The historical underperformance over extended periods (2005-19 and 2005-17) of the BSE SmallCap index relative to the Nifty/BSE500 despite higher volatility/drawdowns highlights that the odds are stacked against small cap investors unless they invest in clean well-run small cap companies. We follow a robust investment process combining our quantitative frameworks and qualitative diligence to shortlist stocks for our Little Champs portfolio. The backtest results of our quantitative framework (CY10-CY19) and the live performance of our portfolio (since August 29, 2019) shows significantly better returns than BSE SmallCap, Nifty and BSE500 with similar levels of standard deviation/drawdown compared to Nifty/BSE500. Thus, unlike the BSE Smallcap index, our Little Champs deliver significantly superior risk adjusted returns over larger cap indices like the Nifty/BSE500.
Performance update of the live Little Champs Portfolio
At Marcellus, the key objective of our Little Champs Portfolio is to own a portfolio of about 15 sector leading franchises with a stellar track record of capital allocation, clean accounts & corporate governance and at the same time high growth potential. While we intend to fill our portfolio with winners, we want to be sure of staying away from dubious names where we are not convinced about the cleanliness of accounts or the integrity of the promoters (even though business potential may sound promising) as the fruits of company’s performance may not get shared with minority shareholders. We intend to keep the portfolio churn low (not more than 25-30% per annum) to reap the benefits of compounding as well as minimize trading costs.
The Little Champs Portfolio went live on August 29, 2019. The performance so far is shown in the below table.
Broad-based small cap investing does not generate returns commensurate to volatility involved
Small firms’ revenues and profits tend to be more volatile than those of larger firms due to dependence on: (a) a single line of business; (b) a small group of people running the show; and (c) limited free float & trading volumes which accentuates the good or bad impacts of any macro/company specific developments. Naturally, therefore, investors expect higher returns from smallcaps (relative to larger caps) to compensate for the higher uncertainty involved in small cap investing.
However, an analysis of the BSE SmallCap’s performance over the last 14 years shows that it does NOT provide this extra return that investors expect to get for the extra risk they are taking. From September 2005 to December 2019, the index has delivered a total return CAGR of 8.9% compared to the Nifty’s 13.0% and BSE500’s 12.5% over the same period (these returns include dividends & buybacks) – see exhibit 2. Even if one were to exclude CY2018 and CY2019 – which were particularly weak years for small caps – and limit the analysis until December 2017, the BSE SmallCap’s performance on a risk-adjusted basis significantly lags that of the Nifty’s and the BSE500’s (see exhibit 3 below).
While small caps typically deliver higher returns (vs Nifty and BSE500) in a rising/bull market, they also decline more sharply during market downturns. Further, most small caps are unable to survive the periods where the business cycle turns downwards. In fact, a cyclical economic downturn often structurally damages small cap companies (for example – as they enter a persistent cycle of indebtedness). Further, in our December 2019 Little Champs newsletter “The importance of accounting quality”, we highlighted the preponderance of fraudulent companies (shoddy corporate governance and poor capital allocation) in the small caps space. Such frauds typically come to the fore during bear markets. As a result, if we combine all the years with negative returns for the BSE SmallCap since 2005, the index value would have eroded by 90% compared to 55% and 67% declines for Nifty and BSE500 respectively. At the same time, BSE SmallCap’s relatively outperformance during years of positive returns have been unable to close the deficit (arising from market downturns) with Nifty and BSE500. Hence, BSE SmallCap has been unable to generate higher risk-adjusted returns over September 2005-December 2019. So, why then does Marcellus have a small cap portfolio?
Enormously favourable risk-rewards, however, in “Quality” Small cap investing
The above explained challenges in the broader small cap space, does not mean that there is no money to be made in small caps. In fact, as highlighted in our previous newsletters, there is an enormous amount of money to be made by investing in high quality small caps. We produce a couple of charts from one of our earlier newsletters which explains that investing in the best quality small caps generates much higher returns than investing in the best quality mid-caps and large caps.
Marcellus’ Investment process to identify ‘high quality’ small caps
We use the following process to build a portfolio of high-quality small cap names for our Little Champs PMS. The process is broadly divided into two parts: (a) Use of quantitative frameworks to help shorten the large universe of more than 1,000 small caps companies into a researchable universe of 40 companies; and (b) conducting deep dive research & diligence on these 40 companies to build a final portfolio of around 15 stocks
Using our in-house Quantitative frameworks to shortlist high quality names:We use the following two quantitative frameworks to arrive a shortlist of companies:
- Our forensic accounting framework: Evaluating the accounting quality of a company needs to be a cornerstone of any investment process in India. We at Marcellus have developed a set of 12 ratios that help to grade companies on their accounting quality. The selection of these ratios has been inspired by Howard M. Schilit’s legendary book on forensic accounting called ‘Financial Shenanigans’. More details about our forensic framework can be found in our December 2019 newsletter. We eliminate the companies which score in the lowest 40% on our forensic framework.
- Our competitive advantage/capital allocation framework uses financial parameters like revenue growth, consistency in gross margin, consistency in interest coverage, improvement in working capital and improvement in fixed assets turnover to rank the companies which clear our forensic framework explained above. We then select companies which score above average on all the above five individual parameters AND deliver metrics above our thresholds on latest year RoCE and net debt-equity levels.
After running both of the above frameworks, we are left with a shortlist of about 40 companies. Essentially, this shortlist consists of clean companies which have demonstrated ability to grow efficiently (by maintaining pricing and balance sheet discipline), generate cash and redeploy that cash to grow further. Essentially, we are using quantitative metrics to identify about 40 companies which are self-sustaining cash machines.
- Backtesting results of our frameworks suggest significantly higher risk-adjusted returns vs BSE Smallcap and even the Nifty/BSE500: We have backtested the shortlists from the above frameworks since CY2010 to CY2019 and the results generated by the Little Champs algorithm (i.e. just using the quantitative framework without any bottom-up research) has not only outperformed the BSE SmallCap index but also given significantly higher risk-adjusted returns compared to the Nifty and the BSE500 as shown in the below exhibits.
Using Bottom-up research on our quant shortlist to find the very best amongst the best
The 40 stocks shortlisted by our screening frameworks are then taken up for deep dive research and diligence by Marcellus’ research team. Besides analysis of the published financials and other secondary data, we aim to build insights into the companies through interacting with a host of primary data network sources. Here, we draw upon our following strengths:
- Forensic accounting skills – We have a deep pool of accounting talent in our team with every single one of our seven analysts being qualified Chartered Accountants and/or Chartered Financial Analysts who have cumulatively done more than 1,000 bespoke accounting projects over the last ten years.
- Access to primary data and insights – The team has built a pan-India network of primary data sources which include dealers, distributors, promoters, ex-employees, customers, vendors, etc.
Besides getting comfort on the management’s integrity and corporate culture, our diligence is also focussed towards understanding 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. We also aim to find companies who are able to achieve the rare combination of high RoCEs with high reinvestment rates without relying upon acquisitions to deliver growth.
Our live portfolio has delivered better returns with lower volatility & drawdowns than even Nifty
Currently, we have 14 stocks in our Little Champs portfolio – the key portfolio metrics compared to the indices are shown in the exhibit below. Since the portfolio went live on August 29, 2019, it has delivered a ‘positive’ return of 8% compared to a ‘decline’ of 9-10% in Nifty, BSE500 and BSE Smallcap indices. More importantly, the standard deviation for the portfolio has been lower than the Nifty and drawdown almost similar to these large cap indices. While one can argue that portfolio is just about eight months old, its relative resilience (particularly compared to Nifty) during one of the worst market meltdowns in recent years should give investors confidence. The fundamental reasons for Little Champs’ resilience during the Covid crisis are described in detail in our April 2020 newsletter. To reiterate the key point made in our April 7th newsletter, “We see limited impact of COVID-19 on Little Champs’ fundamentals beyond the short-term business disruptions given: (i) their strong balance sheets will help them navigate the near-term stress much better than leveraged peers; and (ii) export oriented portfolio companies’ exposure is mostly in essential products (pharma, agro, food) or replacement markets rendering immunity from a potential global recession.”
Marcellus Investment Managers is regulated by the Securities and Exchange Board of India as a provider of Portfolio Management Services and as an Investment Advisor.
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