Last week, S Naren, CIO of ICICI Pru MF and a market veteran we respect immensely, warned investors about exuberance in Small and Mid-Caps. His statement “we think it is a clear time to take out lock, stock, and barrel from small and midcap” created quite a stir on social media.  “With great power comes great responsibility” and we endorse the general warning that Naren is dispensing to the price agnostic retail investor. 

However, our views on investing in Small and Mid-Caps today are more nuanced, and we share our specific stance on this subject below.

• The perception of a typical investor is that Small and Mid-Caps have more risk than Large Caps.  In our view, a debt free Small cap is less risky than a Large Cap Bank that is leveraged 10:1.  The margin of error in a highly leveraged entity is very small.  A small error can result in stock prices falling 30-40%.  Hence, we go where the best opportunity is rather than think small or large cap.  
• Small Cap prices are more volatile than Large Caps because they have thinly traded volumes which result in greater price swings.  Hence, they are perceived as being riskier because of the higher price volatility.
• However, price volatility is not risk.  Rather, risk is the probability of losing capital permanently by investing in low quality business models or promoters with dodgy governance.   Volatility is risk only if one does not understand the game one is playing.  It creates fear and could nudge one to exit at the wrong moment thereby crystallizing a temporary loss into a permanent one.  This is what we believe Naren is trying to protect the retail investor from. 
• We see narrow width of opportunity today not only in Small and Mid-Caps, but also in Large Caps.  This is a time to be cautious, but not where one should freeze or be liquidating portfolios.  Rather, one must be ready to act when volatility provides opportunity.  
• As a Boutique firm that is willing to embrace some illiquidity, we find value in some pockets which will not be of interest to large firms.  If we can buy 5 Cr of a stock, we are interested.  Not all partners may get allocation in every stock, but if a few partners can benefit, it is of interest to us.  Side note, accounts with >15% uninvested cash always get priority allocations. 
• Valuations require nuance, not just extrapolation of history. A few Small caps of interest to us are better and more diversified businesses than 5 years ago (new product lines, new customer segments, new markets) and they are on track to be even better businesses a few years down the road.  Many dominate niches where no large competitor in India exists.  These companies could grow 15-20% for long periods of time off a small base.  For select companies, a premium over the historical bands they traded at in the past may be justified as their narratives too have evolved.
• Select companies of interest to us are trading at the low or mid end of their historical valuation or peer group bands.  The market is dis-interested as these companies lack short term earnings trajectory. The test here is how much you can stretch patience.  They trade the way they do because no trigger is visible and will not attract interest as every Fund Manager has an Index to beat.  If we can be patient and stretch time, we can benefit from both growth and multiple re-rating.  When sentiment turns, one could earn an Asymmetric upside.  We need to be investing more here, not exiting.  
• In small caps, you only get the volume you want, at the price you want during periods of panic.  Panic selling creates entry opportunity.   Hence, we must act when we get our entry prices rather than wait for prices to become even more favourable.  We initiated 2 new positions last week which were on our Watch List for a long time, and which hit our price target.  It will take us a while to build these to 3% (minimum desired position weight) across all accounts.  
• A SIP is not a smart way to invest if all money gets deployed immediately agnostic to entry valuations.   However, it is a strong win-win if you trust the fund manager’s judgement to act when prices are favourable, and they are willing to sit on cash otherwise.  In an environment of fear, prices can correct 10-15% within 2-3 days giving good entry points if one is sitting on cash.  Hence, we encourage SIPs with us.

Investing your hard-earned capital is too important to leave to someone else’s perspective alone.  They may have different objectives and hence be playing a different game.  Define your investing beliefs, introspect on what is an acceptable return vs other alternatives, and your tolerance to draw downs linking them with return objectives.  Then, move forward with strategy, basis what works for you rather than with emotion basis the market’s moods.  The only strategy that works is what you can stay with during difficult time periods.