Small in size, big in returns

While fundamentals are important, getting the management quality right is more so as mistakes on this count can be costly, says Vinit Sambre of DSP BlackRock Mutual Fund

For a category that brings with it the attendant challenges of risk, liquidity and volatility, it can be a difficult task to make money. It is even more difficult to stick to your convictions when these three are constant companions. The category called "small-caps", however, are a happy hunting ground for Vinit Sambre. The 41-year old chartered accountant who has been running the show since 2010 helped investors gain 19.13 per cent returns in the DSP BlackRock Micro Cap Fund and 13.47 per cent in DSP BlackRock Small and Midcap Fund at much lower risks, and in the process beat both the benchmark S&P BSE Smallcap Index as well as competition from across categories and market capitalisations as per the fund size criteria.

This is one of the few instances that a fund manager who is running a small cap fund has won the Business Standard Fund Manager of the Year - Equities award. While this might not be a surprise as small-caps have outperformed their larger peers over one year ending June 30, 2016, making money in smaller listed entities and especially continue doing it remains a herculean task. Ask investors who have burnt their fingers in some of these companies to know why Sambre's performance is special.

Barring two periods, the sub-prime crisis (2008-09) and European crisis (2012-13), the Micro Cap Fund has been an outperformer across all periods. Given the nature of markets, companies will be subject to market swings and unless fundamentals change, Sambre continues to keep the faith. In fact, he uses these bouts of underperformance, as an opportunity to load on a business with good fundamentals which the market is trying to offload in a hurry.

His approach to investment since he started looking at small- and mid-cap companies over six years ago has been a bottom-up one with a clear focus on companies' fundamentals. The criteria, he says, is to pick up companies with a strong outlook over the next few years and an investment horizon of at least two to three years. Given the strength of the businesses, they do not fall as much as the overall markets even in a bad phase. In fact, companies such as Solar Industries and NIIT Technologies have been part of his portfolio for over five years.

Given the higher risk and underperformance, Sambre tends to avoid highly cyclical and commodity-based companies. Instead, he opts for companies whose business cycles are low on cyclicality and where there is durability of growth. He prefers companies with steady growth, for example, in a band of 20-30 per cent rather than one where growth swings from 50 per cent to 5 per cent.

The other set of companies he avoids are those with high leverage which tend to suffer when interest rates move higher or when growth slows down. Even if the company has some leverage, for Sambre, cash flows and the management intention to bring down debt are important.

Not surprising then that management quality and passion for the business is the single most important criteria for him. "It is not just about getting higher returns but also minimising our risks on the quality aspects," he says. Mistakes, especially in the small and mid-cap names, he adds, can be very costly as wrong decisions have eroded investor wealth. Judging managements is both an art and a science with both the softer aspects as well as fundamentals equally important. Sambre also looks at corporate governance practices and tends to avoid companies which have high related party transactions or have complicated group structures. Among financial parameters, the key one he tracks is the return on capital employed, which indicates the ability of the management to allocate capital efficiently to generate higher returns.

One of the calls that has made money for the fund is the investment in chemicals company SRF which is the single biggest holding in the Micro Cap Fund. Back in 2012, the Street was not paying too much attention to the company which had embarked on a Rs 1,200 crore expansion in Dahej on a chemicals complex with a focus on fluorine-based chemistry. Given that the company was making a number of intermediates which were used by global agrochemical companies, the upside potential was large. Fund data indicates that the investment in the company has been a multibagger with market capitalisation increasing from Rs 1,200 crore at the time of investment to over Rs 9,000 crore currently. A couple of calls also didn't work out as anticipated, one being in a material handling company catering to the power sector. While the company was doing well and had good return ratios, slow moving power projects led to cash flows being stuck which the company compounded by raising more debt.

While he is bullish on the outlook for small-caps, they are currently in the expensive zone. He believes that investors should pare down their return expectations in this category over the next year. However, they will make handsome returns if the holding period is upwards of three years. The sad part, he says, is that investors who buy small-caps don't have much patience and head to the exit at the first signs of volatility.