"Have a judicious mix of large and small-cap stocks in your portfolio"

While small-cap stocks promise a lot on the upside, they are also riskier and call for meticulous evaluation, says Apurva Shah of DSP BlackRock Mutual Fund

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Investing in small-cap stocks allows investors to latch on to promising companies at an early stage in their growth cycle. This can lead to multi-bagger investments. At the same time, such stocks are also potentially riskier, and hence call for more meticulous evaluation. In this interview, Apoorva Shah, Executive Vice President and Fund Manager, DSP BlackRock Mutual Fund, dwells on the advantages and disadvantages of small-cap investing, and how investors can safeguard themselves against their potential risks. Excerpts from an interview with Sanjay Kumar Singh.

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Why should investors invest in small-cap stocks? What are the advantages of investing in this space?
Small-cap stocks can fetch potentially higher returns because some of these companies can scale up from a low base and grow into large-caps. Further, new business areas could come up that have a lot of growth potential. The large-cap companies are dominant in traditional business areas. Investing in large-caps, you would never get exposure to these new business areas. Companies could start out small but become big very soon in these areas. Current examples are fields like education that could become large in future. Similarly, media companies are not large today but could become so in future. Moreover, you could come across management in the small-cap space that is ambitious and shows promise.

What are the risks of investing in small-caps?
Small-cap companies are not as well researched as large-cap companies, so as an investor one may not be aware of potential pitfalls in them. Another risk arises from the low liquidity in these stocks. They don't have high trading volumes, so exiting them can become difficult, especially in adverse market conditions. Further, whenever the markets become worried, they tend to affect the valuations of smaller companies more. Also, smaller companies do not have the resources to weather a downturn as large companies have, so the impact could potentially be severer on the former.

What are some of the qualities that you look for when you are evaluating stocks for your micro-cap fund?
We employ a combination of top-down and bottom-up analyses. The business should have growth potential and the ability to scale up. We would also like to have comfort about two things: management's ability and vision is one; its honesty, corporate governance and transparency standards is another. The stock should also be fairly valued or undervalued.

Is it possible through qualitative research to evaluate variables like scalability and management quality?
This depends more on your judgment and understanding of the economic and business environment.

How would you evaluate management?
You meet management periodically. With experience and by observing people over a period of time you develop intangible ways of judging. Since you follow the management year after year, you do develop an intuitive understanding.

What are the specific risks one should guard against in the selection of small-cap stocks?
Many small- and micro-cap companies look attractive but may not be able to professionalise. So the company remains a one-man show and is unable to climb to the next level. Further, the space itself may not grow as big as anticipated. In adverse times, investors may lose interest in companies within that space. Such companies will then not enjoy a good valuation even though they may generate cash flows.

In the last month or so, the global outlook has worsened, especially due to the sovereign debt crisis in Europe. And when the outlook worsens, one of the defensive moves that investors make is to move into large-cap stocks on account of liquidity-related issues in small-cap stocks. Do you think that the current situation warrants such a move?
We are also grappling with this question. On the one hand, we have the problem of indebtedness within the European economies, and the American economy is also in poor shape. On the other, as a result of these circumstances, these governments are pursuing an unusually low interest-rate policy. They are also prepared to do quantitative easing, which means that they will print money in order to tide over the crisis. In a way, they are postponing the inevitable and are hoping that in the meantime their economies will recover and the burden of sustaining the economy will shift from the government to the private sector. So there may be a possibility that they will be able to postpone the inevitable to another period. In the meantime, the extra liquidity could come into economies like ours that are growing - which are domestically oriented and not leveraged. In that case these risks could well turn into opportunities for us. I feel investors should be moderate in their exposure to mid caps and should have a good amount of large caps in their portfolios. If they are adequately diversified they will be able to tackle any eventuality that may arise because of the fragility in the world economy.

What would be a safe level of allocation to large caps on one hand and to mid and small caps on the other within an equity portfolio?
There would be different answers for different investors, depending on their risk profiles and their tolerance for downside risks. We tell our investors to invest in those of our funds that have a combination of large and mid-cap stocks. Both our diversified equity fund and our opportunity fund have a blend of large- and mid-cap stocks.

Is there a number you could suggest?
About 70 per cent in large-caps and 30 per cent in mid- and small-cap would be right for conservative investors, and the reverse for aggressive investors.

What strategies did you employ during the downturn of 2008-09 in your Small & Mid Cap Fund to arrest the decline in NAV?
One, we removed all momentum bets from the portfolio. A lot of companies had been valued on discounted cash flow basis. But this methodology does not work during a downturn as it depends more on future earnings projections. These go haywire during a downturn as the mindset changes to low-growth expectations. So we did not keep these kinds of bets. We had more cash-earning companies in our portfolio. These companies could belong to sectors that allowed them to earn cash, like FMCG and Pharmaceuticals. Alternatively, their business conditions and financial policies had to be such that their level of debt was low. Besides, we had more cash in our portfolio. Also, in a positive environment you tend to invest even in those companies where there is some doubt about the business or the management. But during the downturn we turned very strict in our evaluation and removed all such companies.

To what level did your cash holdings rise?
In some of our funds we went up to 15 per cent cash. Normally we keep cash levels at around 5 per cent.

Your 2009 return from the Micro-cap Fund was 22 percentage points higher than the category average. What were some of the calls that you got right when the markets came back?
This fund was actively managed by a colleague named Aniruddha Naha. He had taken the calls that have yielded these returns. Some of his calls were in the consumer durables and the mining space where he took large bets. Those have done well.

According to our database, your exposure to Metals has been consistently low even though the sector did well during the recent rally. Why was that?
We didn't have a handle on how to value Metals. Metals have an element of investment demand and an element of consumption demand. So the demand is not purely for consumption of metals. A lot of commodity funds invest in Metals as a hedge against inflation or as a hedge against a currency declining. Thus many factors can affect the valuations of Metals over which we have no control. Besides, Metals also tend to be volatile. They are vulnerable to large gains and falls. The global economic recovery is still fragile. If it was a sustained recovery and confidence in it was high, then perhaps we would have been more optimistic. But that is not the case.

Since November 2009 you have been lowering your exposure to the FMCG sector in the Micro-cap Fund.
One reason was that the economy was in recovery mode. Cyclical companies tend to do better during a recovery than the steady-growth consumption companies. Two, competitive pressure was emerging in the FMCG space that would potentially affect their margins. Hence why we reduced weightage.

In the Micro-cap Fund the sector to which you have the highest exposure is Construction. What factors make you bullish on this sector?
Within the Construction space, we had taken bets in mining-related companies which will benefit from the large investments happening in coal and power. Construction is anyway reviving now with the government's focus on infrastructure, and with road projects coming on-stream. Irrigation and power generation are other areas with growth potential. The government is focused in a big way on these sectors and it is getting its act together.

Chemicals is another sector that has a high weightage. What is the outlook for this sector?
In Chemicals, we primarily have companies that are related to agriculture and fertiliser. We are positive about the prospects of the agri space in India. We feel that the government's single-minded obsession is to improve the rural economy and agricultural productivity. As food shortages become common and as food prices go up, the government will have a great challenge meeting food requirements. Therefore, it will have to improve productivity. Any company in this space will benefit from an improving policy environment.

Engineering also has a high exposure.
There are companies in this space that are cyclical. In the previous year growth came from consumption. In the coming year, while consumption will remain a dominant theme, there will be a need to increase capacities because companies have reached full capacity in many spaces. The demand for capital goods will rise.

What is the situation regarding private-sector investments? Are companies once again investing in building capacities?
That has begun in various sectors - cement, automobiles, and the power sector are all expanding. There is road building activity. There are projects coming up in broadband in telecom. In many sectors the demand for capital goods is coming back.

Why is the cement sector expanding? We have been hearing for about a year or more now that this sector has overcapacity.
People are taking a positive view on long-term demand. These capacities come up over a period of time. When the economy moves into a higher growth trajectory, the extra capacity can get absorbed. They may set up capacity and suffer for some time, but eventually they will benefit.

At present many cement stocks have very attractive valuations. How long would it be before the overcapacity ends?
I think the extra capacity might last for two years. Also, companies tend to have pricing discipline. They may be positive due to that aspect.

What does pricing discipline mean?
They keep prices from collapsing through informal agreements. Of course, one has to see whether such agreements can withstand the pressure created by bad times.

Do you have a minimum market capitalisation criterion in the Micro-cap Fund?
We define large caps as the top 100 companies by market cap. Mid caps is 100 to 200, small caps is 200 to 300, and micro is 300 and below. The market cap keeps changing with changes in the market, so we define these categories in terms of number of companies.

Any advice to investors on what the minimum market cap should be if they are investing on their own?
Investors would do well to be diversified in terms of the companies they hold, and the size of companies they hold. Smaller the company, higher the risk. It would be advisable to invest depending on the investor's own risk profile and understanding of the business. Sometimes you have a large degree of divergence in the market: some companies do not go up even though the market as a whole has performed. That is why investing through a mutual fund is advantageous. We track a large number of companies regularly and keep revisiting and changing the portfolio to suit the market environment.

Could you elaborate on the liquidity-related advantage of investing in small-caps via mutual funds?
An investor can liquidate his holding in a mutual fund as and when he wants, which provides him with instant liquidity. Such high liquidity may not always be available in the case of individual stocks. If small-cap stocks are held in large quantities, investors may not be able to sell them in case they need the funds. Of course, that should not be too big a problem for small investors who own only a few shares.

How do mutual funds guard against the liquidity risk in small- and micro-cap companies in adverse markets?
In that space also you do have liquid stocks. We tend to have a mix of illiquid and liquid names in the portfolio. But liquidity risk does exist, especially in the case of micro-caps. We also manage by having higher cash.

And I suppose you reduce exposure to illiquid stocks in adverse times.
We try to foresee problems and pre-empt them. We change our portfolio and we improve liquidity, raise cash, and so on.

Is there anything you would like to add?
Some of the mid-cap portfolios, including in our stable, have given very high returns. And the larger-cap portfolios have given low returns. But these are events which even out and there is always a reversion to the mean in the long run. So if a certain size has underperformed for a long time, like the large-cap space at present, it would be prudent to start investing in it now rather than chasing mid caps. Of course, mid caps may continue to do better for more time. But the performance variation will narrow over a period of time and then eventually the reversion to the mean may bring large-cap outperformance back. Investors should be aware of that and take action accordingly.

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