Mid, Small-Cap Selloff Does Not Deter This Fund Manager
The SMID space is experiencing a downtrend after SEBI asked mutual funds to proactively protect investor interest.
The broader markets plunged on Wednesday, but ITI Asset Management's Rajesh Bhatia still asserts that the India story is seen in the mid and small caps.
The S&P BSE MidCap fell as much as 4.82% during the day to 37,344.69, while the BSE SmallCap declined 5.42% to 40,503.53. The indices eroded as much as Rs 5.58 lakh crore in market cap intra-day.
Over the medium term, the mid- and small-cap stocks are exciting. However, the volatility associated with the mid- and small-cap space can be high, according to Bhatia.
"We are fairly excited about the small, mid-cap space as far as medium to long is concerned," the chief investment officer told NDTV Profit's Niraj Shah in an interview.
Bhatia underscored that far more rapidly growing opportunities, which capitalise on India's growth potential, are being discovered in the mid-cap and small-cap segments in comparison to the mega caps.
The corrections being currently observed are considered very necessary and healthy and it is still a bull market, according to Bhatia.
The SMID space is experiencing a downtrend after the Securities and Exchange Board of India asked mutual funds to proactively protect investor interest amid "froth" building up in the broader end of the Indian equity market. This is the first time the market regulator has taken such a step.
Mutual fund trustees have also been asked to put steps in place to ensure that investors are protected from the impact of the first-mover advantage of redeeming investors.
ICICI Prudential Asset Management Co. has suspended fresh investments through the lump-sum mode into its mid- and small-cap funds, effective Thursday. Switching into the mid- and small-cap schemes from other schemes of the ICICI Prudential will also be suspended.
The move to temporarily discontinue subscriptions is undertaken to protect investors from sudden market movements. No transactions shall be accepted post-cutoff timings of March 13, the AMC clarified in a statement on Tuesday.
How To Tackle This Market
On how to tackle the small-mid slump Bhatia said investors should consider shifting towards stronger business models, where there is no doubt about the execution capability. These models typically exhibit less cyclicality and offer steadier growth prospects, while their valuations still appear healthy.
Exiting investments is advisable in instances where there are unsustainable earnings or other indicators of overvaluation, he said.
Watch The Interview Here
Edited Excerpts From The Interview:
You gave a very good line to me wherein that we might be at the early stage of an economic cycle, but valuations may be at the later stage of this cycle. Now put this into context for us. What does that imply from an investor's perspective?
Rajesh Bhatia: So basically, you know, we've been kind of maintaining all along since the bottom in March 2023 that we like the quality of the rise of this market, because the breadth of sectors that have been participating in the markets would suggest to us that this is a bull market.
You should notice that a lot of economically sensitive sectors have been participating on the rise. And you should also know that markets are usually a leading indicator of the economy as well and that's why, it kind of tells you that this is a startup in the economic cycle. And it's only been a few years and you can see that in various things, especially on the capital expenditure side, but you can see that a lot of what has started is a five-year, seven-year story. I think, you know, as far as the power sector is concerned, there is $500 billion of investments—like half a trillion dollars of investments—to come in the next 5-7-10 years as far as the semiconductor ecosystem that has been created, as far as roads, railways, real estate, that kind of capex that is happening. A lot of that capital expenditure cycle is really at the start of the economic cycle and I think the market seems to be kind of suggesting that as well.
So as an investor, of course, I think there's a lot of debate on whether the valuations are expensive or not, and what should you do about that. As an investor, I worry if I was in the late stage of a valuation cycle and a late stage of an economic cycle. What do I mean by that?
You know, between 2003 and 2007, we had an economic cycle, which was really long. In the last three years of that economic cycle, the GDP grew at 9%. That was a really overheated economy, and then the valuation cycle also kind of extended itself. What was 15 times earnings average for the last five years—between 2003 and 2007—became 23 times. So you became at the late stage of the valuation cycle as well. What was the result of that? Markets corrected 50-55%, which was the worst year in 30 years for the Indian stock markets. Fortunately, maybe, we are perhaps at an early stage of an economic cycle, even though I think there is some valuation debate whether we are overextended on the valuation side.
I think the correction that we are seeing right now is probably healthy. I think we're still in a bull market. But bull market corrections can be violent. I think there was excessive enthusiasm in the mid caps and small caps. So the fact that they are correcting is a very, very healthy phase of the market and a very necessary one in a bull market as well. So that's really what I think is going on at this moment.
Sorry, if I don't know whether you guys have an active multi-cap, or a flexi-cap, or a small-cap fund. But, if you had one, or if you do have one, would you be deploying money right now, or would you still be biding your time, in the small-cap end?
Rajesh Bhatia: Basically, we are an institution. And of course, we have all of these funds as well. We are fairly excited about the mid-cap and the small-cap space, as far as the medium to long term is concerned. You know, the last time I spoke to you, I said, while there is value in the mega caps, the India story is in the mid caps and the small caps.
I think over a longer period we are finding far many faster growing opportunities, which leverage the India growth opportunity in the mid-cap and small-cap space than we are finding in the mega caps. So over the medium term, we are excited but you know how the mid-cap and small-cap stocks behave.
In a bull market, the marginal buyer decides the price and in a bear market, the marginal seller decides the price, because these are illiquid relative to the mega caps. So of course the volatility that is associated with mid caps and small caps is higher. So, given that context, we would feel that over a medium term, I think it's still good to be in the mid-cap and small-cap space. There is an excessive enthusiasm. You have to be selective. This is the time to improve the quality of your portfolio because in a bull market, what tends to happen is while good stocks go up, bad stocks go up as well. So fortunately you've been given an opportunity to improve the quality of your portfolio as you move forward. But over the medium term, we continue to be bullish on the mid-cap and small-cap space.
Let's say, a flexi-cap portfolio of Rajesh Bhatia had 250 stocks. You don't, which is why I am doing this hypothesis. And there is a chance given to improve the quality of the portfolio. What is it that will exit the portfolio, what is it that will get enhanced in terms of weightage in the portfolio?
Rajesh Bhatia: So, I mean, you have to look at it from various perspectives. So let's say, if there is a high-beta sector that has done exceedingly well and the valuations don't seem comforting to you anymore. You should exit those opportunities. There are stocks in the public sector category, which have undeservedly gone up to an excessive amount. So we don't own it, but there is an NBFC in the PSU space, which quotes at four times the price-to-book. So of course, you need to exit that.
We have to also remember that in this bull market, we have benefited enormously from cost of goods coming down. So, gross margins of companies have benefited enormously. Now as you move forward, the earnings growth has to be driven by the top line, because you already got your margin expansion. Let's say, if that was the case for a two-wheeler business, or a tyre business, which benefited enormously from cost of goods sold coming down and therefore margins have expanded. But you don't have a view that the top line is going to accelerate in a very strong way. But yet the valuations have kind of gone up significantly. You should take those profits. I hope I made the point of what you should be kind of getting out of.
What should you move into? You should move into stronger business models—ones, where you don't doubt the execution capability. So, strong business modes, less cyclical and steadier growth prospects, where the valuations still appear healthy to you. Let’s say like a general insurance company. So that's really what we have done as well. We have improved the quality of the portfolio. So, in effect, we have reduced the beta for our portfolio.
Is this improvement of the portfolio’s quality, valuation-led primarily at this stage of the market cycle, or is it that you are comfortable buying into growth at a slightly more than reasonable price?
Rajesh Bhatia: So, anywhere where you see unsustainable price earnings, you should exit. As fund managers, we are always evaluating that.
Look at the history of the Indian markets. There were some fund managers, who said we will only buy great franchises regardless of price. And of course, they got creamed later on. Now, today, the feeling is that everybody should be in the public sector enterprises, etc. So the thing is that these themes keep changing.
As fund managers, you have to continuously improve the quality of your portfolio. You have to sell what you think is excessive, even if they are great businesses. So what tends to get overvalued, you sell and you look for good businesses, but where the intrinsic value still makes sense to you. From a philosophy perspective, you kind of keep churning your portfolio towards a portfolio where you sell what is excessively overvalued, and buy ones which you think are still from an intrinsic value perspective healthy. So that's really the approach that we are taking.
Consumers, staples in particular, have had a bit of lacklustre performance in the last few quarters, if you will, save for maybe ITC, which maybe had a good run and then now lumbered over the last one year. What do you do with staples?
Rajesh Bhatia: I think we spoke about it the last time as well. I think the recovery in the staples and overall consumption space minus high-end discretionary seems to be very, very weak and elusive. The recovery seems to be quite elusive and we're not able to see that recovery. And it confounds us that 1.4 billion people are not seeing the same type of recovery in consumption.
Be that as it may, I think it's very difficult to preemptively call this recovery because we've been trying to do that for the last, you know, couple of years. Neither do the valuations of these companies give us any comfort that look, you know, there's an option value in case the recovery does take place and then the upside is really very big, if that happens. So neither are the valuations that comfortable.
As far as a fund manager, what I can tell you is, I am finding so many other sectors—whether it is general insurance, life insurance, telecommunications, domestic pharma, global pharma, and power sector—where I can see multi-year visibility of growth. So, fortunately, I am able to create a fairly diversified portfolio of multi-year growth opportunity companies, strong companies within all of these sectors. So to that extent, my temptation to preempt a consumption curve is quite low.
Power and defence, after having a strong move are seeing some bit of pushback. Maybe the PSUs, per se, are taking it on the chin, so to say. Do you use this as opportunities to enter into some strong companies?
Rajesh Bhatia: Like I said, let me reiterate. We are in a bull market. This is a correction in a bull market. Correction in a bull market can be very severe, very quick and very swift. From a power perspective, of course, I think you'd have to kind of like I said, everything goes up in a bull market. So you have to make sure that you are in the companies that you want to be. So let us say there we are in regulated, you know, equity companies in the power-producing space. And we feel that those companies being government companies have a cost of capital advantage and there's a lot of runway for them to increase capacity. There was a time in the power space when people felt that this is a dying sector. What is the terminal value of these businesses? Suddenly they found out that your peak power cannot be compensated by just wind and solar and you still require thermal. So suddenly there's now a reassessment of the terminal value of these businesses.
So my sense is that these companies will kind of continue to do well and I think there's a multi-year capital expenditure cycle ahead of them, which they will benefit from.
Do you play ancillaries at all, Rajesh? There has been a lot of talk around change of policy which may disrupt those ancillary businesses. The companies are saying that, hey look at the capacity addition and then think of, you know, what can happen. Are you playing power ancillaries at all?
Rajesh Bhatia: We are playing power finances, per se. And again, we think that's a multi-year opportunity, and I think they again have a cost of capital advantage and any NPAs, I think, are quite a distance away. So my sense is in the NBFC space, that's a very preferred pocket for us to go to.
A lot of people tell me about looking at sectors, which have got large global weightages, and maybe the Indian weightage as of now is not that strong. Some parallel is being driven to real estate in the past being at 7-8% or whatever and currently less than 2%.
The other being, you know, tech companies and the internet companies being a negligible part of the index. In fact, on the Nifty, hardly any weightage and people said that if you look at global markets, these companies have had an outsized 10-15% weightage as well, and India will definitely go there. Any thoughts here, on either of these two points?
Rajesh Bhatia: First of all, the real estate bubble of 2008. I think it was a bubble and companies were measured on land banks. So there was a total irrationality to valuation and that's why it became 6-7% of the overall market and it's about whatever, 1.5-2% as we speak. So that was a bubble and the valuation metrics that were used at that time are not necessarily what is being used today and it's sensible to kind of evaluate them on earnings, etc, rather than on pure land banks.
See, as far as IT is concerned, my sense is that the recovery is fairly elusive. I heard you in the morning say that, you know, the hiring of IT personnel is at a 14-year low, or thereabouts. So there are no early signals to a recovery as far as IT is concerned. So my sense is that even that space, I think, offers less visibility. Again, I'd like to point out that there are just so many other sectors where I have multi-year visibility of growth and these are strong companies that make me comfortable that I can have a portfolio of these companies and yet come out quite well as far as equity earnings are concerned.
What about internet companies? I mean, there's food delivery, there is fintech, etc. Are you constructive in that bucket? Why or why not?
Rajesh Bhatia: I am excited to play anything that plays the India opportunity and I think food delivery and quick commerce are certainly among those, which we have been playing as well. These are emerging business models, I agree. But, I think, the focus has suddenly come to profitability and these companies promise to grow at 40% per annum for the next few years. So, the economics are improving, these are fast-growing businesses, and you can see that it's turning into kind of an oligopoly. Of course there will be new players who will come in, but it's an oligopoly kind of a business. So my sense is, from a structure perspective, profitability perspective, and growth perspective, these make enormous sense as we move forward.
