Transcript for the podcast if you would like to read instead
On this episode I sit down with the Fund managers of VRDDHI, Rohit and Rajat. Rohit and Rajat have around a decade of investing experience having worked with companies such as McKinsey & Co, Elevation Capital (previously SAIF Partners) a sector and stage agnostic fund, and RARE Enterprises – Mr. Rakesh Jhunjhunwala’s family office.
Rohit, Rajat great to have you on the show,
Let’s dive in
Couple of years back small caps as a segment was being shunned by people, but since the past year or so it has come back to glory. Let’s unravel this space.
Sure, so let’s just understand the lay of the land – there are about 3,400 – listed stocks in India. SEBI came out with firm definitions of large caps, mid-caps, and small caps. So as per SEBI the top 100 companies by Mcap are large-cap (Upto Mcap of ~45,000Cr) the next 150 are mid-cap companies (Upto mcap of 14,000Cr) and the rest is essentially small-cap companies. It has a total of ~3,200 companies. So, it is really a vast universe of companies.
Now if we just look at the index itself related to Smallcap – for which we have data going back till 2004- it has generated 14.2 % CAGR, v/s Nifty having a CAGR of 12.7%. That’s INR 100 becoming 1030 with Nifty Smallcap v/s investing in Nifty would have become 816. However, these are just the headline numbers. If we peel this onion a bit further –what we see is that there is a lot of volatility in the index. Over the last 15 years, there have been 4 major corrections, and the index fell by upto 77% v/s max fall of 59% for Nifty 50. One of these corrections lasted for ~34 months, investors must have gone through excruciating times. However, at the same time, Smallcap index tends to rise higher & faster than Nifty 50. Subsequent rise in the indices saw a jump of upto 239% for smallcap v/s 145% for Nifty 50. Median rise across these 4 time periods was 176% for smallcap v/s 93% for Nifty 50. So, in bad times, this segment falls a lot and in good times it goes up a lot as well.
Now volatility is not equal to risk obviously, however in general volatility is not liked by market participants. So, this creates amazing opportunities for someone who is willing to look beyond this underlying volatility and look at individual companies. This is true for all investing but becomes even more important in smallcap investing. If one doesn’t go prepared in this space, then one can genuinely lose one’s shirt.
We keep hearing this a lot, why do you say that? I mean given the kind of volatility is it even worth looking at this space?
There are a lot of companies in this category- not all are good *Insert laugh* and certainly, not all are bad. So, you need to separate the wheat from the chaff. If done right it can be really rewarding, but the caveat is if done right. Like Rajat said we don’t see volatility as something one can avoid it’s just part of the system. So, the question is how can you equip yourself to better deal with that volatility – that is what one should really focus on.
Our experience shows that with discipline, hard work and the right framework one can construct a smallcap portfolio which shows resilience, similar to or better than the large-cap portfolios, during market declines
This point on right framework, there is so much noise in the market, and a lot of information so how does one do that?
I think the first step is to really weed out the bad apples- if we get this right, then that is a major part of the battle won. So, get companies that have had faulty corporate governance issues out, get companies with high debt poor cash flows out. In bull markets, there are many stories that come out – this is the next HDFC, next Infosys or some such. It is better to not take these stories at face value and probably ignore them. *With a hint of humour* Now once you are done eliminating the bad apples – one can look at the remaining names – and select from these. Here if one is disciplined and puts in the hard work it is possible to create a market-beating portfolio (both on the upward and downward).
And when it comes to discipline and hard work- reading annual reports, going through con-calls, looking at peers, understanding the industry structure, understanding the history of the company, promoters, and management. Doing all this will help us answer the question – can this company from wherever it is today can it scale and grow over the next 2/3/5 years? And can it do that profitably? Doing this obviously takes a lot of hard work but it can pay off immensely well. *Stress on hard work* Many times you will come across companies that have a clear right to win in their segment. Finding such names can be really rewarding for an investor. So, in general I would say have a strong framework on what to exclude- bad business, bad balance sheet, bad promoters. With the remaining list – do the hard work and ask this questions – 1) what is the right to win for this company and 2) can this grow profitably over the next 3-5 years. That’s what we do at VRDDHI
Also additionally I would say in small-cap investing – starting valuations matter a fair bit- so having a conservative bend of mind helps. In frothy times one may miss a few chances, but it pays off immensely when the froth is over.
As a mandatory subject, we keep getting this question ki is it a good time to invest in small-caps now?
Well, it’s a million-dollar question right *insert laugh* And it is very very difficult to say whether the markets are going down or not. We don’t take market calls as such.
But for the sake of it let’s look at some data points. If we look at Nifty to Nifty smallcap it does seem that we are getting into a zone from where this segment falls off, however, if we look at rolling returns of 3/5/7 years and compare that to historical numbers it seems we are still just somewhere in the middle.
<Median returns 3 year – 36% 5 year – 74% and 7 year – 90% >
Even if we look at companies and compare their prices from the previous peak of 2018- still ~55% of companies are below – it just indicates that there are still some pockets of opportunities. *Slight enthusiasm*
However, what I will say in general is timing is futile and almost impossible. Even if you see the last rally that we have had from April 2020- from 24 March 2020 lows, NSC 100 rose by ~210%. There were a total of 328 sessions. However, if one missed the best 30 sessions during this time, returns that one would make will be reduced to only 43%.
What we have seen works for us is that focus on the micro i.e., finding opportunities bottom up irrespective of the market conditions keeping in mind the framework that we have talked about.
So, try to invest in companies that can withstand any crisis and bounce back sharply whenever the situation normalizes. This will enable sound decision making during market corrections and more importantly you won’t lose sleep during such times.
Passive investing is in full force globally and catching up in India as well. What do you think about the quality of the small cap index and given the nature of small cap investing how can passive investing come into the picture?
At least at this time there are no avenues – one can’t really invest in Smallcap index as such. The whole endeavour in Smallcap investing is akin to separating the wheat from the chaff- which is not passive. So I am not sure if you one can be passive in Smallcap segment
Before I let you both go, lets talk a little bit about VRDDHI
So VRDDHI is our Smallcap PMS offering at ithought. Where we focus on trying to find emerging giants from the Smallcap space. We follow the framework that we just spoke about earlier in the podcast wherein we eliminate the bad apples and focus only on the good ones.
Our focus at VRDDHI is at buying un-discovered, under-researched and under-owned business which have market leadership in their chosen niche, are run by promoters/management who are ethical, competent and are good capital allocators.
We try and apply private equity style due diligence which involves trying to go deep into the business and the ecosystem to identify and generate unique insights that helps us to have a differentiated view about a company or an industry. This approach has helped us to be risk averse – what we have seen is that when the market corrects a portfolio of such businesses correct much less than the market – making it ideally positioned for the portfolio to outperform and generate alpha whenever the market picks up.