Valuations are reasonable to cheap for small-cap stocks: Janakiraman R, Franklin Templeton

Valuations of many small caps are below 2013 levels. Taking a three-year view, returns will be a combination of underlying earnings growth and rerating due to price-earnings expansion, Janakiraman R, portfolio manager, emerging markets equity, India, Franklin Templeton, told Prashant Mahesh. Assuming moderate earnings growth, investors can make an annualised 12-13% gain over a three-year period. Edited excerpts:

Mid- and small-cap stocks have been the worst performers in the last 18-20 months. The S&P BSE 150 Midcap index is down about 25% since January 2018, while the S&P BSE 250 Smallcap Index lost 57% in the same period. How are valuations looking?
The high watermark in mid- and small-caps was established in January 2018. Both these categories have been correcting for the last 18 months. There is much more compression in small caps. Our schemes prefer to invest in good quality companies, many of these have corrected meaningfully. In terms of valuations, we have come back to reasonable levels in the mid cap space. In fact, in the small cap space, valuations are between reasonable and cheap.

When do you expect a recovery and how will these companies fare?
I expect the macro recovery to pick up but it will be moderate and there will be no V-shaped recovery. In this moderate recovery, small cap companies will do well. If one takes a threeyear view in small-caps, it is quite possible the returns will be a combination of underlying earnings growth and rerating as valuations are below mean level. The valuation of the portfolio of the small-cap fund I manage is below 2013 levels. Today, what needs to be ensured is that the companies one owns don’t go under. In a tough environment, small-cap companies tend to lose their path. Hence one needs to stick to relatively proven companies that have the wherewithal to manage risk.

Given the tough environment we are in, what changes are we witnessing in mid- and small-cap companies?
Right from September 2018, there is a reduction in macro growth. A slowing environment hits mid- and small-cap companies more. The valuation gap between companies that can execute well and the average has widened. Companies that can execute well are managing better in this environment. There is volatility in demand, raw materials, currency, interest rates and in general the risk in the environment is higher. Such a scenario puts onus on company management to manage that risk and clearly higher-quality businesses come out in front. Their competitive advantage has increased, their balance sheet is less levered, they use the situation to increase market share.

What are some of the key parameters that you look at while building a portfolio in the mid- and small-cap space?
We invest in companies where quality is sustainable and business can generate reasonable growth. I value highly return on capital employed (RoCE), free cash flow, working capital management, consistency in execution and cost management. In mid- and small-caps, the key in delivering good returns is not in spotting winners but reducing the number of mistakes. Generally, the number of mistakes are higher in small-caps. The strategy I am spelling out may sound boring, but it works over a period of time.

Given the tough environment, what have been your learnings in the last 18 months?
Things have changed a lot and the emphasis is much more on the sustainable character of a business model and free cash flow is important. Earlier, companies had access to capital markets and debt could be raised. Hence, in a business model that gives you growth and profitability but free cash flow was absent, it would not be a concern. The most important tool is putting the business through quality framework. When I am investing in a small-cap company where past track record is not strong, you look at what extent promoter has interest in other business, go through related party transaction and also look at who the bankers are. A good banker is comfort and a hygiene factor. Look at the quality of the auditor. In addition, I also look at cash tax payment. If the cash tax paid is too low, it’s a red flag for me. This means I have to be careful and do more diligence in that company. The other thing is if you are unable to understand how this business is delivering numbers, you avoid it.

What kind of returns can investors expect in small-cap funds?
The returns from small-cap segment could be higher due to a PE (price-earnings) multiple expansion in that space. If an investor takes a three-year view, in the worst case, earnings growth could be at least 8-10%. If there is moderate recovery in the economy, one could expect a 10-12% (growth) and of course it could be even higher in an optimistic scenario. Add 1-2% the segment will get due to the rerating and investors could earn an annualised return of 12-13% over a three-year period.