“Small-caps are important wealth creators and have become too big to ignore”

With the belief that it is the length of the growth runway that counts in the long run, Trust Mutual Funds has focused on small-cap companies that are often in the highest growth phase of their lifecycle and can sustain this momentum for one or two decades. In this interview, Mihir Vora, CIO, Trust Mutual Funds, elaborates on this investing philosophy.

As the CIO of Trust Mutual Funds, what has been your core philosophy when managing investments, particularly in the Small-Cap space?
At Trust Mutual Funds, our investment philosophy is to buy stocks with high and sustainable growth at appropriate valuations. It is called terminal value investing. The crux of the philosophy is that for high-growth stocks, the valuation (market capitalisation) is determined not by the next few years of profits and growth, but by the length of the growth runway, i.e. the growth rate beyond the next few years and the sustainability of the same. Small-cap companies are perfectly suited to this philosophy as small-caps are often in the highest growth phase of their lifecycle and can sustain this growth for 10-20 years. The length of the growth runway can be very long, lasting many years or decades for small-caps.

Small-cap funds are known for their growth potential but also their volatility. According to you, what makes small-cap companies an attractive investment option despite the inherent risks?
Mid-Caps and small-caps are important wealth creators and have become too big to ignore. About 15-20 years ago, mid-caps and small-caps used to be 20 per cent of the market capitalisation. Today, they are almost 40 per cent. In 2020, the number of small-caps with a market capitalisation of more than Rs 2,000 crore was about 220 while today the number is 800 – a four-fold increase. The largest small-cap used to be around Rs 7,000 crore in market capitalisation while today it is around Rs 30,000 crore.

Moreover, in many high-growth segments, the options are exclusively or predominantly in small-caps or mid-caps. For example, there is no Large-Cap stock in the hotel sector and consumer durables segment. There are only two large-cap chemical stocks versus 60 small-caps and two real estate large-caps versus 30 small-caps. There are many high-growth sectors where there are 10 times the number of choices in small-caps versus large-caps.

Contrary to the current popular narrative, valuations are not expensive for small-caps. The PE ratio of the Nifty Small Cap 250 is similar to that of the large-cap Nifty 100 index at around 19-20 times. However, the projected earnings growth for small caps is higher at 18 per cent for the next couple of years versus 8-10 per cent for large caps. So, growth-adjusted valuations are not that expensive for small-caps. All these considerations make small caps an exciting space to invest in.

What are some of the key characteristics that you look for in small-cap stocks that have the potential to grow to mid-cap or even large-cap status?
We believe that there are three variables which, if they come together, create gorillas i.e. companies which are rare to find but become dominant, unchallenged with longevity of growth. These variables are leadership, intangibles and megatrends. Leadership encompasses vision, culture, management depth, governance, hunger for growth, execution excellence, etc. Intangibles include technology, brands, intellectual property, etc. Megatrends are long-term demographic, economic or technological trends which are irreversible.

Are there any emerging themes that you are particularly excited about in the small-cap segment? What sectors or industries have shown the most promise in recent years, and what factors are driving this growth?
The sectors we like fall into three broad themes: rising income levels, physical asset creation and technological disruption. Rising income levels mean that premium item consumption growth will be higher. This means segments like premium vehicles, premium real estate, jewellery, consumer durables, hotels, airlines, etc. It also means that segments which cater to financial savings will grow faster – insurance, wealth management, asset management, broking, exchanges, depositories, registrars, etc. Physical asset creation includes sectors like real estate, capital goods, construction, infrastructure, power, defence and railways. Technological disruption includes all the new-age companies in the B2B and B2C space, which use technology to create new business models or to disrupt the existing ones.

How do you view the current developments in the Chinese equity market, particularly the high activity in the option series, and what impact do you foresee this having on foreign institutional investors (FIIs) inflows into the Indian market?
The flow of money to China debate is pretty much settled after the events of last week. Equity investors have not made money in China in the past 25 years – the period in which China went through its greatest period of growth and became a global manufacturing powerhouse. If one didn’t make money during the best of times, how do you expect to make money when it is struggling for growth and the government is taking knee-jerk, desperate measures to stoke growth and consumption? The demographics are against China and in favour of India. So structurally, India should continue to attract flows. It is too risky to bet against India.

The Securities and Exchange Board of India (SEBI) has introduced several regulatory changes to protect investors and improve transparency in the mutual fund industry. How has Trust Mutual Funds adapted to these evolving regulations and what are your thoughts on the impact of these reforms on the industry?
At Trust Mutual Funds we have proactively embraced regulatory recommendations and implemented them even when they are not mandatory. For example, there were regulations to stress-test the small-cap and mid-cap portfolios to ascertain how long it will take to generate liquidity. While we had a flexi-cap fund and the rules did not apply to us, we went ahead and stress-tested our portfolio to check for the liquidity of our holdings. We believe that SEBI regulations have gone a long way in protecting the interests of the small unit holders and have ensured complete safety and transparency at multiple levels. 

Mutual fund penetration in India is still relatively low compared to global standards. What efforts is Trust Mutual Funds taking to increase financial literacy and spread awareness about the benefits of investing in mutual funds?
Mutual fund adoption and penetration is rising rapidly in India with an increase in investor awareness and the ease of investing in mutual funds through online tools. At Trust Mutual Funds, we are looking to conduct investor education programmes at multiple locations and in multiple languages. We emphasise on the importance of correct asset allocation, taking the help of an advisor or distributor and staying invested for long periods of time to tide over market volatility and benefit from India’s unfolding growth opportunities.

In your opinion, how can mutual funds contribute to long-term wealth creation for retail investors?
Mutual funds offer one of the most cost-effective, tax-efficient solution structures to create and preserve. There is a vast variety of funds to cater to any sector or asset-class view that any investor may want to participate in. The low ticket size required to invest and the fact that regular investment and withdrawal plans are available to make mutual funds infinitely flexible to match the cash flow and income requirements for any age profile. As long as they stay invested, investors do not get exposed to capital gains tax – whatever churn the fund does within the portfolio has no tax implications for the investor. Thus, the impact of tax-efficient compounding can be fully enjoyed by investors for long-term wealth creation.

Disclaimer: The opinions expressed above are personal and may not reflect the views of Dalal Street Investment Journal.