The Hindu Business Line : ‘Institutional interest is on the increase’

Index and large-cap stocks seem to have run out of steam in recent weeks, while small and mid-cap stocks have seen considerable action. Is this the beginning of a more sustained trend and where do the investment opportunities lie? Business Line caught up with Mr R. Rajagopal, CIO of DBS Cholamandalam Mutual Fund, who was in Chennai to flag off DBS Chola Smallcap Fund to get his views on these issues.

Excerpts from the interview:

Several small-cap stocks have registered sharp appreciation in recent weeks though the indices have gone nowhere. Do small-cap stocks typically have a low correlation with the indices?

The BSE SmallCap index came into existence only in 2003. If we see the performance, it is very clear that the small cap index has returned 100 per cent more than the large cap index since then. So, over a longer time frame, small-cap stocks followed by the mid-caps are likely to outperform large-caps.

This is logical because these companies move up the ladder in terms of size and earnings.

Whenever in the short-term, there has been a valuation gap between the mid-cap and large-cap stocks, the mid/small-caps have quickly caught up. Mid/small caps have given much better returns over the long-term because of the simple reason that, on a lower base the earnings momentum is always higher compared to the large cap companies in the same sector and business areas.

Could the newfound interest in small-caps be because FIIs are running out of headroom in the index stocks and large caps?

If we put small, mid and large cap stocks and private equity in a spectrum, you have the private equity on the extreme right and large caps on the extreme left.

Small-caps fall somewhere in between, just left of private equity. So, when new money comes into India it will always target the large cap companies first. Then it will move to the mid-caps; small-caps will take further time.

Probably that is why this time, the large-cap indices have done so well. This could also be the reason why you have not seen institutional holdings in the small-cap space go up from the FII perspective.

Whatever has happened in this space is probably because of the domestic institutions. Here is now an opportunity for those who do not have the capability to participate in private equity investment, to come and participate in India’s nascent businesses. So, definitely we see interest shifting to small-caps going forward. The institutional interest is definitely on the increase.

The sustained rally in index and large-cap stocks since 2006 has resulted in a wide gap in valuation between large caps and the other stocks. Will this be bridged?

If you look at valuations based on the latest earnings estimate for the BSE Small-cap index and the Sensex, there is about a two half points differential that exists. Now whether that should exist or not is the question. We have seen in the past that the valuation gaps do catch up. So, although in the short-term there could be a valuation gap, definitely over the medium-to-long term it catches up.

If we look at history, you will see that every time the small-caps underperformed for a long time, they have caught up immediately.

That is why we feel that investing in them has nothing to do with timing. Small-caps offer a higher potential return. But there is an inherent risk because of the smaller size and transparency issues of the management.

Is this a good time to take exposure to small-cap stocks?

The small cap index has a better sectoral representation than the large cap index. One, the number of companies in the index, around 484 currently, is an advantage over the large-cap index. The small-cap index covers almost all the sectors of the Sensex and Nifty except one sector- Telecom services.

Two, it is under-researched. If you look at the 484 companies in the Small-cap index, 45 per cent of the companies are not researched even today. Whereas Nifty-50 or the Sensex-30 are well covered and everybody knows what is happening in those companies. This highlights the need for a strong research team to track such stocks. This could help generate more alpha. Indian fund managers have typically been using small-caps and mid-caps to get that extra alpha even in their normal diversified schemes.

Three, the institutional holdings in these companies have been steadily going up, though it is still not very significant. That is noteworthy. From 11.28 per cent in 2004, the institutional holding stands at 16.84 per cent as of September 2007.

This trend indicates two things. First, new money is coming in which is dedicated to this segment. Second, even the existing funds seem to be going more towards these companies.

Also, there lies an immense scope in the form of new listings that may happen. Whenever new IPOs come, they typically come in this range only. That’s where new business opportunities will also exist. They will bring new sectoral representation and new ideas.

What are the selection criteria you would use for small-cap stocks?

Our stock selection will depend on five different crucial points. The first criteria would be the business niche. We strongly believe that small-cap companies will definitely be operating in business niches. So, we will have to find in what niche they operate.

The second factor would be the attractiveness and scalability of their business model. Scalability would depend on management capability, the third criteria.

Pricing flexibility of these companies will be our fourth factor. For instance, take the auto component industry today, the small-cap and mid-cap companies.

On one hand the raw material costs are on a rise and on the other hand, the OEMs are not increasing prices. So there is problem with the pricing flexibility.

The last criteria would be the potential for the company itself to unlock value. Value unlocking will depend on how the company plans to take its businesses forward; either by way of hive-off or partnerships.

The other way could be by way of acquisitions; these companies can become acquisition targets for the large cap and mid-cap companies. Small-caps are not always about growth. We believe there are some value investments also, which will lead to value unlocking going forward.

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