'Looking at short-term data would lead to erroneous conclusions,' says Mahesh Patil of Aditya Birla Sun Life Mutual Fund
Multiple factors, both domestic as well as global, have contributed to the under-performance in small cap stocks in recent times
Small cap mutual fund category has been in pain for the last one and a half years now. The category is the worst performer in the last one year with average returns of -17 per cent. In the three-year period also the schemes, on an average, have generated a meagre 3 per cent CAGR returns. What is the reason behind the prolonged underperformance?
Multiple factors, both domestic as well as global, have contributed to the under-performance in small cap stocks in recent times. Factors such as economic slowdown and significant decline in automobiles and manufacturing GDP which has high weightage in small cap indices, NBFC’s fund crisis and resultant liquidity squeeze for the small and medium enterprises and higher interest cost, slowdown in exports and global trade, large redemptions in India dedicated and emerging market funds which led to significant sell off in small cap names where FII ownership was large and concentrated, high returns in base year 2017 of 60 per cent and others are all factors which led to significant underperformance in small cap indices over the last 1-2 years.
Specifically, for small caps it would be misleading to compare returns for only 1-year and 3-year since the segment is quite volatile. In the past, if we look at periods of 2011-13, the segment has shown significant underperformance vs the large caps but bounced back meaningfully in 2014-17. In fact in 2017 the small cap index had a massive run-up of nearly 60 per cent. The small cap returns look particularly poor in an abnormal polarised equity markets currently, where only select small number of large cap stocks are holding up due to crowded trade while the broad markets represented by large number of stocks is seeing selling and underperforming.
More fundamentally, the small cap indices are a play on domestic India economy, which has seen significant contraction in recent times. For example, the recent GDP estimate of 5% per cent is the lowest in the past five years. The fund returns which generally track the indices are hence poor.
Aditya Birla Sun Life Small Cap Fund is the worst performer in the small cap category in the last one year with -25 per cent returns. The scheme is 16 per cent down year to date. The scheme has been underperforming the index in the last one and a half years now, and the gap is widening.
As compared to peers, Aditya Birla Sun Life Small Cap Fund was overweight on NBFCs, industrial & manufacturing, and construction sectors which impacted our performance competitively. Few stocks which had done well for us till 2017 impacted our performance adversely in the past 18 months. Although the fund has underperformed the index over the past nine months or so, it is a very short timeframe. It should be noted that the fund has consistently beaten its benchmark and generated positive alpha in each of the last five calendar years.
ABSL Small Cap Fund is a growth-oriented small cap fund, which focuses on earning growth and follows GARP (Growth At Reasonable Price) philosophy. Even after poor earnings show in June 2019, our portfolio companies are estimated to grow their earnings by more than 20 per cent and have valuations which are considered fairly cheap, with PE of 10-11 times forward earnings, and ROE in access of 16 per cent. Overall, our portfolio has above average earnings growth and bought at fair valuation.
We have been true-to-label and maintained a focused strategy with 80-90 per cent invested in the small cap stocks. In a market upturn, the fund should be able to capture the upside and improve its peer ranking.
Some mutual fund advisors and fund managers are of the view that the small cap category can be totally avoided by general investors. They say the category has failed to reward for the extra risk taken by investors. Do you believe they are right in saying so?
Indian small-and-mid-sized companies have created huge wealth for investors over the last two decades and that is likely to continue. The recent underperformance in the small cap stocks is overshadowing this long-term historic outperformance and wealth creation. We would discourage investors from making segment allocation decisions looking solely at short term returns. In a way the markets today are exactly opposite to the environment in 2017, where investors were disregarding large caps in favour of small caps. Looking at such short term data would lead to an erroneous conclusion and mis-allocation as would have happened two years ago.
Hence, we strongly recommend investors to stick to their segment allocation looking at their investment objectives and long-term historic returns for each of the market segments. The small cap segment is particularly suitable for seasoned investors who have experience of investing in the market and can withstand volatility in NAV with long term time horizon. First-time investors may avoid investing in this segment considering the volatility.
Some mutual fund managers believe this is the right time to enter small caps and mid-caps. They say some pockets in the segment have turned attractive due to lower or reasonable valuations. What is your view? Can we expect a turnaround in small caps in the near future?
The recent price correction has made the mid-and-small cap segment extremely attractive from valuation point of view, with valuations declining to multi-year lows. We do believe that at these valuations the small cap segment discounts near term uncertainties to a significant extent, offering significant value and favourable risk-reward for patient investors. Hence, we have been recommending around 20 per cent of equity allocation by investors to the mid-and-small cap segment.
Not only small caps but all the equity fund categories in the industry are in red. We have been receiving a lot of investor complaints saying that all their gains made in equity funds, especially mid caps and small caps, in the last two years have wiped off. What is your advice to them?
It is a well-established fact that equity as an asset class goes through cycles but can provide best returns over the long term. Over the last two decades the Indian equities have generated tremendous wealth for investors. Factors such as the increasing per-capita income in the country, our high economic growth potential, and the ongoing efforts by the government to boost growth bode well for the equity market going forward. The current economic slowdown is a result of culmination of multiple negative factors all playing out at the same time. It is likely to be transient and we should see a revival from here.
Indian equities continue to offer an excellent long-term opportunity for investors who are able to maintain a disciplined asset allocation. Given the recent underperformance and attractive entry point, mid and small caps could do relatively better over a 3-year timeframe and give good returns.