Small cap stocks: How should investors think through their portfolio?

Investors who’ve made outsize gains in this bull market are more likely to have invested in smaller companies. As a basket, these stocks have led the rally with price increases tracking both earnings growth as well as an increase in valuations.

But a 45 percent rise in the BSE Small Cap Index in calendar year 2017 and the volatility starting February 2018 have left many asking the inevitable question: Has the market already priced in too much growth? Are gains in these stocks at risk in the event of a steep fall in the indexes? And importantly, what should investors do with their gains?

As a rule, smaller companies are riskier investments when compared to their larger counterparts. They’re more susceptible to macroeconomic swings like rising interest rates or commodity prices. They may not be able to fight a bruising price war with a larger competitor or they may not have the cash to fund an important business innovation. As a result, it is not uncommon to see smaller companies lose half their value in a correction.

After a successful run with small cap stocks, how should investors think through their portfolio?

Smaller companies are more susceptible to macroeconomic swings

To get answers to this, Forbes India turned to DSP BlackRock, which has been running a successful Microcap Fund since 2007—long before the category was the flavour-of-the-season investment it is today. Its performance is nothing to be scoffed at: The fund has delivered a five-year compound annual growth rate of 33.5 percent and has seen periods of severe undervaluation (during the 2013 Fed taper tantrum) and overvaluation (now). The reason for its performance is that the fund identified a lot of companies early on and then stuck to them as earnings came through. As a result, it was able to take full advantage of the gains as they accrued. Investors who’ve entered the mid-cap party late would do well to remember that a large part of the gains in this category have probably been front-ended.

Mid-cap investing is probably not for someone who is going to get rattled by a dip in the market. “You need to stick with these companies for long periods,” says Anup Maheshwari, chief investment officer at DSP BlackRock. He downplays the last five-year outperformance and points out that the mid caps only emerged from a prolonged valuation drought in five years preceding 2013.

In the five years to 2013, the BSE Small Cap Index returned 6 percent a year. In the five years since then, it has returned 23 percent a year. In addition, since returns in 2017 for equities were linear, it meant that investors began to downplay the risk and volatility that are often associated with stocks. As the rally continued through 2017, the last three months of the year saw a lot of stocks that hitherto hadn’t participated in the rally on very large volumes.  
 
Vinit Sambre who manages the Rs 6,500-crore DSP BlackRock Microcap Fund believes that what got successful investors till here is what may stand them in good stead in the years to come. Don’t chase the next big idea. “This is a market in which we are trying to avoid new ideas. Often, business owners take decisions based on their stock performance,” he says. Instead stick to basics. He’s meeting fewer companies these days and refuses to change his investment style to suit a raging market. Case in point: The fund’s top 10 holdings have largely stayed the same in the last year.

As the bull market has matured, he’s noticed that investors in the hunt for the next big idea have bet on companies with business models that may not necessarily stand the test of time. Case in point: Shrimp companies. These days he struggles to find even one worthwhile idea each year, but says he prefers to tend to the portfolio than take a higher level of risk with a new company.

The team at DSP BlackRock is using its time to retest their hypotheses. Are the business models still relevant? Can these companies continue to deliver the earnings growth that their prices indicate? Are there any redundancies that have crept into their portfolio due to either the company not performing or the sector going through a tough phase?

This process has allowed the fund to sometimes increase its bets in sectors where the performance has shown up with a lag. Take the case of the specialty chemicals sector where companies have faced headwinds and the earnings growth has not come through. Sambre’s conclusion was that the headwinds are temporary and he used the opportunity to increase exposure in two chemical stocks—SRF and Atul Limited—that are among the top 10 holdings in DSP BlackRock’s Microcap Fund portfolio. Unlike the past when the fund added to its positions quickly, it has adopted a more measured approach and buys when valuations appear attractive.

Other ideas that have not worked out are weeded out of the portfolio. Take Jagran Prakashan, which the fund reckons, has not delivered either in terms of growth in circulation revenue or increase in advertising. The fund exited its holdings.

Sambre who believes that the small-cap category is overvalued also points out that risk evaluation needs to be done at different levels of the market keeping in mind both the stock price of the company as well as index levels. (In February 2017, the Microcap Fund stopped accepting new investments.)

This wait-and-hold strategy has in the last year led to the fund underperforming when compared to the benchmark S&P BSE Smallcap Index. Still, DSP BlackRock refuses to go down the quality ladder and bet on companies with a questionable future potential. “Now it’s a matter of us being patient,” says Maheshwari.