Dear Investors,
The following chart depicts our returns viz BSE 500 TRI:
In this month’s newsletter, we discuss the hot topic of frothy valuations of Indian small and mid cap listed companies. We have already covered this topic multiples times in the past but admittedly it remains the top concern for anyone interested in deploying fresh capital in small & mid cap equity strategies like ours.
As always in the past, we will start by repeating our stance that it is impossible to perfectly time the market. No one can predict the future and we feel it is a wrong strategy to take an overall cash call on the portfolio and exit the market believing stocks are overvalued with very little upside left. This is because though valuations may be stretched in the near term and markets poised for a short-term correction, the long-term prospects over the next 3-5 years may still be very bright. Leaving aside frothy valuations, the state of the Indian economy is quite healthy with leverage of corporate India and bank NPAs at all time low, inflation coming down and high possibility of rate cuts not only in India but globally, Indian forex reserves at all-time high, a central govt. that is highly focused on lowering fiscal deficit and improving sovereign credit rating and thus cost of borrowing, etc. So, the chances of the Indian economy performing well is quite high over the next 5 years.
In that case, one might miss the long-term gains just to avoid near term pain and drawdown. The problem with an overall portfolio level cash call or staying out of the market is it is impossible to time your re-entry into the market and one may completely miss the long-term bull run. This happened with investors who exited the market during the outbreak of Covid in March 2020 or during the correction phase of Dec 2021-March 2023. Most of them were never able to re-enter the market subsequently due to anchoring bias and missed the subsequent bull phases.
In summary, we will never take an overall cash call based on market levels and sit out. However, we closely track the valuations of our existing positions and are quick to exit ones that have become so expensive that they don’t offer any incremental upside rationally over the next 2-3 years. In total, we have sold 26.5 Cr of stocks in YTDCY2024 (~10% of June end AUM) and are continuing to exit positions that don’t offer attractive risk reward anymore.
We will begin our analysis by looking at the current state of overvaluation in Indian equities. The table below shows the past 5 years CAGR ending in June 2024 of large, mid and small cap benchmark indices. It is very clear that mid and small cap indices have comprehensively beaten the large cap index by a huge margin. The same is true for the broader markets with share price appreciation of small and mid cap companies in general has been much higher than that of large cap companies
The sharp increase in valuations of the broader market is highlighted by the below chart showing the P/B valuation of constituent companies of the BSE 500 index. The % age of companies in the BSE 500 index with expensive valuation of over 5xP/B is at an all time high of 55% currently.
Source: ACE equities
Another chart below highlights the sharp rerating in valuations of mid cap companies historically. Currently, the share of mid cap companies with 1 year forward P/E of 60 or higher is at an all-time high
We have enough evidence of valuations of most small and mid-cap companies at an all-time high. However, we have also taken a position of not timing the market and continuing to remain invested / deploying capital. So, how does one minimise the risk of suffering permanent capital loss or subpar returns over the long term. We think there are 2 things to do to handle the current situation. One, which we have already shared at the start, is to handle stock expensive valuations in a bottom-up manner.
As your portfolio manager, we are prudently exiting positions that have become overvalued and rationally leave very limited upside over the next 2-3 years. Also, we are becoming very cautious about investing in new positions. We have become even more disciplined about our entry valuations and business quality and are happy to invest in a staggered manner and hold large cash positions, especially in newer portfolios. However, we are still finding opportunities that are reasonably valued even in current markets so deploying capital is still not a challenge we are facing. These are in sectors / niches that markets do not find hot because these sectors may be going through some near-term challenges. For example, our recent investment in PI Industries, whose stock price has only appreciated by overall ~30% despite delivering a 19% CAGR in the last 3 years (P/E rating has almost halved in the last 3 years). This has happened because of the market's fear of near-term challenges that the agrochemicals sector is facing because of incessant dumping by Chinese agrochemical manufacturers. To summarise this point, we have become cautious about overvaluation in our existing positions as well as about not overpaying for any new investments.
The second and much more important strategy to tackle current market levels is to be committed to remaining invested for the longer term. There is no strategy that can avoid corrections in equity investing completely otherwise it would make equities guaranteed investment products, which they are not. When markets suffer corrections, a prudent strategy will most probably suffer a lower drawdown. To completely do away with the risk of negative returns, the only way is to remain invested for long horizons.
Source: NSE; All above returns are in CAGR (per annum)
The chart above highlights that the minimum return that an investor could have made by remaining invested in Nifty 50 TRI index for 7 years historically is 5% per annum. The minimum return increases to 9% per annum if one is committed to investing for 15 years. On the other hand, the worst possible return in a single year is as high as 55%. So, the message is loud and clear for the investor that he/she needs to be patient and suffer short term corrections to lower the risk of poor returns. In fact, no matter how good the strategy of a fund manager is, the onus is on the investor to remain invested for the long term to take benefit of that.
Another chart (source: ET online) below highlights the benefits of remaining patiently invested for the long term. The worst performing small cap fund has delivered an IRR of 16.36% over the past 10 years ending on July 8, 2024. We believe this is a very healthy return across all asset classes like real estate, fixed income, gold, etc over the past decade. So, the importance of being patiently invested for 10 years is much more than the MF selection at the beginning because the 10 years return is very healthy even in case of the worst performing MF.
We are not making this point to absolve our duty of generating alpha for our investors but just to drive home the importance of being patient long-term investors. We firmly believe that there are very few investors that would have stayed invested for the past 10 years in these small cap MFs to take advantage of the attractive returns generated.
The table below highlights the drawdowns suffered by these same small cap MFs over the past 10 years. Most of these MFs have suffered huge drawdowns during the long phase of correction in Indian small cap stocks from 1st Jan 2018 to 31st March 2020 (only exception is Axis Small Cap MF, highlighted in yellow, that has a commendable track record of much lower drawdown than category average over a much shorter phase). The small cap MF category average max drawdown is 41.53% during the last 10 years. Very few investors in these MFs would have remained invested during this prolonged 2 years + phase of correction and thus were able to enjoy the bull phase from March 2020.
Source: Morningstar.in; Funds are listed top to bottom in the above table in decreasing order of past 10 years returns
In summary, we just want to emphasise that we are aware of the frothy valuations of small / mid cap stocks and are taking steps to lower drawdown risks by exiting expensive positions as well as being cautious in making new investments. However, we are still finding undervalued opportunities with good prospects to invest in the market, so deployment is not a constraint for us. For our existing and prospective customers, our advice is just to keep their return expectation realistic and not extrapolate the very high small cap returns of the past 3-4 years to the future. Also, invest now with a patient long term investment horizon of 3-4 years + at least so that the starting point becomes irrelevant.
Please feel free to reach out if you have any questions.
Regards,
Prescient Capital