First, let’s talk about some recent developments we’ve seen in the broader market. What does it show?
That shows a lot. On his January 3rd of this year, we were also long on your channel, mainly small-cap, mid-cap and small-cap stocks, which shows a few things. First, there is a clear difference between five years ago and now, especially in the small-cap space. FII participation has increased dramatically in the small cap space.
Previously, FIIs wanted to cover India’s story only in the top 50 stocks or at most the top 100 stocks. Now he or she wants to play the Indian story in terms of broader themes. These small-cap stocks generally have lower market capitalizations. Free float is less in terms of rupee value. Therefore, FIIs are either a bit insensitive to price or are not price elastic unlike domestic companies, which increases their PE significantly. They’re buying India, but they’re not just buying specific stocks.
So we’re seeing some reappraisals. Every time there is a PE revaluation, we see a change in FII exposure. I analyzed around 10 companies that had the highest volatility in FII holdings in the Nifty Small Cap 250 small cap index. If FIIs increase their stake, we will see real movement in terms of price movement and PE movement.
So, point number 1 that I am making shows that the broader market interest of FIIs has increased dramatically. Second, India has a significant stake in the capital market, in fact it says it is the largest in the world. India cannot make it into the top 100. Domestic players have also experienced a shift in recent months. There are a few, but I’ll stop here for the next cue.
There’s a lot of talk about bubbles and problems in small-cap stocks. Small-cap stocks are in a tortoise-and-hare race, and so far they’re like the hare, never reaching the finish line. But isn’t it time to bet on the tortoise that is large caps? From small and medium cap funds he secured a return of 15-20% and is it time to move to large caps and funds?
First, on a conceptual level, I slightly disagree with parts of the story. Small-cap stocks are the bottom 250 stocks of NSE 500 as per his SEBI definition for mutual fund investors. It is fundamentally wrong to subject 250 companies to a single decision. I found that the smallest stocks in the small-cap index are companies with a market capitalization of 3,200 billion rupees, and the largest stocks are over 50,000 billion rupees. That is Suzlon Energy. This is the highest weighting among Nifty Small Cap 250.
Now, a Rs 50,000-crore company is also a small-cap company. The Rs 3,200-crore company is also a small-cap company. The country has 51 unicorn companies, but they are not included in the small-cap index because of the way the index is formed. Therefore, it is incorrect to paint with the same brush. The name of your game must be specific in Smallcap. Nifty allows for a wider range of activities. You can judge 50 companies as a basket. Because these companies represent a larger free float, accounting for almost 65-70% of India’s free float. What I’m saying is don’t paint everything with the same brush. I’m not saying they’re not underrated or overrated. One of the largest stocks is 106PE. And there is another stock in the same index with a P/E of 9. How can we get everyone to have the same rating?
But if that’s not the standard, then what is? The current value of Nifty Small Cap 250 is close to around 13,000 and the P/E ratio is still 19 as per earnings estimates. If you look at the bubbles in the index as a whole, it is negative. Even if you add PE21, you can expect a further rebound of 1000 points. But the goal of the game is to get the specifics and not pass judgment on the broader headline numbers.
What are the top three small-cap funds you would recommend for investment? I know there’s a fee, but maybe you’d like me to say it on the air for free.
Of course, there are no variable costs, so we will do it for free. I will be happy to tell you. HDFC Small Cap, Invesco Small Cap, Birla Small Cap, these are his three small cap funds as they all have very different approaches. Chirag Sethalwad is a great fund manager. Despite his large size, he has a talent for smelling business. Looking at his portfolio, there were around 17 stocks with a market capitalization of less than Rs 5,000 crore. And those were not the stocks chosen by all the Jantas. They were put into portfolios long before the market woke up. That is Chirag Setarwad.
Tahir Badshah runs Invesco Small Cap Fund, a small-cap fund, which has been receiving inflows. Tahir Badshah showed his ability in the small caps even when he was with Motilal Oswal. That’s the second fund.
The third one is Birla Small Cap. When we picked it up, it was one of the underdogs. Of course, people will never want to buy it. But this year, it took a turn for the worse and became one of the best out of 385 active funds. In other words, these three funds have complementary properties in the small-cap space. However, we have a research team that will be on the ground to investigate trends in the small cap market for a month until AMFI figures out at the end of the month. Estimates for November put inflows into small-cap funds at around Rs 2,400 crore. If you look at all the small-cap funds in this space, liquidity still seems to be chasing these categories. After a few months, you’ll start to worry a little about your valuation.
Over the past three years, small-cap stocks have delivered better returns than large-cap stocks. Will the tide change in three years? As the saying goes, periodicity is always at play in this tortoise-versus-hare race. In the traditional stories we read, the turtle wins. However, when it comes to mutual funds, sometimes the tortoise wins and sometimes the hare wins.
As you said, small-cap stocks have outperformed over the last three years if you look at the numbers. He moved his portfolio from 5% to 30% small-cap stocks and found many entry points. If we look at one entry point, it will be biased because it depends on the starting point. Add to this 5 years i.e. his 2018 after the IL&FS crisis and you will see that small cap stocks are on fire. And when compared to Nifty on the day we made our recommendation, we see an underperformance of almost 4.7% over five years.
If we look at the number of trading days of small cap stocks, we can see how many times they underperformed the Nifty in 2007-08. As for Nifty, he is still in a five-year underperformance. Of course, on a three-year performance basis, as you rightly pointed out, it has outperformed. Smallcap has some ideas. This is a great canvas for fund managers to exploit. So I’m not too worried about the three-year outperformance. This is because outperformance disappears if there is a delay of a few years.
What is the optimal portfolio allocation right now? What is the exposure to mid-cap, small-cap, gold, or other asset classes?
In large caps in the current 14 scheme model portfolio, the implied large cap exposure is approximately 50%. Approximately 29% are small-cap stocks and 20% are mid-cap stocks. That’s exactly the opposite of what people believe. 50% is for errands. Mid-cap stocks generally have larger allocations than small-cap stocks. We turned it upside down.
We allocate more to small-cap stocks than mid-cap stocks because we are less satisfied with the earnings potential of 150 companies called mid-cap stocks. From an asset allocation perspective, India is entering an election year. Having a large amount of debt can be very detrimental. Debt allocation in India is significant in that only about 12-13% of Indian households own equities and the remaining 85-87% is debt and other instruments.
So if you don’t participate in elections and you stay in debt, that’s not great. I think there should be little allocation to long-term debt. Gold is definitely a great hedge and a great plan B. You can own gold sovereign bonds because you get tax benefits and interest as well. This is because you will earn about 4% per year. Gold sovereign bonds are gold plus, plus.
If one were to realize this and exchange all their gold holdings (coins and bars) into sovereign gold bonds, it would be more efficient than buying new gold in the portfolio.