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Mumbai: The world’s best-performing stock fund is discovering the downside of success.

After producing a three-year return of 275%, more than any other equity fund with at least $500 million, managers of the DSP BlackRock Micro Cap Fund say bargains are disappearing in their market niche of Indian small-caps.

The dearth of cheap shares has become so severe that the fund took the unusual step of limiting client inflows as India’s benchmark small-cap index jumped to an all-time high this month.

The move, almost unheard of at a time when active managers around the world are struggling to prevent withdrawals, reflects growing apprehension toward one of the great investment stories of the past three years: India’s economic revival under Prime Minister Narendra Modi. While few dispute that smaller companies have benefited from the country’s world-beating growth, DSP BlackRock and other skeptics from Ativo Capital Management Llc to Auerbach Grayson & Co. say share prices have climbed too far, too fast.

“We are not comfortable with the current valuations, which is limiting our ability to build decent-sized positions," Vinit Sambre, a co-manager of the Micro Cap fund at Mumbai-based DSP BlackRock, a JV between the world’s largest money manager and India’s DSP Group, said by e-mail. “Valuations discount much of the near-term positive developments."

Small-cap fever

The Micro Cap fund, whose assets have expanded 11-fold over the past three years, began restricting daily inflows to 100,000 per investor from 10 August tightening the cap from 200,000 in its second attempt to cool new subscriptions in two years.

Aside from SBI Funds Management Ltd, which stopped sales of its small- and mid-cap fund in October, attempts to limit inflows by Indian money managers have been rare since the global financial crisis in 2008.

Investor demand has been especially strong for small-cap stocks in recent years as they outperformed every other major Indian asset class.

The S&P BSE SmallCap index has jumped 121% since Modi was named the prime ministerial candidate of India’s Bharatiya Janata Party in September 2013, versus a 43% gain for the large-cap S&P BSE Sensex and a 42% increase in Bank of America Merrill Lynch’s gauge of Indian government bonds. Gold, a popular store of wealth in India, is up 3% in the period.

Mobius bullish

Some investors are still bullish on Indian small-caps despite the rally. Mark Mobius, executive chairman at Templeton Emerging Markets Group, said in a June interview that he planned to increase holdings because of Modi’s growth-boosting measures. He reiterated a bullish stance on smaller emerging-market companies in 25 August blog post.

Small-cap companies in India are more exposed than their bigger counterparts to domestic economic growth, which clocked in at 7.6% during the year ended 31 March.

That was thanks in part to Modi’s efforts to boost infrastructure spending and open up sectors such as railways and defence to foreign investment. Private consumption increased 7.4% during the period, helping to offset the drag from declining exports.

“Rising income levels and aspirations, better education, economic reforms and better government policies are boosting demand for new products and services," said Krishnakumar Srinivasan, the Chennai-based head of equities at Sundaram Asset Management Co., whose mid-cap fund has returned 42% annually over the past three years.

“Many of the small and medium-sized companies in these segments have great growth potential."

Those prospects don’t come cheap. The S&P BSE SmallCap index trades for 2.1 times net assets, approaching the ratio of 2.2 that signified the start of a brief bear market in August 2015. The Indian gauge is valued at a 62% premium over the MSCI Emerging Markets Small-Cap Index, according to data compiled by Bloomberg.

“Too much money can be a bad thing, especially for a small-cap manager if it has to remain flexible and nimble in its investment strategy," Ram Gandikota, who helps oversee $1.5 billion as senior portfolio manager at Ativo Capital in Chicago, said in an e-mail. “It also becomes very difficult to trade in and out of these smaller cap names without incurring significant market impact, which is detrimental to performance."

The DSP BlackRock Micro Cap fund’s latest reported holdings show how elevated some small-cap valuations have become. While the fund’s positions traded at an average 3.25 times net assets and 24 times earnings, some are significantly pricier. JK Lakshmi Cement Ltd is valued at 91 times trailing earnings, according to the BSE Ltd. That’s twice the five-year mean after shares climbed 39% this year to a record. Maharashtra Seamless Ltd, a pipe maker, has a price-to-earnings ratio of 39, up from an average multiple of 26 over the past five years. Both stocks were among the Micro Cap fund’s disclosed holdings at the end of July.

“It’s hard to find bargains," said Nikhil Bhatnagar, a New York-based senior vice- president for Asian equities at Auerbach Grayson, a brokerage specializing in international trading. “The market is looking frothy." Bloomberg

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