How would you characterise the outperformance in mid and smallcap indices that we started off with in 2021? Are the valuations justified?
Starting from 2020 and continuing in 2021, we have seen mid and small caps rallying. The interesting bit from our perspective is that midcaps did make new highs but smallcaps are still off the highs that they have made in early 2018 — 5-10% on the indices — but what is more important in terms of valuations is the way we look at things. Clearly both small and midcaps on the index level have been treading into an overvalued zone. We would think that while largecaps are slightly overvalued, they still make relatively better players compared to small and midcaps. So we are taking a cautious stance when it comes to allocating in small and midcap strategies.
How should investors approach the mid and the small cap universe? Do you believe that once can invest in mid and the small cap funds as a strategy for the long haul?
It is very important to lay the context right. When we think of mid and smallcaps, we say they are potentially overvalued right now. But that does not mean that investors should stay away from them. What we say is invest but take a slightly more staggered investment approach.
Very clearly, as an investor one needs to have the right time horizon in mind. By right time horizon, I mean anything in excess of 7 to 10 years because history has taught us that draw downs in this segment can be pretty sharp. We have seen drawdowns in excess of 70-80% back in 2008. From the highs of early 2018 till 2020, for almost two years, we were down about 50% odd on these indices. So clearly drawdowns can be sharp and it can be prolonged.
Investors need to first come with a mindset that I need to park this money away for the long term and when we say long term — at least 7 to 10 years. Obviously valuations have run up and one should be ready for blips and significant blips in terms of drawdowns on your portfolio value. As long as you have the right time horizon and have the right sort of investment approach, you should be okay because mid and smallcaps are wealth generators of the long term but you need to have the right approach for investing in that.
Where within the broader markets are you finding opportunity? Are you picking up any particular trends?
We have been very traditional asset allocators. We have been frequently rebalancing our portfolio and raised our equity exposure when the March crash happened. At the same time, we have actually been doing exposures since June. We have actually gone underweight mid and smallcaps to the extent of almost 25% of our strategic allocation.
Our most aggressive portfolio had 30% weight. We have brought it down to almost 25% in mid and smallcaps given where valuations stand. We have very interesting opportunities. One, is the index which the market tracks but in terms of funds and alpha generation, there are some great mid and small managers. These are the guys who have cut their teeth in terms of building up research for small and midcaps. There are very experienced managers from HDFC, Kotak, SBI, Franklin on the mid and small cap side.
There are some excellent opportunities there coming at the right time. Stay invested because the returns have been very polarised. Even in the mid and the smallcap side, the healthcare and tech stocks have done really well in 2020. Stick to your investment approach and asset allocation as an investor. Tha is how we would approach investing in general and in mid and small cap funds too.
What is the realistic return or average return that investors can look forward to in some of these funds going forward?
I will go on a limb and say that it is probably not going to be as good as it has been in the past, especially given the valuations we are at right now. A lot of the stocks have moved up significantly but over a long-term horizon, you should be in a reasonable position to outperform the broader market or the benchmarks by 200-300 bps and get returns in teens. I am going on a limb saying that you have to stagger your investments because if you have some chunks of money to put in right now, do not do that in one shot, given where the market levels are.
Look at staggering that over the next 12 months at least and be realistic with the expectations. We have seen some significant returns come in since March and investors should not get carried away. The indices are almost 100% up but we have seen elongated periods of negative to flattish returns. For a lower to teen digits return, a 10-year horizon should be a reasonable option given the alpha that the small and midcap managers can generate.
