Actively-managed small caps have potential to generate alpha over long term: Aniruddha Naha

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July 09, 2021 12:48 PM

In an exclusive interview, Aniruddha Naha of PGIM India Mutual Fund shares his views on whether it is the right time to invest in small cap funds and what should be the strategy of investors.

New investors must be aware of the risks associated with an asset class before investing.

The markets in general might look a little stretched, but there are decent opportunities across the market capitalisation. Any investor who comes in with a 3 to 5 year time-frame should be able to benefit from the rising demand and profits for corporate India. So far as small caps are concerned, the segment has generated very strong returns in the last one year and hence one needs to temper down expectations over the next couple of years. Any investor who is looking to invest in small caps must come in with a 5-year view, and in such a case, should be able to realise good risk-adjusted alpha, says Aniruddha Naha, Senior Fund Manager-Equity, PGIM India Mutual Fund.

In an exclusive interview with Sanjeev Sinha of FE Online, Naha shares his views on whether it is the right time to invest in small cap funds and what should be the strategy of investors in the current scenario. Excerpts:

The stock markets are currently very volatile. In your opinion, is it the right time to invest in midcap and small cap funds?

The markets in general might look a little stretched, but there are decent opportunities across the market capitalisation. Any investor who will come in with a 3 to 5 year time-frame should be able to benefit from the rising demand and profits for corporate India. It might not be as easy to be positive on sectors outright as it was last year, but at a company-specific level there are lots of opportunities, and hence stock picking skills will be rewarded.

What should be the long-term strategy of investors?

The increased availability of vaccines and the Covid second wave numbers coming under some control are positive for the economy. B2B segments like steel, cement, logistics are doing very well. Lower Covid numbers and higher vaccines should see the B2C segments like retail chains, hotel, mall, multiplexes open up over time. There is demand across industries, which augurs well for the companies in terms of growth. A growth in profits will eventually get captured in the markets. We remain positive on the markets with a longer-term view, though the near term might be volatile, given a strong performance in the last one year.

Over the next 3 to 5 years, we believe that financialisation, digitisation and consumption will be strong themes which will play out for a developing country like India. As the per capita GDP moves beyond $2000, one should see consumption pick up. Also, one will see the formalisation of the economy and people will move from cash to more formalised banking channels. Increased penetration of the internet will lead to digitisation with the acceptance of digital platforms for different needs.

In the small cap funds segment, which sectors are performing well?

The economy has borne the brunt of the Covid 2nd wave. However, B2B businesses like cement, steel, logistics, etc have not been as impacted as B2C businesses like retail chains, hotels, restaurants etc. Hopefully as the economy opens up, one should see the B2C businesses bounce back. A vaccinated population should help the economy come back to normalcy by the start of FY23. Small caps are more stock-specific rather than sector, and hence it will be difficult to comment on sectors. Individually there are stocks across sectors which are doing well and should generate decent returns.

What are the points investors should take note of while investing in small cap funds?

Actively-managed small caps have the potential to generate alpha over the long term. Secondly, small caps give exposure to many sectors like, textiles, construction, chemicals, IT product companies, and real estate, among others, which are underrepresented in the major indices. The segment is under owned and under researched, which provides the opportunity of generating alpha over time. The risk with small caps is that they are volatile and could lead to deeper drawdown vs large caps or midcaps. The positive takeaway is that, small caps have cleaner balance sheets and stronger cashflows vs their history and hence the resilience of this segment of the market is better and chances of mortality is less. We have seen over time, good small cap companies graduate to become midcap companies and even large cap companies over time.

New investors must be aware of the risks associated with an asset class before investing. Within asset class, segments like the small cap are prone to more volatility. Investors must understand the extent of notional losses which can happen once they have invested to get a better understanding of the underlying asset class. Once they are comfortable with the volatility, they will be able to sit through volatile markets and even add during volatility to generate returns over a longer period of time.

What percentage one should invest in the small cap funds?

The percentage of small caps will depend on the risk return profile of the investor along with the time-frame that the investor has in mind. Ideally, risk-averse investors could avoid the segment. Investors looking for some risk-adjusted returns could invest 10-15% of their portfolio in the small cap segment. That said, there is no single solution that fits everyone. To get the right asset allocation mix, investors should consult a financial advisor.

Why do investors need to look at small cap funds in their portfolio?

The small cap segment has generated very strong returns in the last one year and hence one needs to temper down expectations over the next couple of years. Having said that, the strong returns have come after a year, when the small cap index corrected almost 50% and hence over the last couple of years the returns are more realistic. Over the last 3 to 5 years, small caps have underperformed the large caps. Any investor who is looking to invest in small caps must come in with a 5-year view, and in such a case, should be able to realise good risk-adjusted alpha.

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