Smallcap stocks: Resham Jain of DSP Mutual Fund shares his investing mantra, prefers these emerging themes

Smallcap stocks possess an inherent advantage of being under-researched, which presents opportunities for potential mispricing, says Resham Jain, Fund Manager at DSP Mutual Fund. In an interview to Amit Mudgill of BT Markets, Jain said he prefers smallcap themes such as domestic consumption, infrastructure & engineering, healthcare, manufacturing, sustainability, technology and financial services. Edited Excerpts: 

>Smallcap equity funds have seen a sharp surge in flows of late. What has led to the trend and is it sustainable?

The impressive performance of small funds in recent years has attracted the interest of many investors. A significant number of funds in this category have consistently outperformed their benchmarks over both five- and seven-year periods when compared to largecap funds. Furthermore, awareness of mutual fund investments has seen substantial growth over the past five years. Investors have come to appreciate the benefits of maintaining their SIPs (Systematic Investment Plans) even during market volatility. This positive investment experience has motivated them to persist with their SIPs, leading to a noteworthy increase in inflows.

>Smallcaps, many a time, rally at the fag-end of a market rally. But is this time different? If yes, how?

Over the past two years, we have witnessed a noteworthy improvement in corporate earnings and a reduction in leverage on balance sheets. This positive financial performance has been accompanied by an increase in stock prices. While historical market cycles have often seen smallcaps surging towards the end of a rally, it's important to recognize that market sentiment can sometimes override fundamental factors. During the Covid-19 pandemic, for example, we saw how extreme negative market sentiment led to a significant correction. However, the current market situation seems to be characterised by a more positive sentiment, with a greater focus on the upside potential rather than downside risks. As a result, valuations may appear slightly more expensive than historical averages.

>What is your mantra to smallcap investing? As a fund manager, what are the key aspects you watch before identifying an investable set of smallcap stocks?

The universe of Small Cap companies is vast and encompasses a wide range of industry sectors. Selecting the appropriate set of companies requires a multifaceted approach. Financial parameters are highly useful in screening the right companies, but there are several other crucial factors to consider when identifying companies within the Small Cap category. These factors include the size of the opportunity, the quality of management, the organizational structure, capital allocation practices, competitive intensity, regulatory framework, HR policies, governance standards, and more.

These stocks possess an inherent advantage of being under-researched, which presents opportunities for potential mispricing.

Furthermore, their smaller size offers them greater potential for growth, as they have a longer runway to expand. Additionally, their ability to reinvest their limited cashflows into the business at higher return on equity (ROE) enables them to achieve faster growth compared to larger companies. These characteristics collectively make small cap stocks an attractive choice for investment.

>Smallcap is all about bottom-up investing but there would surely be certain common sectors where you are finding valuations reasonable and growth prospects strong. Which are they?

The small cap universe offers a wide range of sectors and sub-sectors that are not accessible through the midcap and largecap categories. Investing in these sectors provides exposure to rapidly growing industries.  The formalisation of Indian economy is providing opportunity to gain share from unorganised companies as well. Many of these small cap companies have established themselves as leaders in their respective fields, both domestically and globally. Moreover, as the Indian economy keeps growing, they could gain scale which will make them more competitive at global levels. A prime example is the chemical sector, where several small cap companies have successfully transitioned to midcap or largecap status over the past decade.

We see opportunity across multiple such sectors. We currently like themes related to domestic consumption, infrastructure & engineering, healthcare, manufacturing, sustainability, technology, food & agri and financial services. Each of these themes offers varied opportunities. For example, within domestic consumption, we like themes related to changing lifestyle & demographics which include sub-sectors like QSR, home improvement, fashion, among others.

>Do you think individual investors need to be cautious, given the volatile global environment? Do you think many smallcap stocks look expensive after the recent rally? Do we have better opportunities in largecaps space?

Smallcap funds have already delivered handsome return year-to-date despite volatile global environment. Given the current valuation there is a possibility that market may remain range bound or could marginally correct as well. Hence, investors with short-term horizon should refrain from investing in this category. However, investors with long-term horizon (5-10 years) and SIP may continue to remain invested. On the other hand, large cap valuation at this points looks more palatable.

>Entering a smallcap stock is easy but getting an exit is sometimes difficult. What is your view?

The smallcap category generally exhibits lower liquidity when compared to midcap and large-cap companies. Consequently, both entering and exiting positions in this category may result in higher impact costs. Therefore, it is advisable to formulate an investment strategy with a slightly extended time horizon in mind. The average holding period of stocks in DSP Small Cap Fund on an average is five years which is reflecting through our turnover ratio.

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