We Aim To Build & Run A Well-diversified Portfolio Rather Than A Concentrated One: Harshad Patwardhan, Edelweiss Asset Management

What was the rationale behind launching a small cap fund at this time? Do you think the correction that began a year ago is now on its last legs?

2018 was the worst year on record for small cap stocks as compared to their large cap peers. NSE Small cap 250 index (proxy for small caps) underperformed Nifty (proxy for large caps) by 31 percentage points. The previous worst relative performance was in year 2008; when small caps underperformed large caps by 17 percentage points. In 2018, in absolute sense, large caps were up 3% but small caps were down 28%. Many stocks experienced much more correction- a few as much as 50%+.

Historically, after such a strong under-performance, there is typically a strong bounce back in small cap stocks. This typically happens as the fear and panic that leads to such a strong underperformance subsides eventually.

This underperformance was not limited to stocks of businesses that experienced fundamental deterioration. Even stocks of businesses with stable and improving fundamentals also suffered. There are several examples of small cap stocks where the business exhibited robust earnings growth and significant improvement in ROE but the stock price declined meaningfully. This was primarily the result of forced (or non-discretionary) selling as some portfolio managers received redemption during the turmoil. This has resulted in valuations of many of these stocks becoming attractive.

We therefore believe that following the carnage in small cap stocks in 2018; now may be a good time to start taking an exposure to this segment from a medium to long term perspective. 

Despite a steep correction, valuation multiples for small-cap indices remain as high as they were in January 2018. Is this not a concern point in your mind?

In our industry (and in media), a lot of discussion on valuation of small caps happens on a trailing basis. In our opinion, looking at valuations on a trailing basis is like driving a car looking at the rear view mirror and is not of much use. In fact it may even lead to incorrect conclusions. People tend to use trailing multiples as the forward multiples are not available as not all the stocks in small cap indices are well researched by sell side analysts. 

Comparing valuations of large cap and small cap indices is in itself incorrect as their composition is so very different. For instance, financials is a big proportion of large cap indices (well over 30%) but barely account for mid-teen levels in the small cap index. Comparing valuations of these two indices will be like comparing apples and oranges.

As mentioned earlier, for many quality small cap businesses with improving fundamentals; valuations have become a lot cheaper compared to a year ago.

Tell us a bit about the STEP feature of the product. Do you believe that staggering the investment over five instalments will make any material difference in terms of rupee cost averaging?

The logic behind introducing STEP feature during NFO of Edelweiss Small Cap Fund was to provide an option to investors to invest in the fund in a staggered manner, given the big upcoming domestic event of general elections. With elections slated for the month of April/May and results around mid-May, we have designed this feature to allow investors to deploy 60% of their investment before the election outcome and the remaining 40% after the election result announcement. This will allow investors to navigate the volatility surrounding this event. 

Will you be maintaining a top down or bottom up approach for this fund? Do you plan to run a well-diversified or a concentrated portfolio and why?

We will have a bottom up approach to investing in this fund as in this segment selectivity is of paramount importance. We will of course have a risk mitigation overlay to make sure that we are not taking large inadvertent sectoral bets. We aim to build & run a well-diversified portfolio rather than a concentrated one.

Will you be deploying moneys right away or sitting in cash for some time, as you await opportunities?

Generally, we will not be taking cash calls in the portfolio and deploy the money as soon as possible trying to minimize impact cost. We expect investors to do their own asset allocation.

Lastly, what sort of investors should be committing moneys to this fund and why?

We believe this fund is appropriate for investors with higher risk appetite as the inherent volatility of small cap stocks is likely to be higher than overall equities.