‘Biggest risk for small- and mid-caps is earnings growth’: Edelweiss fund manager

Small- and mid-cap funds have attracted significant investor interest, but their higher growth potential comes with greater volatility and the risk of sharper declines during market corrections. As earnings expectations, valuations and liquidity come under scrutiny, investors must assess whether their exposure aligns with their financial goals and risk appetite.

In an interview with The Federal, Dhruv Bhatia, Fund Manager (Equity) at Edelweiss Mutual Fund, discussed the sectors driving growth, the risks of earnings downgrades, portfolio liquidity, SIP discipline and the importance of asset allocation.

Edited excerpts:

Are small- and mid-cap valuations justified by their earnings growth?

Looking at valuations in isolation would not be fair. They have to be considered alongside earnings growth.

Over the last few years, it has been quite evident that growth rates in the mid- and small-cap segments have been better than those in the large-cap universe.

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We expect these growth rates to continue to be better than those in large-caps. Their opportunity to grow in terms of both top-line and bottom-line performance is much greater than that of large-cap companies.

It is not that large-caps are inherently in a bad condition. It is just that the opportunity set is much larger for mid- and small-caps.

Hence, earnings growth will probably be better in the mid- and small-cap segments, driving their relatively higher valuations.

Which sectors are performing well in the small-cap segment?

Almost 30-35% of the small-cap index comes from the manufacturing and industrial segments.

The same composition in a large-cap index is hardly in the low single digits.

This is a space that is delivering very strong growth in terms of order inflows and order books, with opportunities in both domestic and export markets.

Another sector is capital markets. Exposure to capital markets in the large-cap space is much more limited than in the mid- and small-cap segments. This is another space that is doing fairly well.

What are the biggest risks for small- and mid-cap investors if earnings growth fails to meet market expectations?

If earnings growth does not meet what the Street expects, there will be multiple corrections. We will also see earnings downgrades.

That is the biggest risk because we are not envisaging multiple expansion in the markets currently.

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Our return expectations are based on the assumption that returns will be a function of earnings growth. Over the last 12-18 months, we have seen earnings downgrades driven by macroeconomic uncertainty, geopolitical issues and India-specific factors.

The earnings downgrade cycle that was underway is probably behind us. The probability of further downgrades will depend more on macroeconomic challenges rather than the microstructure of the market.

So, the biggest risk would definitely be earnings growth.

The health of mid- and small-cap balance sheets and their return ratios are quite superior to what they have been in the past.

This gives us comfort that even if there is some earnings correction, we should not see a large drawdown. Instead, it could present an opportunity to reconsider this space.

Healthy balance sheets are a function of how sustainable and how fast growth rates will be.

How vulnerable are small- and mid-cap funds to liquidity pressures during a sharp market sell-off?

Liquidity is an imminent priority for every fund manager.

If you had asked this question four or five years ago, the answer would have been very different from what it is today. Mid- and small-cap companies are no longer mid- and small-cap in terms of the size and scale they used to have five years ago.

When we position our portfolios as fund managers, we consider stock allocation from a liquidity perspective.

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We assess how liquid or illiquid the companies we invest in are. Liquidity is definitely an important risk metric to keep in mind while selecting stocks and constructing a portfolio.

What should investors check in a fund’s portfolio concentration, stock selection and stress-test disclosures before investing?

There are a lot of things investors should consider. Firstly, they should not chase very near-term returns from a fund.

It is important not to look only at the short-term returns of funds and make a judgment based on that.

Investors should take a call on multiple factors. These include the investment style of the fund manager, the stock selection, and why the manager has entered a particular space or sector.

They should also examine portfolio concentration and allocation across different stocks. This is where it becomes important to look at the portfolio-level allocation rather than just liquidity.

Specifically, for the small-cap segment, the stress test that AMFI requires funds to disclose on a monthly basis becomes an important metric to consider.

It helps investors understand whether liquidity is in check for the entire scheme.

All these are important parameters, but the key parameter is the sustainability of returns over time.

Should existing investors continue their SIPs in small- and mid-cap funds during market volatility?

Definitely. The very purpose of an SIP is to deploy money when markets are more volatile or at the lower end.

During such periods, investors can accumulate a greater number of units. Hence, they should continue with their SIPs during more challenging times.

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But they need to keep re-evaluating their allocations in the schemes and products they have invested in.

They should assess whether these were the right products and whether they have delivered the right returns so far.

SIPs are not meant for the very short term. They are a very long-term investment.

SIP investment is one of the better ways to invest during very volatile times.

Should investors rebalance their portfolios towards large-cap or diversified funds amid valuation concerns?

Asset allocation is more important than simply diverting exposure away from mid- and small-caps during a difficult period and investing more in large-caps.

It is important to maintain a combination of investments where the asset allocation is appropriate from the investor’s perspective.

We always prescribe diversification across different asset classes, whether it is equity, hybrid or multi-asset investments.

At this moment, growth rates continue to be better in mid- and small-caps, though their valuations are relatively more expensive than those of large-caps.

It is a bottom-up market, with pockets of opportunity in each space, rather than simply giving a blanket yes to mid-cap, small-cap or large-cap investments.

Should first-time equity investors start with small- and mid-cap funds or build their portfolios through large-cap and flexi-cap funds first?

Again, the same answer applies: Asset allocation is more necessary for a first-time investor.

They should initially be more diversified and have exposure to a few different schemes, depending on their investment objective and age profile.

Investors should see how performance has been over the year gone by, examine the risk metrics and understand their risk-taking ability.

Based on these factors, they can continue deploying money into mid-cap, small-cap or large-cap funds.