September 2024 / Q2 FY25

01Is Small-Cap Investing Dead? Not Quite

With the ongoing sell-off in small-cap stocks and the increasing concern on valuations, media and many market men have already started writing the obituary for the small-cap genre of investing. We have spoken at length about our views on bubble formation and valuations in our March 2024 and December 2023 newsletters, and we maintain our stance.

1AEmpirical Evidence: Small Caps as Leading Wealth Creators

Historical data supports that, despite short-term volatility, small caps have generated the most substantial returns over time. Of the top 250 current stocks in India, 112 (~45%) had an average market cap of ₹2,500 crore in 2005. Over 20 years, these companies reached an average market cap of ₹90,000 crore, providing investors with a ~20% CAGR — equating to a ~36× increase in invested capital[3].

However, the journey to significant wealth creation in small caps is marked by volatility, with many companies turning out to be value destroyers. This is precisely where our investment approach — deeply understanding each business — becomes critical in separating hidden opportunities from risks. Small-cap investing requires an extremely ground-up approach to capture outsized wealth creation while mitigating unforeseen accidents.

1BGrowth and Liquidity: The Holy Grail of Wealth Creation

Investors reward companies that demonstrate consistent growth, and when this is combined with ample market liquidity, the potential for exponential returns emerges — something we’ve observed increasingly over recent years.

In this light, we tested both parameters (growth and liquidity) for small caps, and the results have reassured our belief that this is a genre for substantial wealth creation in the coming time.

Small Caps Lead in Growth (But Only If One Digs Deeper)

We analysed data for all listed companies during the post-COVID era (last four years):

At first glance, the top 100 companies (Large Caps) reported the highest aggregate earnings growth, followed by Mid Caps, with Small Caps appearing to lag. However, over the past three years, Small Caps have drawn substantial attention and liquidity. This is because, although ~1,200 companies in this segment show modest aggregate growth, nearly 40% of these small caps achieved growth exceeding 20%, attracting significant investor interest.

Our portfolio has demonstrated this strength, delivering a 28% CAGR over the last three years and a 39% TWRR[2]. Notably, we’ve seen a similar trend in Q1 FY25, where the profits of small-cap companies have surged ahead of their large- and mid-cap peers:

1CWhat Is Driving Small-Cap Growth?

Despite concerns about a global economic slowdown, we have been maintaining that growth will primarily come from manufacturing, engineering, and infrastructure, where momentum is strongest. India’s “China+1” and “Europe+1” strategies, along with the government’s focus on infrastructure spend and manufacturing incentives like PLI schemes, continue to drive expansion in these areas.

To gain further insight, we analysed export data for key sectors benefiting from these tailwinds. The segments hereunder have experienced high growth over the past three years:

Sector Composition: Nifty 50 vs Nifty Microcap 250

The Nifty 50 is heavily weighted towards Financial Services, IT, and FMCG, which have been under pressure due to the global slowdown and sluggish domestic consumption. In contrast, small caps — represented by the Nifty Microcap 250 — include 44% in manufacturing and engineering, sectors that have shown strong growth:

1DGround-Up Investing: Capturing Outperformers

Our ground-up approach to stock picking, focused on granular business analysis, has allowed us to identify companies that consistently outperform broader sector trends:

1EIs This Growth Sustainable?

In our March 2024 newsletter, we highlighted how government infrastructure spending and increased gross capital formation have supported growth in manufacturing, engineering, and ancillary sectors. To assess corporate readiness for sustained growth, we analysed capacity expansion trends — particularly in engineering and manufacturing, where companies have invested significantly in upgrading their capabilities:

Historically, Indian entrepreneurs relied heavily on bank debt for capacity expansions, with little heed paid to business visibility — the intent largely being to create long-term family assets with borrowed capital. However, this cycle of expansion has been largely funded by internal accruals or equity infusions, reflecting greater confidence among promoters in business potential. When promoters commit their own capital, it often signals strong confidence in sustainable growth.

02Will FII Selling Deplete Market Liquidity?

In October 2024, FIIs pulled back significantly, with net sales reaching over ₹1 lakh crore — a record monthly outflow in Indian market history[5]. While this withdrawal has raised concerns about liquidity depletion and potentially deeper market corrections, several factors indicate that market liquidity remains stable:

India’s increased weighting in the MSCI Emerging Markets Index (now ~20%) is also likely to attract renewed FII interest over time[6]. The surge in domestic liquidity we’ve witnessed over the past few years hasn’t yet faced a significant market correction. How these new-age investors respond to sharp market drawdowns will be crucial in determining future liquidity conditions — that remains the key factor to monitor.

Regulators Act to Stabilise Markets

Proactive steps were taken by SEBI to maintain stability — most notably removing over 1,000 companies from the list of securities approved for margin funding[7]. This reduces over-leveraged positions and minimises the risk of panic selling. Most of our portfolio companies are not on this list, lowering the chance of margin-induced sell-offs.

Additionally, tighter regulations in derivatives and stricter IPO norms for SMEs are expected to ensure stability in Indian equity markets going forward.

03How Are We Navigating This Volatility?

At Equitree, we’ve experienced two significant market drawdown cycles over the last 12 years, yet we’ve consistently delivered an XIRR of ~32% during this period[2]. We understand that volatility is an inherent part of the markets, and we believe it should be leveraged as an opportunity for wealth creation rather than a cause for concern.

Anticipating a potential correction, we took a cautious approach in our deployment strategy. We maintained a cash reserve of approximately 40–60% for new investors and ~15% across our overall PMS (individual portfolios may have different allocation levels based on start date). We have been using this correction to buy deeper into our own portfolio companies, which have been exhibiting very strong earnings momentum.

New Opportunities on the Watchlist

We have also been exploring new opportunities and have shortlisted several businesses, including:

We plan to initiate investments in these businesses as they approach our valuation comfort levels.

Outlook

We anticipate that current market volatility may persist until the end of earnings season and the U.S. election outcomes, with stabilisation likely thereafter. Broader market performance in Q2 earnings has been mixed, which may drive further corrections as valuations adjust to reflect underperformance. Amidst this, our portfolio companies remain on track to meet growth targets, and we expect renewed buying interest as earnings are reported.

Looking ahead, we encourage investors to adopt a balanced perspective on returns and investment horizons. With the growth potential and reasonable valuations of our portfolio companies, we are confident in achieving at least a 25% IRR from a long-term perspective. We strongly recommend using this correction as an opportunity to strengthen your portfolio for sustained wealth creation.

For any feedback or further information, please feel free to reach out to us.

Sources

01

PMS Bazaar — Top 10 PMS rankings across 1-, 3-, and 5-year time frames as of September 30, 2024.

02

Nuvama Custodian Services; Equitree Capital internal performance and NAV records (September 30, 2024). Returns are TWRR, net of fees and expenses, and not verified by any regulatory authority/SEBI.

03

Equitree internal study of the top 250 listed Indian stocks, tracking 2005 vs 2024 market capitalisation; ~45% of the cohort had average market caps of ₹2,500 cr in 2005 and ~₹90,000 cr today.

04

Ministry of Commerce — India sectoral export data, FY21–FY24; Equitree Research compilation across engineering goods, auto components, apparel, and defence/aerospace.

05

AMFI — Net inflows into Indian equity mutual fund categories, including small-cap funds (3.85× growth over four years; H1 FY25 net inflows of ~₹15,000 cr); record FII outflow of >₹1 lakh cr in October 2024.

06

MSCI — India weighting in the MSCI Emerging Markets Index (~20% as of late 2024).

07

SEBI circular — Removal of 1,000+ companies from the list of securities approved for margin funding; tightened derivatives and SME IPO norms (calendar 2024).