Can value-focused Quantum MF crack the small-cap code?

Quantum Mutual Fund (not to be confused with Quant MF) has been one of those promising investment managers that never aggressively went after asset gathering. As India’s first direct-to-investor mutual fund, Quantum chose to play it differently. Over 17 years it has launched only three actively managed equity funds — namely Quantum Long Term Equity Value, Quantum Tax Saving, and Quantum India ESG Equity.

After a gap of over four years, the fund house, backed by Canadian billionaire Prem Watsa, has launched its offering in, arguably, the riskiest part of the market: small-caps. The new fund offer of Quantum Small Cap Fund closes October 27. Driven by copious inflows, is there any steam left in small-caps, which have already risen over 36 per cent (CAGR) in the last three years? More importantly, will Quantum MF, known for its value investing lineage, be able to strike gold in the growth-oriented small-cap space? Here is a lowdown.

Quantum’s small-cap strategy

Small-cap stocks have the potential to create wealth and generate alpha returns as they are under-researched, often mis-priced, innovative, or niche businesses with a long growth runway and scope to increase market share. Having recognised all this, most leading asset management companies (AMCs) dug their heels deep in the small-cap space. Funds such as Nippon India Small Cap (5 stars), SBI Small Cap (4 stars), Axis Small Cap (4 stars), HDFC Small Cap (3 stars), and Kotak Small Cap (3 stars) have a track record of wealth creation.

Quantum MF believes that, of the many small-cap funds available today, the right one is that which prioritises liquidity and does not stray from its mandate. Because of the gold rush for small-cap funds, such offerings with a large AUM (assets under management) can become over-diversified and face illiquidity, with a negative impact on performance.

Quantum MF’s two existing funds (value and equity-linked savings scheme or ELSS) are currently rated 2 stars by our MF rating system due to below-average performance.

First principles

The Quantum Small Cap Fund will be a high-conviction, diversified portfolio of ‘quality’ small-cap companies. The fund aims to adhere to a few key principles mentioned below:

1. True to label — Quantum Small Cap Fund aims to keep fund capacity under control to maximise performance. Despite small-cap stocks seeing a buoyant performance, four out of eight mega small-cap funds (with at least Rs 10,000 crore individual AUM) have under-performed the respective benchmark in one- and 3-year periods.

2. Liquidity priority — The fund will focus on stocks with minimum Rs 2 crore average trading volume per day. Some peer small-cap funds also have liquidity filters.

3. High-conviction portfolio — Quantum Small Cap Fund aims to maintain a 25-60 stock portfolio for optimal diversification to avoid becoming a ‘closet’ small-cap index. Note that there are small-cap funds from the stables of Nippon (200 stocks), Bandhan (116 stocks), ABSL (107 stocks), HSBC (93 stocks) and Axis (96 stocks) with a long tail.

4. Limited ownership — A holding limit of 5 per cent of market capitalisation in all stocks. This limit is not unique, as among over 20 small-cap funds, few individual schemes have more than 5 per cent in one stock. At the same time, the Quantum offering wants to keep a minimum weight of 2 per cent (at cost) in each stock. This is good because many peers have less than 1 per cent weight in many small-cap stocks, leading to nil major impact even if they turn multibaggers.

These apart, Quantum Small Cap’s portfolio of stocks will aim to have broad exposure to various sectors. It will reflect three broad themes: domestic consumption, exports, infrastructure development.

The fund will be benchmarked to S&P BSE 250 Small Cap TRI.

Value/growth conundrum

Over the years, the team has been rejigged at Quantum MF. Notwithstanding the changes, the fund house’s value focus appears unchanged. According to ACE MF, the portfolio PE of Quantum Long Term Equity Value is about 28 times — which is at the lower end of category and peers. Similarly, the value bias of Quantum Tax Saving (a sort of replica of long-term equity strategy) is evident if you look at its portfolio valuation. Even Quantum ESG’s portfolio PE at 43 times is lower than that of quite a few ESG/ethical fund peers.

Small-caps are more about growth than value. Both the long-term equity fund and tax-saving fund have good value bias. Within the Indian market, navigating the small-cap segment can be likened to traversing a value investing minefield. It’s important to note that small-cap stocks trading at lower valuations often come with governance- or business-related challenges. So, becoming rigid on value investing may not help in small-caps.

In Quantum’s current fund portfolios, allocations to small-caps include Castrol, CDSL, CAMS, Dr Lal Pathlabs, Mahindra Logistics, Rallis, ABSL AMC, Exide, Gujarat State Petronet, ICICI Securities, and Nuvoco Vistas.

Our take

Historical analysis indicates that investing in small-cap funds after significant market declines, rather than during bull markets, can lead to better returns.

Picking small-cap stocks in India presents a distinct challenge compared to large- or mid-cap stocks. Small-cap investments necessitate a bottom-up strategy that involves staying attuned to governance practices and management decisions. So, we prefer small-cap funds with a specialist manager.

We generally lean towards small-cap funds that have a proven track record of weathering entire market cycles, both bullish and bearish. As the Quantum Small Cap Fund is a recent addition, it may be wise to wait until its performance is more established.

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