Large Caps Will Grow, But Small Caps Will Create Wealth, Says Samit Vartak

A large number of market advisers suggest putting money in dominant companies, which will get stronger as the Covid-19 pandemic decimates the weak. But investors’ chances of creating wealth lie with applying this principle to the small- and mid-cap stocks, according to Samit Vartak.

“The smaller companies are growing at a much faster rate than the dominant large-cap companies,” the founder and chief investment officer of SageOne Investment Advisors told BloombergQuint in an interview.

The Indian economy has witnessed a fall in credit growth and sales growth, eating into corporate earnings over the last five years as bad-loan saddled banks get more risk-averse. Credit is fuel to the economy and the lack of it’s the biggest problem for corporate India, he said. Return on capital employed, too, has been dropping at a time when both profit and inflation aren’t high, he said.

Concerned about the future of the Indian economy, Vartak said these risks have been factored into the broader markets which is why small caps have significantly outperformed the market in the last few months.

Other market veterans, including Bharat Shah, Raamdeo Agrawal and Saurabh Mukherjee, say that companies with strong balance sheets—which may to survive the Covid-19 storm—are likely to grow stronger as they attain market share of the weak companies that go bankrupt.

Vartak, too, said that his first filter is that to find a good business that can get through the tough times. His argument is that a small- or mid-cap market leader is likely to give more than a large cap.

The small-cap universe is made up of around 600 companies. Even if two-thirds of the companies are eliminated from these for poor quality, investors are left with 200 companies to build a portfolio from, Vartak said.

“As these are rarely tracked/researched by sell-side analysts, if one’s good at stock picking he/she can find tremendous ,” he said in a memo to the company’s clients while making the same argument.

In comparison, the large-cap space offers only 100 companies, of which once an investor eliminates poor businesses, they are left with 50 companies, most at extremely high valuations.

The move towards large caps is driven by recency bias, Vartak said. Since December 2017, earnings growth and valuation of high quality companies and the rest of the universe have diverged and hence the performance has seen a big divergence. However, he questions if this will continue going forward.

A good small-cap stock tends to double its earnings within three to four years, according to Vartak. In addition, assuming there is at least one bull cycle in five years, a stock’s valuation increases two-three times from the bottom of a cycle to the top of a cycle, he said. This gives the investor a potential and likeliness of four-times returns in three-four years, he said.