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'Even in this environment, there are mid and small caps that are doing well'

R Srinivasan, Head - Equities, SBI Mutual Fund talks to Value Research about SBI Small Cap's approach to picking stocks, attractive themes, the problem of liquidity and more

'Even in this environment, there are mid and small caps that are doing well'

Investors tend to have a love-hate relationship with small-cap funds. In bull runs, small caps leap ahead; however, in slumps, they rush towards the bottom, causing their investors to lose sleep. With the Nifty hitting all time highs but returns from mid and small caps still remaining subdued, investors are asking if the funds investing in them are poised for a turnaround. We speak to R Srinivasan of SBI Mutual Fund about the outlook for small caps and the challenges of small-cap investing. He manages SBI Small Cap, a five-star fund, which also features in our recommendations.

Small caps are usually the worst hit in an economic downturn. With the Indian economy still not out of the woods yet, what's your view on them as a segment?
I don't know how to answer this question. To talk about small caps as a segment is complicated. I don't think it's a homogeneous basket with common characteristics. The small-cap index, for instance, has some 700-plus stocks. If you take a call based on index fundamentals, then you are exposing yourself to a fallacy of the average, especially since most of this universe, in absolute numbers, is not even investible.

If you are a top-down guy, I guess, you could presume small caps will do worse in a falling market and better in a fast-rising market. But this has largely to do with volatility, which in turn is a function of flows and liquidity.

We are largely bottom-up. From a long-term-investing perspective (three to five years), what matters is the outlook on the business, the quality of management and valuations. Here, I see no reason to differentiate between a small cap and a large cap. Even in this economic environment, there are mid and small caps that are doing very well.

Do you think the steps taken so far by the government, such as the corporate tax cuts, are adequate to revive growth? Is there anything on your wish list?
I hope so! I'm not a macro expert. Corporate earnings over the last five years have been extremely disappointing. Our in-house analysis shows this has been due to a breakdown in the correlation between nominal GDP growth (which is already impacted by lower inflation) and sales growth, a resultant negative operating leverage, high real interest rates and higher taxes as a percentage of sales. This was probably driven by demonetisation, a subsequent GST, the NBFC and real-estate crisis and more lately the elections. Taxes have been partly addressed; maybe there's a case to address personal taxes. Monetary policy is easy (for now!) and should address rates. If sales pick up, hopefully, the operating leverage will turn positive.

What's your approach to picking stocks in the small-cap universe? What are some of the red flags you use to weed out the minefields which otherwise look promising going by the numbers?
We practise a stock-selection philosophy that centres around the business model, management quality and valuations. That enables us to screen the universe for aligned parameters such as growth, return on capital, cash conversion, leverage, fundamental volatility or valuation multiples. We may choose to make exceptions here, but basically this exercise makes the universe manageable and aligned to our objectives. Two, the experience of the team helps in the sense that an analyst or a fund manager typically has some history with a majority of the stocks in the universe. Three, the hundreds of meetings we have as a team and the multiple reads keep throwing up ideas. Not to mention that there's a very smart sell-side out there.

On red flags, we run an internal forensic model that tries to capture anomalies and prods us to investigate deeper. Our analysts and fund managers have little respect for what they know and habitually conduct channel checks with competitors and industry folks to glean negative insights. Lastly, our generous rejection policy and a lenient approach towards errors of omission help, I think.

What sectors or segments among small caps look attractive to you at the moment?
We run a pure bottom-up style of investing, especially on mid and small caps. Having said that, we do like certain themes around aspirational consumption, industrial manufacturing and market-share shifts.

Your small-cap portfolio's turnover is fairly high compared to your peers. Our analysis of your portfolio shifts suggests that you've made deft entry into and exit from many stocks but a strict buy-and-hold may not be your style. Would you agree? What are usually your triggers for entry and exit?
Our reported portfolio turnover is distorted by the rollover on derivatives. The net equity turnover is low and below 30 per cent for the last one year.

I presume you derive your conclusion from our holding period for the recent top holdings. They did undergo a bit of a churn after an outlier performance in the small-cap bull run. This was to reduce the impact of mean reversion, given excessive valuations. We do not expect it to be a regular feature.

Despite the restrictions on fresh inflows, the AUM has continued to increase rapidly. Is that a concern?
Yes. In this space, a rising AUM is almost always a concern because it aggravates liquidity risks, reduces the investible universe and increases the number of holdings.

How much does the liquidity of underlying stocks worry you?
Well, technically the liquidity of the underlying should be a cause of worry. But, practically speaking, it's not. Our investor base is highly fragmented and as a house, we haven't seen unmanageable redemptions even in the worst of times. Nevertheless, we are worried about liquidity. One way to mitigate this is to focus on higher probability outcomes. This may, over time, tend the portfolio towards quality.

Do you deploy any strategy to mitigate the risk of investing in small caps? You usually don't invest much in large caps, nor do you keep a lot in cash.
Well, we are required to own a minimum of 65 per cent in small caps. Let's say 70 per cent, assuming a buffer. Plus, we restrict cash to 7 per cent of the fund. On the balance, we are free to own large caps or index futures and we do. However, this has never been from a category-risk-mitigation perspective. It is only if and when we are short of high-conviction ideas in this space. We'd like to believe that investors do their own risk mitigation by spreading their allocation across market-cap categories and asset classes.

You've increased the portfolio size to about 45 stocks. Is it where we expect it to remain?
Right now, we are short of conviction ideas. So, I guess yes. But, our desire would be to reduce the number of holdings.

But even at 45 holdings, yours is a relatively more high-conviction portfolio in the universe of small-cap funds. What kind of guidelines do you have on stock- and sector-level concentration?
Rather, I'm concerned the portfolio is not high conviction enough. You may be right from a relative peer-set perspective. We do have guidelines on stock- and sector-level concentration but I must confess they are extremely flexible.

You have a fair spread of some of SBI's flagship funds to manage - Hybrid Equity, Small Cap, Focused Equity. How difficult is it to keep track of them? How do you divide your time?
Believe me, the larger the size of a fund, the easier it is to manage. That's because the investible universe goes down significantly. And, there's so much research and analysis out there on large caps. Yes, the pressure is greater but not so with time. Rather, I'm sure I spend a lot more time on mid and small caps. More importantly, it's not about me. We have a large and smart research team and strong internal processes. Whether I do or do not keep track, the team always does!