Over the last decade, while the BSE Small Cap index constituents have grown operating profits in low teens, the Little Champs constituents have consistently delivered 20%+ EBITDA growth. This has resulted in superior, consistent long term returns alongside sharper recoveries post drawdowns than the BSE SmallCap index. In recent quarters, while the fundamentals for Little Champs companies have continued to remain healthy, there has been a disconnect vis-à-vis returns due to quality investing being out of fashion in the broader market. With the LCP companies delivering growing their profits at a healthy rate quarter after quarter, we remain confident that portfolio returns would again converge with fundamentals.

Performance update for the Little Champs Portfolio
The Little Champs Portfolio went live on August 29, 2019. The performance so far is shown in the below table.


Portfolio changes – addition of Prudent Corporate Advisory Services to the Little Champs portfolio

Prudent Corporate is an independent retail wealth management services group in India. It is the 2nd largest non-banking Mutual Fund distributor (based on commissions earned) and the 5th largest overall (up from 12th in FY17). Prudent is one of the fastest growing mutual fund distributors with its AUM recording 41% CAGR during FY17-22 versus industry CAGR of 14.5% for the same period.

Prudent’s sustainable competitive advantage is embedded in the trust it enjoys among the ~25K+ Independent Financial Advisors (IFAs) who operate on Prudent’s platform. This trust is underpinned around availability of a spectrum of financial services products under Prudent’s platform. This range of products allows Prudent to onboard more IFAs under its technology-enabled investment & financial services platform.

We expect Prudent to benefit immensely from the broader theme of ‘financialization’ of savings in India, while its unique B2B2C model offers massive operating leveraging possibilities. Prudent is scaling up its non-mutual fund distribution by leveraging upon its IFA channel. This should extend the longevity of growth in this business. The incremental capital requirement in this business is negligible and hence, the business throws off a lot of free cash which can be used for further inorganic opportunities (which are likely to emerge as smaller distributors get squeezed). We expect the company to report strong FCF growth along with solid return ratios.

Little Champs perform consistently across cycles unlike most Smallcap stocks

In general, most small cap companies tend to go through couple of years of good earnings growth followed by prolonged periods of flat/negative earnings growth. Resultantly, across cycles and even on a 3-year basis, the BSE Small Cap index has delivered high single digit revenue growth/low double digit EBITDA growth (see exhibit 2 above).

The impact of such inconsistency in fundamental performance is visible in the chart below, which clearly showcases how the BSE Small Cap index is susceptible to lackluster performance (it went through an almost 10-year period of no returns over December 2007- October 2016!). It is only during periods of euphoria that the index has made a sharp move upwards. Even after the recent euphoric phase during 2020-21, the 10/15-year CAGR for the BSE Small Cap index stands at 16%/7% respectively (for the period ending Feb’23)

We had discussed in detail the factors leading to severe volatility and drawdown in the BSE SmallCap index in our earlier newsletters. In summary, the key reason for this is the preponderance of companies in the small cap index with: (i) fragile business models (debt laden, high dependence on a handful of customers, low pricing power, etc) that are not able to stand the test of market slowdown; and (ii) questionable accounting & governance which usually unravels during periods of market crisis.

However, unlike typical small cap companies, Little Champs has delivered healthy and consistent fundamental performance across different time periods. Over the last decade, while the Small Cap index has struggled to generate EBITDA growth in the low teens, the Little Champs companies have consistently delivered 20%+ EBITDA growth irrespective of ongoing macroeconomic scenario thanks to the strength of the franchise (sustainable competitive advantages, high quality management teams) and the resultant fundamentals (strong unit economics, cash surplus balance sheet).

The consequent impact is visible in the chart below which compares the returns trajectory of a hypothetical portfolio comprised of current Little Champs companies (with returns computed using median of constituent companies’ monthly returns) to that of the BSE Small Cap index over last decade.

Two things clearly stand out in Exhibit 4:

  • The long term returns clearly move in line with the underlying fundamentals. While the portfolio with LCP companies would have returned ~27% share price CAGR over last decade (in-line with 20%+ EBITDA growth), the corresponding return for the BSE Small Cap index is ~16% CAGR (again in-line with low teens EBITDA growth).
  • While the LCP portfolio may also go through temporary periods of sharp declines (eg. Dec’2015-Feb’2016, Feb’2020-Mar’2020, Oct’21-Feb’22 – encircled in exhibit 4), the recovery in the value of the portfolio is usually sharp as returns realign with fundamentals. The BSE Smallcap index, on the other hand, is prone to elongated periods of declines as the fundamentals are unable to justify the increase in price during euphoric phase – besides the 10-year drought highlighted earlier, Dec’17-Mar’20 also saw the Small Cap Index decline by ~30% while the LCP portfolio would have returned ~20% (both cumulatively) during this phase.

Little Champs continue to chug along healthy earnings
The strong fundamental performance for LCP companies has continued in the recent quarters as well. At the overall portfolio level, the median YoY EBITDA growth in 3QFY23 was 20% and the allocation weighted EBITDA growth was 21%. This is despite headwinds such as the normalisation of Covid-19 related additional revenues (for Tarsons, Amrutanjan, Alkyl, Vijaya Diagnostics) and inventory destocking arising from both deflationary raw material environment and correction of excesses built through the Covid-19 period (particularly impacting companies like Alkyl, Amrutanjan, Tarsons).

In 9MFY23 too, the weighted average revenue and EBITDA have grown at 26% and 32% respectively (on YoY basis). These figures are significantly better than the median figures for BSE Small Cap Index (Revenue growth: 20%; EBITDA growth:12%) as well as the corresponding figures over FY19-22 for the LCP portfolio (weighted average Revenue growth: 19%; EBITDA growth: 22%) suggesting that our investee companies are only going from strength to strength.

While stabilisation of gross margins have helped (as raw material prices started correcting from their peaks in the last  quarters), the key reason why portfolio companies have been able to sustain their performance – as highlighted in our earlier newsletters and webinars – is the heavy reinvestments made by the companies over the last two years in both organic and inorganic expansion. These investments have now started bearing fruit and are helping the LCP companies develop an additional stream of revenues (eg. new products, new geographies) and/or gain market share from competitors weakened by Covid-19 and its chaotic aftermath.

However, fundamentals and market performance have diverged over the last year

While the fundamental performance of the portfolio has been healthy, the share price performance has been lackluster (see the table below). In fact, over the last year or so, the divergence between LCP fundamentals and share price performance is opposite to that seen for the broader BSE Small Cap index (which has fallen less than the Little Champs inspite of relatively weaker fundamental performance over 9MFY23).

So what happens next? We expect portfolio fundamentals to be robust; share price returns have converged to fundamentals historically after temporary periods of disconnect  

  • We expect fundamentals of the Little Champs portfolio to be robust over the next 3-5 years

Going forward, given the sharp retreat in key input material prices we expect the gross margins of our investee companies to stabilise at (higher) levels. Given that most of the LCP companies had high-cost inventory sitting in their books for most of the last nine months, as those inventories or those inputs have got consumed the benefit of the ongoing correction in the underlying raw material prices should start reflecting in profits in the upcoming quarters.

Secondly, as mentioned earlier, many of the companies especially catering to Pharma/Diagnostics space (Alkyl, Amrutanjan, Tarsons) saw volume growth depression due to a high Covid-19 related revenue base. As we head into the 4QFY23/1QFY24 and the impact of Covid-19 related spike wears off, we expect the growth metrics to start showing healthy growth again.

Thirdly, as we’d covered our Oct’22 newsletter, any impact from the turmoil in the Western Hemisphere would at best be temporary. For example, during GFC crises of 2007-08, whilst the revenues of the LCP companies got impacted between autumn 2008 to autumn 2009, the recovery thereafter was pretty steep.  Further, most of the export-oriented franchises in LCP cater to resilient industries like food or pharma whose revenues don’t ebb and flow too much with the macroeconomic situation. From a structural standpoint, any recession in developed geographies would actually be beneficial for Indian companies due to their lower cost structure vis-à-vis peer countries. As western companies look to rationalize their own cost structures, there’s a high chance that Indian companies would be able to capture much of the incremental business.

  • Disconnect between the fundamentals and the returns?

As discussed above, there has been a disconnect between the fundamental and returns performance of the portfolio. However, what gives us confidence regarding the LCP companies’ going forward is:

  • While in the short term there may be temporary disconnect between the fundamental and price returns, in the long term they converge (see exhibit 4 above). This explains why temporary drawdowns in quality portfolios like LCP are followed by subsequent sharp recovery in returns. The long-term convergence of fundamentals and returns also explains the superior long term returns of the LCP portfolio companies vis-à-vis the BSE Small cap index.
  • As regards the relative performance vs the index in the last 1-1.5 years, there have been instances in the past decades where quality has taken a backseat during periods of euphoria. During such periods, companies that rank low on accounting quality (D7 to D10 in Marcellus’ accounting frameworks) have performed better in terms of returns vis-à-vis higher quality stocks as shown in exhibit below. However, while riding the momentum in junk stocks (i.e. Zone of Thuggery stocks) is always alluring, when the momentum fades junk stocks often suffer heavier losses than gains made earlier. (Details on Marcellus’ Forensic accounting approach can be accessed in Little Champs December 2019 newsletter (click here) and our September 3rd, 2020 webinar (click here))