

How do you determine allocations across large, mid and small caps?
In a way, the fund is quite agnostic to market caps, as actual allocations in the fund are more of an outcome of individual stock selection. We do understand and consider that usually large caps outperform in an uncertain/volatile environment while mid and small caps tend to perform well in an era of easy monetary policy/liquidity. Earnings outlook and stock valuations do play an important role in the overall process.

The fund has been large-cap heavy in the last one-two years. Should investors consider this as the norm?
Not really. If we consider the last four-five years, the portfolio has had higher weightages to companies in mid and small caps (2015-2017) when the earnings outlook was more favourable and valuations reasonable. In 2018, valuations turned expensive and the macro environment started turning negative for many mid- and small-cap companies and we reviewed and reduced exposures.

Do you employ any special safeguards for mid and small caps?
Every company runs risks on balance sheet (excess leverage), management quality (mainly on ability and at times on intent) and business moat (sustainable profitability). These risks are usually more pronounced on mid and small companies vis-a-vis large-cap ones. We review each company on the above three risks.

What is the outlook for mid and small caps?
We think mid and small cap as a category has seen a reasonable correction in valuations in 2018. In terms of business growth, these companies are likely to fare well over longer horizon as Indian economy continues to grow and benefits of scale and efficiency show up as operating leverage in smaller companies. We believe companies with lower financial leverage and reasonable valuations would deliver returns for investors who keep patience.

What can investors expect from your fund in the next one year?
While we cannot guide on returns expectations, what we can say is investors should expect some change in portfolio construct as post the correction in 2018, we find some mid and small companies available at attractive valuations. We continue to monitor these companies and look to add them.