Many quality mid and small-caps have also come down in the last 12 months. They are not trading at frothy valuations any longer, says Sachin Shah, Fund Manager, Emkay Investment Managers

Cherrypicking some mid and smallcaps and staying with them for the next 2-3 years has the potential to deliver good returns. Most of the retail investors should restrict their smallcap allocation in the range of 10-25 per cent of their total equity exposure, Sachin Shah, Fund Manager, Emkay Investment Managers said in an interview to Moneycontrol’s Sunil Shankar Matkar.

Edited excerpts:

Q: How does one position oneself in current market condition ahead of general elections?

A: The markets have been quite choppy for the last 12-13 months (CY2018), although the headline (Nifty and Sensex) indices don’t look so bad, most of the stocks are down in the range 10-30 per cent and many in the mid and smallcap space are down even more.

The flows into the domestic mutual funds have also reduced considerably compared to CY2017. Therefore the valuations of many businesses have now become quite reasonable.

At the same time, the corporate earnings outlook is much better for the next couple of years, as benefits of the big economic reforms such as demonetisation and GST should now play out. A greater focus of the government on the rural economy should also help the overall pick-up in the aggregate demand. Therefore, it is a good time for investors to allocate funds to Indian equities with a perspective of the next 2-3 years.

Q: Many mid and small caps are trading at attractive valuations after sharp correction since 2018. Do you advise to pick to those stocks?

A: Yes, many quality midcaps and smallcaps have also come down in the last 12 months. They are not trading at frothy valuations any longer.

So from that perspective, cherrypicking some of those midcap and smallcap and staying with them for the next 2-3 years has the potential to deliver good returns.

Q: In the past, midcaps and smallcaps have given more concerns than large-caps. Do you feel the scenario will continue for the next few quarters?

A: Firstly, there is no question that investing in small-caps does have its inherent risk in terms of the small businesses being much more vulnerable to external and internal challenges. Also, higher volatility of share prices and poor liquidity results in higher impact cost during investing and exiting in such companies.

So keeping all these factors in mind, investors definitely need to have a reasonable allocation to small-caps of their overall equity exposure. My sense is, for most of the retail investors, they should restrict their smallcap allocation to in the range of 10-25 per cent of their total equity exposure.

Secondly, smallcap investing is largely a bottom-up game, i.e. very company-specific investing, therefore just looking at the overall smallcap index may not give you the very correct picture. This is simply because the difference in returns for the bottom end of the list, the median return and top end of the spectrum among small-cap stocks is very very wide.

Therefore the key to investing in small-caps is buying good quality stocks that have:
a. Management with strong capability and high integrity
b. Strong balance sheet – low to zero debt,

  1. Sustainable business model – cash flow positive businesses

To understand the above three, a study of the company’s long track record is very important and then the most critical part is to understand the growth outlook and scalability of the business for next few years.

Q: If one wants to build a portfolio, what themes one should look at?

A: From a retail investor’s perspective, having the right allocation to different asset classes and within equity, plus a very balanced allocation to large-cap, midcap and small-caps keeping in background the individual profile and goals are very critical.

Q: What are things one should take care of or avoid while building a portfolio?

A: Firstly, the selection of right management and businesses is very critical (as explained above). Secondly, allocation discipline is very critical – for e.g., no single stocks or sector should have a high concentration in the portfolio.

Thirdly, from the investors perspective, they need to give adequate time. Anything less than five years may not make sense for true investing.

Therefore, while selecting the company, investors need to study the track-record and have a disciplined investment process on the above parameters.