We focus on clean, dominant, high RoCE and low-debt small and midcap companies: Ashvin Shetty of Marcellus Investment Managers

Market Outlook

Ashvin Shetty, who has over a decade of experience in the capital market, says that he remains more positive on clean, dominant, high RoCE and low debt small and midcap companies,

In an interview with Moneycontrol’s Kshitij Anand, Shetty said that the strategy of Little Champs portfolio is to identify and invest in 15-20 niche-dominant small-cap companies with clean accounts & corporate governance, a track record of prudent capital allocation, and at the same time have decent growth potential. Edited excerpts:

Q) Big gains in small packets! This has been the theme of the year 2020 where the broader market outperformed the benchmark indices after 2 years of underperformance. What is your outlook for the year 2021 for small & midcaps?

A) Contrary to the environment of despondency surrounding the small and midcaps at the peak of the COVID-19 fears in March 2020, the comeback in rest of the last calendar year has been astonishing.

This has been fuelled by unprecedented liquidity and abating COVID-19 fears. Also, expectations of an economic recovery started gaining ground which has historically benefited small-caps’ earnings disproportionately along with the massive underperformance of the last two years creating attractive value propositions or at least the perception thereof in small caps.

However, a downside of this has been unwarranted exuberance in low quality small caps. On the other hand, we see an ever-widening gap brought upon by the economic slowdown and disruptions of recent years between high quality and weak franchises.

Hence, as compared to the broader small and midcap space, we remain more positive on clean, dominant, high RoCE, and low debt small and midcap companies.

Q) Little Champs has been consistent with its returns to investors. The PMS has given over 40 percent return in 2020 (Source: PMSBazaar.com), which is the highest among the smallcap theme category. What was your strategy?

A) Our strategy in Little Champs portfolio is to identify and invest in 15-20 niche-dominant small-cap companies with clean accounts & corporate governance, a track record of prudent capital allocation, and at the same time have decent growth potential.

Having such attributes in the portfolio companies also helps in minimising the drawdowns and reducing volatility which we think are very important portfolio requirements in the smallcaps space.

In fact, Little Champs’ outperformance in CY2020 (vs the benchmark BSE Smallcap) was mainly driven by its relative resilience in 1QCY20 (portfolio fell only half to that of BSE Smallcap during this period).

Q) How do you pick stocks for the portfolio?

A) We follow a combination of quantitative frameworks and in-depth research/diligence in portfolio construction.

Our proprietary forensic accounting model (to weed out companies with sub-par accounting quality) and capital allocation framework (to select companies with healthy RoCEs, earnings growth, and balance sheet) help narrow the starting universe of over 1,000 small-cap companies into a researchable universe of 40-50 companies.

The stocks shortlisted by our screening frameworks are then taken up for deep-dive research and diligence by our research team.

Besides getting comfort on the management’s integrity and corporate culture, our diligence is also focussed towards finding the sources of the competitive advantages of these companies, their track record of dealing with technological or competitive disruptions, and the wisdom of their capital allocation decisions.

This is achieved through extensive analysis of financial statements & available secondary data and building insights through interacting with a host of primary data network sources.

Q) With over Rs 500 crore in AUM and a little more than a year old, what are your plans for 2021? Any new product launches?

A) Little Champs has been closed for subscription since around mid CY2020. We continue to deepen our understanding of the portfolio stocks by closely tracking the quarterly financial performance, analysing the annual reports, interacting with management on a regular basis and continuing to gain insights from our further primary data interactions. As of now, there is nothing to comment on any new product.

Q) When did you fell in love with equities and stock markets? Who has been your biggest inspiration in life?

A) After qualifying as a CA around 15 years back, the initial years of my career were spent in two of the big four auditing firms. This kind of spurred my interest in analysing the financial statements of the companies.

And what better than equities where you get to analyse, research and diligence a lot of companies from different sectors, with different management teams, with different history and backgrounds.

Q) If retail investors want to maintain a similar discipline in their portfolio what are the important parameters which one should watch out for?

A) Over the long term, the stock price largely tracks the company’s fundamentals. Hence, earnings growth, RoCE, and balance sheet discipline remain the most important parameters. Add to that, also the management’s track record vis-à-vis minority shareholders.

Q) Which are the biggest risks you foresee that could derail the rally in the small & midcap space?

A) While there has been a recovery in the share prices, the fundamentals of the companies too have to recover. Otherwise, the rally would lose steam sooner than later.

As regards the recovery of fundamentals are concerned, as said earlier, due to economic slowdown and disruptions of recent years, a whole host of small-cap companies’ earnings potential and balance sheet has got structurally impaired. We remain sceptical of such companies.

Furthermore, a headwind that has emerged recently is the sharp spike in the commodity prices like steel, copper, aluminium, precious metals as well as crude-based derivatives like PVC While threatens to spoil the otherwise positive impacts of the top-line recovery.

Here too, we believe companies like Little Champs would be able to weather the commodity inflation headwinds much better than most small caps because of the strong pricing power (enforced by their dominant market share) and in some cases presence in the resilient end-use industries.

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