‘Small caps’ returns have gone into a different planet’

Shankar Sharma, founder GQuant Investech.
Shankar Sharma, founder GQuant Investech.

Summary

  • Veteran investor Shankar Sharma says that Sebi is right in sounding the alarm bells about the froth in the small-cap space, even as these warnings are being ignored by the market

Small caps have become the logical hunting ground for the new -age retail investor as large cap returns, barring a few instances in recent times, have been a sub-optimal 13% compounded over the past decade, a fact being ignored by most of us, veteran investor Shankar Sharma tells Mint amid the frenzy in many of these stocks. The founder of GQuant Investech believes that Sebi is right in sounding the alarm bells about the froth in the small-cap space , even as these warnings are being cheerfully ignored by the market. Edited excerpts:

Sebi has sounded off AMCs on concerns of froth in mid and small caps with low free float. Funds in response have started restricting SIP and lumpsum flows, the latest being Kotak MF. Your views?

There is absolutely no doubt that small caps have gone into a completely different planet in terms of returns.

The reality is that the data for long-term returns from large caps is extremely sobering and something that almost every market participant is ignoring. The data of returns for Sensex from May 2014 up until the present day is just 13% CAGR! This is a full 2.5% pa below long-term Sensex returns!

But that is how the human mind works: somehow all of these data points have become forgotten in the frenzy surrounding small caps and all of us have started believing that the entire market returns have been superlative!

This is called recency bias. The more recent data points become larger than life and overshadow the complete data set.

Therefore the entire action in the last 10 years and in particular in the last four years has been only in the small cap space with some isolated movements in groups like the state-owned companies recently and the Adani group back in 2021. Otherwise, large caps have been extremely barren of returns.

I mean the key question is that why should anybody invest in equities if the 10-year compounding return is just 13% and that is including a very strong last four-year returns. Because adjusted for volatility, long-term equity return for the last 10 years from Indian benchmarks have been abysmal, with a Sharpe (risk- adjusted return) of below 1!

And the fact is that the emergence of the small investors in India has made the small cap market the logical hunting ground for such investors. Hence there is a very good product market fit!

The frenzy in many IPOs, including unknown company ones, with not very well understood financials are all warning signs of a bull market which is getting out of control.

Therefore it is very right for the regulator to sound the warning bells. How effective that will be is quite another matter because history has shown that each time regulators sound warning bells the markets cheerfully ignore them and the example I will give you is that of Alan Greenspan's warning about irrational exuberance back in 1996 on technology stocks in America and right from that day itself a huge and giant bull market took off!

What’s your advice to retail investors who flock to mid and small counters?

No matter what the advice is to retail investors the fact is that all bull markets do end and they do end badly. Any bartender who tells customers that they should be drinking responsibly is not going to sell a lot of drinks!

Therefore it is in nobody's interest today to warn people about anything because the party is going on nicely and strongly.

The bills will obviously come but we always work on the Greater Fool Theory in investing!

My simple advice to retail investors is that keep taking money off the table at every 20-25% rise in your individual stocks. Investing is not an all or nothing game.

It is a game of calibrated entries and calibrated exits and exits determine how much money you eventually take home to enjoy your life with.

Converting all the vapour into paper is really what successful investing is all about!

Do you feel a situation like in 2018 in smalls and mids could recur when a famous name in the fund industry returned shares to investors in lieu of cash redemptions?

I definitely hope not! But, of course, old-timers like us have long memories and that is probably a barrier in such bold markets but the fact is that when the tide turns in small caps there is absolutely no exit. None, whatsoever.

This is the only train in which you should jump off when it is going at high speed rather than when it is slowing down!

Is a bottom-up approach more practical in markets which have largely priced in all the positives on macro and political stability fronts?

In so far as small cap investing is concerned the only formula that I know of that works very well is buying around 25 or even 50 half decent companies and then critically examining them at every single data point, which is quarterly numbers and their respective stock price performance, and ruthlessly eliminating the laggards and rotating the money into the winners.

There is no other surefire way of making good sustained and even excellent long-term returns in markets.

This year while margins grew, top-line growth disappointed. How do you expect earnings to pan out in FY25/26 comparatively?

For large caps I do not expect a very strong top-line growth because top-line growth ultimately is simply a mirror of nominal GDP growth and then nominal GDP growth in India is extremely slow as we all know. And that is exactly where the problem for the large cap lies, because they derive their growth from nominal GDP growth and when normally GDP growth is just 9-10% their top-line growth is going to mirror this. And I do not see much scope for margin expansion; therefore at best you can expect 9-10% large-cap earnings growth , which is not good enough for them to substantially go up in aggregate.

Inflation is always good for corporate earnings and corporate revenue growth. Higher nominal GDP growth is a boon for stock markets, especially for the large-cap companies.

PSU banking stocks in particular and PSU stocks in general have attracted phenomenal inflows in the last six months on hopes of stake divestment. What’s your take on investing in these counters, given that apart from SBI, BPCL, etc., most have low free float?

You see investing is a very interesting game in which the market almost always rewards under-owned groups and companies and sectors. A few years ago the Adani group was the most under-owned group in India and they delivered fantastic returns but nobody in the institutional markets owned them!!

It is the same with the state-owned companies, because people were busy owning all the sexy private sector banks and private sector companies and this became an overlooked and under-owned sector and, there you go, the markets ended up surprising everybody.

I don't think there is much juice left in these companies incrementally and if somebody was lucky enough to spot the rotational trade then he should be taking money off the table.

On corporate governance and regulation, do you feel there are improvements in listed companies from the past decade or do you think more needs to be done? There is the case of Zee and Paytm. What do you feel with respect to such cases?

I think by and large corporate governance has improved by leaps and bounds over the last 35 years that I have been in this business, and that is primarily due to amazing and effective regulation across securities markets and banking. Technology also has come to play a major part in this. However, no matter what the level of regulation and technology, there will always be companies that can exploit loopholes. The companies you mentioned are the larger and more prominent ones but I can tell you at the lowest levels of the listed markets there are enough rotten eggs that nobody is even aware of.

What are you gathering from foreign investors who have been deploying more incremental cash to Korea, Taiwan over India. What's the catch?

This is a typical rotational strategy; people take money off the table in successful countries and regions and invest in the laggards and that's exactly what foreign investors are doing.

The fact of the matter is that these are strategic shifts which people keep doing across time and history and there is no need to get perturbed about it.

Is private capex picking up? On rates do you see Fed cutting in H2 and what will RBI do in case Fed doesn't cut?

Private capex is a mirage that is trotted out by all financial market participants from time-to-time to support the capex cycle story. But, the reality is that capex must always be done by the government because their balance sheet is huge and most importantly the capex being done by the government does not have a profit and loss account attached to it where people can calculate what is the return on these investments.

The private sector will never have the luxury of not being able to report what is the level of capital efficiency in their capital expenditure programmes and hence they will always be hesitant to put large amounts of capital at work.

Also, the fact is that through history companies investing large amounts of capex in India have suffered and that will continue to cast a shadow of doubt over large-scale private sector capex.

In any case, the aggregate profits of large companies in India simply cannot support any level of capex even remotely close to what the government of India can invest.

Big Indian companies are largely services driven , which is banking, finance insurance and information technology, and none of them do any capex at all.

So, if you exclude them from the profit pool and only count the manufacturing companies, the aggregate profits of such companies is minuscule in comparison to the requirement of private sector capex to move the needle.

The government capex is 11 trillion. ($120-130 billion). It is my belief that the private sector capex number simply cannot move the needle compared to the government capex, given the large dominance of services companies in India to the overall profit pool. Ultimately, a company can only invest part of its profit and not all of its profit and annual cash flow on an ongoing basis into capital expenditure because the market does not like or reward such companies that invest large amounts of capital. The whole investing 'likes and dislikes' has changed to supporting companies that do not require vast amounts of capital expenditure to grow so the incentive for private sector in India to invest large amounts of capital expenditure is extremely low even from a stock market valuation standpoint.

Stock markets simply do not reward companies doing high capex and Indian promoters are the smartest in the world when it comes to judging what the stock market likes!

Therefore the fact of the matter is that our entire growth story based on capex is and has to be a government-led capex story. If the government does not increase its capex on an ongoing basis then to expect the private sector to take up the slack is nothing but wishful thinking.

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