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Small is beautiful – What makes them big?

Updated: May 15, 2023

Greetings from Team Carnelian!!


We all know that structural wealth creation happens when a company travels the path from being small to mid to finally large. However, there is a common perception that mid & small caps are risky, and often we get worrisome questions from investors about the risks involved in mid & small cap investing.


This letter expresses our thoughts on the same.


History educates us about both - success and failure stories. As an investment firm, we pay special attention to understanding history. What went right/wrong? Why did it happen the way it did?


While we believe that certain things (trends/cycles/technology) change all the time, few things don’t change at all (human psychology, greed, fear, cycles of creation & destruction etc.)


If you look at the history of returns of mid & small caps (refer chart below) at an index level, it is abundantly clear that these companies have outperformed the broader index by a huge margin. While the Sensex delivered 19x return (15.8% CAGR), BSE Mid cap index delivered 28x (18.1% CAGR) and BSE Small cap index delivered 34x returns (19.3% CAGR) in the last 20 years, clearly showing how small caps have outperformed by a huge margin! Of course, there will be periods of low/ uncertain times where mid & small caps underperform, but eventually this reverse.

Despite the above, the question still arises – is one taking excess risk by investing in mid & small caps? are mid & small cap risky?


To answer this question, we need to know the risks we are talking about. Is it risk of loss of capital (Type A), or it is the risk of volatility (Type B). (refer letter).


If you are worried about short term / medium term volatility in your portfolio values, you are right, mid & small caps can be risky. In uncertain times, mid & small caps become illiquid, and one can’t sell easily.

But if you are worried about the loss of capital, then the answer lies in understanding the sources of the risk. Let’s look at some historical data about companies which delivered, and which didn’t deliver within the mid & small cap space.


A study of 338 companies over a period of 20 years (beginning 31st Mar 2003) with market cap between Rs.50cr to Rs1,000cr, revealed the following returns:

“Above par” - 128 companies (~38% of the total) generated >18%

“At par” - 62 companies generated returns in the region of 12%-18%

“Below par” - 69 companies generated positive but returns <12%

“Losers” - 22 companies generated negative returns


Clearly, there is a stark difference in their revenue, profitability, and capital efficiency profiles.

Above par

These companies have consistently displayed strong execution capabilities coupled with a healthy profitability growth. Superior product/service offerings, competent management, financial discipline, and good corporate governance practices are visible across these companies. E.g. - Eicher Motors, Bajaj Finance, Carborundum Universal, Siemens, Timken India, Can Fin Homes, MRF are some of the prominent names in this category.


At par

These companies have been performing well, though not much is extraordinary about them. They have a good product/service offering and grow in-line/slightly higher than the economy; basically, performing in-line with the market. Procter & Gamble, GE Shipping, Century Textiles, GE T&D, BEML, Unichem, Ingersoll-Rand are some of the companies featuring in this category.


Below par

These companies lacked good leadership, good capital allocation and competent product offerings. Madras Fertilizers, Jain Irrigation, J&K Bank, Unitech, Bajaj Hindustan, Kesoram Industries, Indian Overseas Bank are some of the names visible in this category.


Losers

Extremely poor capital allocation decisions, lack of management focus, spiraling debt, corporate governance issues, are some of the characteristics common to these companies - Reliance Capital, Future Enterprises, Ramco Systems, Rolta India are some of the names here.


So, even within the mid & small cap space, there are companies which make it big without doubt, many companies stay where they are, and few companies go down the drain.


Real risk & opportunity lies in differentiating good ones from the bad ones. Risk is not in capitalization; in fact, mid & small caps provide a screaming opportunity provided you know how to identify and differentiate between winners and losers. If you are long-term investors, you should seek small caps which can become big rather than finding safety in large caps.


The Carnelian framework of identifying and evaluating companies at an early stage of their growth trajectory helps us in identifying potential wealth creators while minimizing the risk of failure. Key aspects of our framework are as under:


  • Opportunity size / tailwind / enablers

  • Core competence / Moat

  • Scalability mindset of promoters/managements and execution capability

  • Efficient capital allocation

  • Strong governance

Opportunity Size/Tailwind/Enablers

No matter how good the company is, it’s growth will always be constrained by the opportunity size it operates in. So having a good and growing opportunity size is very important. Is there a tailwind for the industry to grow faster or a change in potential due to some shift, is important to understand.


While evaluating a company we evaluate the opportunity size along with management intention & capability to explore and create adjacent opportunities. While assessing current opportunity size is an easier task, the later one requires a deep dive into organization, culture and leadership capabilities along with industry dynamics. Needless to mention – bigger alpha lies in later…


Company’s core Competence / Moat / Business model

“In business, I look for economic castles protected by unbreachable moats.” – Warren Buffet


One of the most important aspects we focus on while looking at the smaller companies after opportunity size is the company’s technical capability or core competence. It is like a test match; you cannot survive for long if you do not have the core competence. Also, people tend to carry a perception that small companies have inferior

offerings/no competence vs large cap companies. We beg to differ that this might not always be the case. Carborundum Universal (current market cap - Rs. 20,500 crores) which was a ~Rs. 100 crores market cap company about 20 years ago with a dominant market share in the abrasives industry, had a breakthrough with metallized cylinders and is looking at serious innovations in the electro minerals part of the business. Royal Enfield created a market by itself which led to the successful transition of Eicher Motors from a small to a large cap company (35% CAGR over last 20 years)


Having a sustainable core competitive advantage in today’s ever-changing environment is very difficult.


Likewise, certain business models are inherently weak and risky. We totally avoid them. Like we have never believed in the Small Finance Bank (SFB) model or Micro Finance model, especially the environment in which they operate. They are inherently risky business models. They get expensive deposits and lend to risky customers to be profitable in a leveraged business. For us it is a CLEAR NO. There are hardly any SFBs which have delivered shareholder returns over a cycle. It might make money in a smaller cycle, but it is very hard over a period.


One needs to have a detailed understanding of the business model and core competence a company carries.


Scalability mindset of management and execution capability

Vision to foresee and execution skills are equally important and probably one can argue these are the most important. A company can have opportunity size and core competence but if the management lacks vision/hunger/execution skills, the company will not be able to make it big. ~27% of companies (refer the table above) were not able to generate returns above the cost of equity over last 20 years.


The different stages of a company’s growth phase require different kind of execution skills. When the company is small, agility in decisions is of prime importance, as the company scales a little bit – delegating responsibilities, allocating capital, having processes, and building team is of utmost importance. However, inculcating a good culture at an early stage is of paramount importance, which transforms the business into an organisation. This comes with a deep understanding of the company.


Strong return ratios of business

Businesses which do not require capex/working capital for growth are platinum - they have strong moats usually brands/Ips; businesses which requires either capex or working capital but can generate returns over the cost of capital are gold and businesses which fail on both the above counts end up inherently destroying shareholders wealth over a long term.


Financial management is extremely crucial as the company grows. Capital, which is scarce, allocation of that is the toughest decision for one to make. There are various parameters to judge the financials of a company, few prominent ones being:

  • Return on capital employed along with incremental return on new capital employed.

  • Working capital days

  • Capital intensity of the business

  • Margins of the business etc.

Most important characteristics in all the companies which have gone onto become big is return on capital employed and their ability to convert profits into cash. For companies with long history, it is easier to evaluate capital allocation history, however the job is tough for companies with limited history or where there is a recent management change.


Later case again requires much deeper analysis of qualitative factors like management background, organization culture, decision making metrics. Again, bigger alpha lies in later part…. 😉


Strong governance

There cannot be any alternative to good corporate governance practices. We like managements which have a clear alignment of interest. We avoid companies with material unexplainable related party transactions, bad and maligned history, serious misallocation of capital. Investors should not have any prejudice and paint the entire space of small companies with the same brush. The real risk is the risk of holding a bad business and incompetent management and not the risk of it been a smaller company in size.


Glimpse of past mid & small caps that transformed into large caps


A glimpse of our Shift Strategy & Structural Shift Fund focusing on mid & small cap jewels

Carnelian Shift Strategy (PMS) /Structural Shift Fund (AIF) are designed to capture structural decadal shifts presenting large opportunity in:

  • Manufacturing led by conducive regulatory and global environment.

  • Tech evolution empowered by digitalization globally.

Carnelian Shift Strategy/Structural Shift Fund is designed to capture the aforesaid opportunity focusing on mainly mid & small cap companies qualifying all the attributes mentioned above under the Carnelian framework.


Glimpse at key attributes of our portfolio companies

Our portfolio comprises of stocks having niche businesses and competitive moats. We hold companies having a mix of good import substitution, export opportunity and strong domestic demand as well. We put a strong emphasis on forensics and have our proprietary CLEAR framework. Even in the mid & small cap space, we hold businesses which are market leaders in their own industry. We put a strong focus on managements’ alignment of interest and corporate governance practices.


Our Shift Strategy and Structural Shift portfolio is uniquely curated to offer superior growth and better capital efficiency along-with a higher margin of safety.


Faster, Stronger & Cheaper

Earnings of the strategy are expected to grow by ~20.5% CAGR over FY23-25E vs the benchmark (BSE-500) at ~17.5% CAGR. This is encouraging given the fact that our strategy does not carry any highly leveraged companies. Our detailed investment research process and thrive to find out impactful ideas enables us to find out such businesses. This has led to superior returns at the Shift Strategy vs the benchmark. This is particularly interesting – as the outperformance is on a low beta.


Performance

Conclusion


It is inappropriate to treat mid & small caps space as just one single basket. Picking stocks in this space requires deep research and continuous monitoring. Select companies despite being small in capitalization size, do hold leadership positions in the industry they operate. Mid & small caps offer great opportunities to create meaningful wealth over a longer period. We argue that Risk is not the risk of price volatility; the real risk is of not understanding the opportunity correctly. Risk evaluation should be done on “fundamentals” and not price volatility. In view of the above, we urge investors to have a deep thought on – “Are mid & small caps really risky?” Since you are at the end of this letter, you know our answer 😉


We see mid & small caps as a real pot of opportunities where one can make disproportionately large returns while being mindful of the risk and putting up with short term volatility. Risk Reward is screamingly favourable.


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