Not all smallcaps are same; 3 best smallcap funds for investors: Feroze Azeez

Let us just begin by talking about the kind of move that we have seen within the broader markets of late. What does that indicate?
It indicates a lot of stuff. We have gone long on small and midcaps and smallcaps largely on your channel as well on 3rd of January this year and so this indicates several things. One, there is a clear difference between five years back and now, especially in the smallcap space. FIIs’ participation has gone up dramatically in the smallcap space.

Earlier, the FII would want to play the India story only with the top 50 or the top 100 stocks at best. Now, he or she wants to play the India story from a broader theme perspective. These smallcap stocks are low on market cap generally. There is less free float in terms of rupee value. So, PEs get elevated significantly because FIIs are a little price insensitive or they are not price elastic unlike the domestic guys. They are buying India but not buying the specific stock alone.

That is why we see several re-ratings. Whenever there are PE re-ratings, we see the FII exposure change. I analysed about 10 companies which have had the largest change in FII holding in the small cap index of Nifty Small Cap 250. You would see a substantive move in terms of price movement and the PE movement if FIIs increased the stakes.

So, point one I am making, it indicates that FIIs’ broader market interest has gone up dramatically. Second, it says that India has a reasonably large number of stocks in the capital markets, largest in the world, in fact. India cannot be represented by the top 100. The domestic guys have also had flows over the last few months. There are several things but I will stop here for the next queue from you.

There is a lot of narrative that there is a bubble and a trouble in smallcap stocks. Small cap stocks in a tortoise and a rabbit race and are like the rabbit right now and will not reach the finish line. But it is time now to bet on the tortoise, which is largecap stocks? Is it time to book 15-20% profits from small and midcap funds and perhaps migrate to largecap stocks or funds?
First on a conceptual level, I have a little disagreement with the narrative bit. See, smallcap stocks are the bottom 250 stocks of NSE 500 as per SEBI’s definition for a mutual fund investor. Putting 250 companies in one judgment itself is fundamentally incorrect. I discovered that the smallest stock in the smallcap index is a Rs 3,200-crore market cap company and the largest one is above Rs 50,000 crore. And it is Suzlon Energy. It is the largest weight in the Nifty Small Cap 250.

Now, a Rs 50,000-crore company is also a smallcap company. A Rs 3,200-crore company is also a smallcap company. There are 51 unicorns in this country which are not a part of that smallcap index because of the index formation methods. So painting them with the same brush is not right.The name of the game is to be specific in smallcap. At Nifty, you can be more broad based. You can judge 50 companies as a basket because they represent a larger free float, almost 65-70% of India’s free float. The point one I am making is do not paint them all with the same brush. I am not saying they are not undervalued or overvalued. One of the largest stocks is 106 PE. And there is another stock with nine PE in the same index. How can valuation be the same for all of them?

But if that is not the criteria, then what is? The Nifty Small Cap 250’s value today is close to about 13,000, the earnings estimate tells me that the PE is still 19. If you look at the froth in the index as a whole, it is negative. Even if you attach a 21 PE to it, 1000 points of further rally is expected. But the name of the game is to get specific and not be judgmental about the broader headline numbers.

Which are the top three smallcap funds which you are recommending as a house? I know you charge fees for that but maybe I will urge you to say it on air for free.
Of course, I will do that for free because I do not have any variable cost. I am more than happy to tell you. HDFC Small Cap, Invesco Small Cap and Birla Small Cap, all of them have a very different approach is why these are the three small cap funds. Chirag Sethalwad is a great fund manager. In spite of the size, he has the knack of smelling businesses. When you look at his portfolio, there were about 17 stocks which had less than Rs 5,000 crore market cap. And those were not stocks picked by all janta. They were brought into the portfolio much before the market woke up. That is Chirag Sethalwad.

Tahir Badshah is managing the Invesco Small Cap Fund, a smaller size small cap fund, which is getting inflows. Tahir Badshah has shown his capability in the small cap, even when he was in Motilal Oswal. So that is the second fund.

Third one is Birla Small Cap. It was one of the underdogs when we picked it up. Of course, people would never want to buy it. But this year it turned around and it became one of the best in the 385 active funds. So these are the three funds which have a complementary nature in the small cap space. But we have a research team which works on ground to find out flows in the small cap space for the month before AMFI gets to know it at the end of the month. The estimate is in November, we have seen about Rs 2,400 crore of inflow in the smallcap funds. If you look at all the smallcap funds in the space, liquidity seems to be still chasing these categories. A few months later, I would be a little more worried about valuations.

Last three years, small caps have given returns which are better than large cap. Three years, will the tide turn? Like they say cyclicality is always at play in this tortoise versus rabbit race. Tortoise wins in the traditional story which we have read. But in a mutual fund, sometimes the tortoise wins and sometimes the rabbit wins.
As you said, if we look at the figure, smallcaps have outperformed in three years. When we took the small cap in our portfolio from 5% to 30%, we saw a lot of entry points. If we look at one entry point, there is a bias because it depends on the starting point. If I add five years to it or 2018 after the IL&FS crisis, you would see that the smallcaps got rogered. And you would see underperformance for a five year period of almost about 4.7% vis-à-vis Nifty on the day when we gave the recommendation.

If you look at the number of days in the smallcap as traded, it was 2007 to 2008 and then see how many times has it underperformed Nifty. We are still in a five-year pocket of underperformance with respect to Nifty. On a 3-year performance basis, of course, like you rightly pointed out, it has outperformed. There are several ideas inside smallcaps. It is a great canvas for a fund manager, he can capitalize. So I am not too worried about the three-year outperformance because if you pull it a couple of years behind, the outperformance disappears.

What is the best portfolio allocation right now? What would be your exposure to mid cap, small cap, gold, if at all, other asset classes?
In the largecap, in the current 14 scheme model portfolio, the implied largecap exposure is about 50%. There is about 29% of smallcap and 20% of midcap. It is very contrary to how a person would believe. 50% is for large. Generally, midcaps have a larger allocation than smallcaps. We have turned it over its head.

Smallcap has a larger allocation than midcap because we are not very comfortable with the 150 companies’ earnings potential, which is called midcap. Now coming from an asset allocation standpoint, India is going to election year. Having large portions of debt is going to be very detrimental. India’s allocation to debt is significant with respect to only about 12-13% of India’s households have equity and the rest of the 85-87% is debt and other instruments.

So going into the election, if you stay out and stay in debt, it will not be a great thing. I would say there should be very little allocation for long term money in debt. Gold is definitely a great hedge and a good plan B. You can have sovereign gold bonds because you get a flip of almost about 4% per annum because of the tax advantage and also the fact that you get an interest. Sovereign gold bond is gold plus, plus.

If a person realizes that and converts all his gold, which is coins and bars to sovereign gold bonds, that will be more efficient than buying new gold in the portfolio.