Dear all, in this memo we wanted to compare our performance viz major indices and answer the following leading questions:
Are we nearing the peak of the small/mid cap index? Is a correction imminent?
How does our portfolio stand in terms of valuation viz leading indices?
What are we doing to preserve returns in your portfolio?
Sectors that we find interesting to invest in
The chart below highlights our performance viz BSE 500 TRI index:
Our performance mirrors the rise in the small/mid cap indices and a lot of you might argue and ask if we are nearing the peak for these indices and a correction is imminent. We will try and answer this question through the following analysis.
NOTE: Calculated for data between Oct 1, 2009-June 20, 2023
We have tried to tabulate the longer term profiles of BSE 500 (representing largely large caps), BSE Mid Cap and BSE Small Cap index. From the data above the following observations are pertinent to set the right expectations:
Small and Mid cap stocks give you a higher return but one has to bear higher volatility, something that you may have seen in your portfolios over the last 18 months when compared to large cap stocks/portfolios.
We think and the data also proves that if invested well, the returns in small/mid cap far exceed the volatility. Between small and large cap, the median daily returns are almost 2x whereas the median volatility is higher by ~ 10%.
Over the last ~ 14 years, the BSE small cap index has been up ~ 58% of the time when compared to the BSE 500 which has been up ~ 55%. This also breaks the often believed myth that it's safer to invest in large cap stocks. Per us, most of the large cap stocks are often rich in valuation which increases their volatility and hence increases the odds of a downside.
Small/Mid cap investing requires a higher order of patience when compared to large cap investing as there could be elongated periods where earnings growth doesn’t translate into stock price movement. While there may be marginal daily movements, small/mid cap stocks can remain corrected for a long period of time.
If you consider data given above, a 50% correction in an index for a 2 year period is mentally very daunting for even experienced fund managers, leave alone the retail/institutional investors. Compare this ~ 50% prolonged 2 y correction in the small cap index to ~ 22% correction in a large cap index. This is where we enter the behavioural part of investing where conviction kicks in. We have often found portfolio companies demonstrating a healthy >15% earnings growth but their stock prices have corrected by 50% for 12-18 months. During this period we often dig in and do more work to build a conviction around strong future growth in earnings.
Capital invested during this period of a prolonged drawdown has the highest IRR. As shown by data too, capital invested during this prolonged drawdown in small cap index can compound at even an IRR of ~ 50% for a 2 year period.
It therefore becomes even more pertinent for fund managers who invest in small and mid cap companies to have a detailed understanding of their portfolio promoters, business and pay the right price. Any of these three if goes wrong, one could be looking at a prolonged period of correction.
The chart below highlights the movement of the small and mid cap index since Oct 2009:
Both Small and mid cap indices are up by 18-20% from their lows in the first three months this year. The indices have however returned 12-15% returns over the last one year. This implies that we are still not in the heated up zone.
We believe that a near term correction is likely given the global macros haven’t improved significantly. We therefore remain cautiously optimistic about investing in the small mid cap companies in the near term.
Our portfolio continues to be fairly priced viz leading indices. Our portfolio's median trailing 12 months PE is 20.7x compared to 24.3x for the BSE 500 index. Refer:
We continue to exit richly priced companies in the portfolio (Mrs Bector Foods exit at a TTM PE of ~ 55x, Hindware exit at a TTM PE ~ 40x) and add companies that are attractively priced (MM Forge entry ~ 17x TTM PE, Kirloskar Oil entry at ~ 15x PE, Jyothy labs entry at ~ 30x TTM PE, RPG Life entry at around 20x TTM PE, Just Dial entry at a cash to Mcap of ~ 75%).
We also continue to reassess and exit companies where our thesis needs more validation or where there is a risk of loss of capital. We already discussed our investments in agri chem space in the last memo. We also exited Sharda Motors post ambiguity around its Income tax paid and due.
During peaking markets it is imperative to not drop the quality bar. Value investors like us are often short of ideas due to rich valuation of good companies. Deployment of capital creates pressure to look for value bargains by either dropping the bar on promoter quality or by quoting secular growth for all (good to bad players) in a sector. This is a long term trap that may cause permanent loss of capital. We therefore continue to follow the discipline of taking 6-9 months to deploy your capital. This period gives us enough time to validate/revalidate our allocation behind a company and also provides time to take advantage of a downcycle in the markets. For instance, we were aggressive in deployment of capital during the March 22-June 22 period and Jan 23-March 23 period of correction.
Lastly, the on the ground outlook in India is tepid. The GDP growth of ~ 5% and bottoms up sector assessment also highlights the same:
BFSI: Will continue to demonstrate 12-15% credit growth for the next 12-18 m. Segments such as MSME are still struggling to come out of the covid impact. Personal loan growth has shown a slowdown due to degrowth in brown goods and personal vehicles. On the other hand, corporate, commercial vehicle and gold loans continue to grow. Housing loans growth may taper given the impact of rising interest rates.
Pharma: Domestic pharma continues to grow at 10-12% with chronic illness segments doing better than acute illness segments.
Cement: Demand continues to hold and easing raw material prices will improve margins and performance.
Manufacturing: Probably the only sector showing signs of a secular growth in demand across most engineering and manufacturing segments.
Auto: Sluggish 2W demand and slow growth in 4 W may persist in the near term. Strong demand for 2w EV and its components is a demand driver. Exports of auto components is a dominant driver.
FMCG: Sluggish demand for another 6 months due to high price rise and expensive inventory in the channel. Regional players expanding distribution reach, helping in growth.
Thanks & Regards
Prescient Capital