'We cap our position at 5 per cent in any single stock'

Pranav Gokhale is the Fund Manager of Invesco India Small Cap Fund. In this interview we caught up with him to find out more about the strategy he uses to pick and discard stocks, and how he manages risk inherent in the small-cap space.

Your fund has beaten the small-cap category and index by a wide margin over the last one year. What's responsible for this?
Our proprietary stock-selection framework has helped us invest in good-quality companies as well as minimise certain pitfalls associated with small-cap investing. Our endeavour is to invest in companies with healthy financial track records with decent promoter pedigree. This has helped the overall portfolio.

Having underperformed for the last one to two years, small caps have started to move again. Has the small-cap rally started? Does it have legs?
The BSE Small Cap 250 Index has rallied 16 per cent over the past six months. Despite the current rally, the index is down 21 per cent over the last two years.

The companies in mid/small-cap space are more correlated to the domestic economy, which hasn't done well over the past couple of years. These mid/small-cap companies may be beneficiaries when the tide turns and domestic growth picks up. Their valuations are also lower than the long-term averages. This provides a good entry point for generating long-term alpha.

How do you pick stocks for your fund?
We look at scalable businesses with healthy return ratios and ability to generate free cash flows. We also look at competence of people running the business and their capital-allocation decisions over the longer term in identifying stocks for our fund.

How do you avoid wealth-destroying small caps?
We always try to invest in businesses with the right capital allocation strategy and good promoter pedigree to avoid accidents as far as possible. We exercise due care and caution in dealing with companies that show unusual growth as many times the period of excessive growth may come at the cost of compromising the balance sheet or cash flows. We are careful in avoiding companies where decisions taken for shorter-term gain are likely to result in a long-term pain.

What do you do to contain volatility in the portfolio?
We tend to cap our position at 5 per cent in any single stock. However, in doing so, we also ensure that we are overweight the benchmark for every company in our portfolio. Thus, prudent exposure management helps manage the volatility in the portfolio.

With 44 stocks currently, you run quite a concentrated portfolio. Given the inherent risk in small caps, what gives you conviction?
We tend to adopt a balanced strategy in managing the portfolio. We typically cap the weight of an individual stock at 5 per cent and run a portfolio with 40-50 stocks. In doing, so we are not overtly aggressive but also benefit from having a sizeable position (active overweight) to generate long-term alpha.

Managing investor expectations is crucial in a small-cap fund. How do you do that?
Our aim is to generate a longer-term alpha with lower volatility. We try to do so by buying good businesses run by capable management and balancing the risk and volatility by right position-sizing and ensuring adequate liquidity for the portfolio without taking cash calls.