Small caps have room to grow, but investors should avoid low-quality bets, says Harish Krishnan of Aditya…

Reports coming in for today mention that Small-cap mutual funds continued to attract firm investor interest in August, recording the highest net inflow among major equity fund categories. The category saw Rs 7,973.33 crore of inflows during the month, according to data from the Association of Mutual Funds in India (AMFI).

With small-cap stocks continuing to see firm earnings expansion and domestic investor participation, questions stay over whether the trend can sustain and how market participants should identify the next set of potential winners.

In an interview with Moneycontrol, Harish Krishnan, CIO at Aditya Birla Sun Life Mutual Fund, stated smaller firms have better room to grow, but cautioned market participants against assuming that size alone guarantees expansion. He stated sustainable expansion depends on factors such as capabilities, financial discipline, access to talent and the ability to build a differentiated business.

Small-cap earnings have outpaced large caps recently. What makes you believe this earnings cycle can sustain?

On a year-on-year basis, the percentage of small caps growing at 15 percent or elevated is more than that of mid-caps and large caps. Given the larger number of firms in the small-cap universe, the sheer number of firms growing at 15 percent is elevated.

I think there are two key structural aspects. First, small caps are generally more inefficient than their larger counterparts, with softer margins. When the economy rebounded strongly post-Covid, greater economic activity resulted in greater flow-through for these firms, leading to a sharp gain in earnings expansion.

Second, small caps generally have more debt and a elevated cost of debt. Structurally, interest costs have come down meaningfully compared to the pre-Covid era. As a result, the cyclicality of small- and micro-cap earnings has reduced quite significantly.

Looking at 25-30 years of data, aggregate earnings typically double every five to six years. Large caps, on average, double every five to five-and-a-half years, while mid-, small- and micro-caps double in around four-and-a-half to five years. So, while smaller firms tend to double faster given their smaller base, the gap is a lot smaller than market participants may assume.

Market participants should as a result not extrapolate the firm post-Covid performance of small and micro caps and believe that this will always happen

Do you think domestic flows are fundamentally changing the way small caps respond to FII selling and global risk events?

In some sense, prices are set by the marginal buyer and seller. And the marginal buyer, I mean, domestic mutual funds have become like the foundation flow. As an aggregate, the industry gets a certain amount of flows, and that gets allocated, by and large, to a certain set or pool of stocks.

As a result, domestic flows are acting like a shock absorber. The marginal price is still being set by the marginal player, which means it could be the foreign investor, or it could be the domestic retail/HNI participant, which has additionally become very active post-Covid.

So, these are the two sets of people that set the pricing. But for sure, the shock-absorption capability has improved meaningfully with domestic mutual funds. This is why, even during large outflows, volatility gets dampened quite significantly because of the very firm domestic participation.

What does a future small-cap compounder look like before the market recognises it?

I think there are three things we specifically focus on to identify firms that are doing things differently.

The first is value addition. It could be gross margins or, in certain cases, EBITDA margins. We prefer firms where the gross-margin value add is much elevated than that of the rest of the participants. This means they are doing something differently and extracting greater value from their customer base as well as their suppliers.

The second is reasonably elevated ROEs, which points to financial discipline. We have noted things go wrong when working capital gets stretched as expansion comes through strongly. As a result, we want firms with firm working-capital discipline and very good ROEs as a manifestation of that discipline in their financials.

The third is capabilities. This is qualitative and cannot be judged by numbers alone. Every firm has a expansion agenda, but is it doing more of the same, or does it want to move up the value chain in terms of capabilities and have the hunger to do so? That is what we look for.

You have increased exposure to financials while reducing exposure to IT and capital goods. What changed in your investment thesis, and how much has this shift contributed to the performance of your funds?

I think it's additionally a function of various elements or various segments within each of these sectors, which have become far more attractive.

For example, in the small-cap space, in financials, there have been areas like microfinance, etc., which went through a lot over the last two years and now seem to be on the recovery. As a result, some of that gain happened there.

It could additionally be in terms of many of the banks or NBFCs which have got significantly funded by large strategic market participants coming on board. As a result, the capital availability brings in the fuel for the next expansion cycle. That explains it. Along with that, financials is one area where overall valuations still are quite reasonable compared to many other pockets of expansion.

The second area you spoke around is capital goods. For sure, the domestic story on demand looks quite encouraging, and that should help overall business demand for various industrial and capital-goods firms. For us, the key aspect is when we look at valuations. In a cyclical segment, we don't want to necessarily provide peak valuations at peak cycle because that is where things turn and the potential for negative surprises starts coming through.

What is the biggest misconception market participants have around small caps today?

I think market participants have, in my opinion, become slightly complacent and started to believe that just because firms are small, they can grow. Yes, smaller firms have better room to grow, but expansion is a function of multiple things, including capabilities, access to resources, capital discipline and access to talent. All of that is important for sustainable expansion.

So, one shouldn't just believe that because a stock or firm is present in a high-expansion segment, expansion will naturally come to them.

What creates value is not just expansion for the here and now. What creates value is how differentiated you can build a business compared to the rest of the players. And for that, it requires access to talent, the ability to adapt to various business challenges, etc. That, to my mind, is where I think market participants have become slightly complacent.

As a result, when we look at many, in our opinion, low-quality businesses that are getting significantly bid up, we think that possibly there is an element of mispricing happening in the markets today.

I won't say it is all-pervasive, but there are pockets wherein we think even softer-quality businesses, which have very low cash-flow conversion, are additionally getting bid up. And that, I think, market participants would be better off avoiding, to create a slightly longer-term wealth-creation journey.