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Small cap stocks used to fall by around 40-45% during corrections in the pre-covid period. However, post-covid, the average decline has been closer to 25%, said Samit Vartak, founder and chief investment officer of SageOne Investment Managers. Simultaneously, earnings growth has accelerated, Vartak told Mint in an interview. While small-cap earnings growth largely mirrored that of large caps prior to covid, though with greater volatility, it now outpaces large-cap earnings growth by at least 5 to 8 percentage points. Here are some edited excerpts from the interview. Where do you see pockets of growth now? Small caps tend to be very cyclical. In the past, they went through a 3-4 year cycle, followed by 9-18 months of correction. The peak was around September 2024, and 18 months later the correction phase was largely complete. But now the earnings growth is picking u p specially in March and June. Small-cap earnings growth was around 32%, while mid-cap was 28%. So, based on the cyclicality and earnings trajectory, we are entering a good 2.5 year phase for smids. Your strategy deals mainly in small caps. Why do you prefer small caps to other stocks? Smallcaps have become bigger in size. The market cap of the 1,000th company was around ₹240 crore in 2019. Today, it is above ₹3,000 crore, or 13 times larger. In 2019, a ₹23,000 crore company was a large cap. Today, a ₹37,000 crore company is a small cap based on Sebi’s definition. Secondly, the quality of small caps has improved significantly post-covid. In 2019, the median net debt-to-equity ratio for the small-cap universe was around 0.5 to 0.6. Today, it is almost zero. More than 50% of small-cap companies are debt-free. Profitability has also improved. Return on equity for the small-cap universe used to be around 10-12%; today, it is about 15%. The same is true of cash-flow collection. Earlier, companies could show good profits, but a lot of the money was stuck in receivables. Operating cash flow to net profit was around 85-90%. Today, it is around 115-120%. So, the smallcap companies are now much larger and have increased profitability, high cash flows, and low leverage. Previously, small caps used to fall around 40-45% during a correction. Post-covid, the average fall has been about 25%. While, earnings growth has picked up. Pre-covid, small-cap earnings growth was broadly similar to that of large caps, albeit more volatile. Today, small-cap earnings growth is at least 5-8% higher than that of large caps. The opportunity size for a fund manager like me has also increased. Large caps would account 75% of the total market cap but it has dropped to about 58%. So the opportunity size has gone up. Within small caps, where is the growth coming from? Financials, FMCG, IT, and oil marketing companies account for nearly 70% of the total Nifty weight. Small caps have very little exposure to financial services, IT or FMCG. Most are manufacturing-oriented — building materials, power ancillaries, power companies, defence, CDMO and other critical industries. That is where the real growth is happening. There is also a lot of export-oriented growth. With FTAs (free trade agreements) being signed with the UK and Europe, we are seeing opportunities in textiles and garments, CDMOs (contract development and manufacturing organizations) and specialty chemicals. The rupee's depreciation is also helping So, with bottom-up stock picking, you will mostly find good, export-oriented companies. Taiwan and South Korea are now seeing meaningful foreign outflows, yet India has not seen a corresponding large-scale shift in capital. So, is the ‘India as an anti-AI trade’ thesis actually playing out? The biggest risk today is the rise in interest rates in the US and globally. The US 30-year yield is almost 5.3%, the highest since 2007-08. The 10-year yield has also crossed 4.8%. Whenever interest rates go up, emerging markets are generally perceived riskier. So there is some outflow from emerging markets, and India is part of that basket. South Korea and Taiwan are also very much AI trades. When interest rates go up, the AI trade becomes less attractive because it requires a lot of investment. Higher interest costs make that capital more expensive and reduce the return on investment. Valuations are another factor. PE multiples are widely followed, but for cyclical businesses like chips, price-to-book is a better measure. SK Hynix, for example, used to trade at around 1 to 1.5 times book value and recently went up to almost 10-11 times. Samsung went from around 1 to 1.5 times, to 5 to 6 times book value. When valuations become expensive, they start trimming positions. So there are three things happening: emerging markets are becoming less attractive; the AI trade is becoming less attractive because of higher interest rates; and valuations in markets such as South Korea and Taiwan have become expensive. For India, allocation will always be driven by growth. Investors will come when India's growth is significantly better than the rest of the world. Today, India doesn't offer a great growth differential. US companies are growing at similar rates, while companies like Samsung, SK Hynix, and certain Taiwanese companies are growing much faster. India's growth is in rupee terms, so if rupee is depreciating, dollar growth is even lower. Is the defence theme coming back? There is huge capex happening in defence and the demand has probably gone up six- or seven-fold in the past three years. Globally there is an ammunition shortage. The Russia-Ukraine war and the Iran-US conflict have exhausted a lot of short-range rockets, long-range rockets and missiles. And then Europe is building its own defence capability. Earlier, Europe depended heavily on the US for its defence needs. But over the last few years, countries don't want to depend entirely on the US. And nobody wants to depend on China, while manufacturing in Europe or the US is extremely expensive. Now, India is focusing on becoming an export hub for defence. That is why Indian companies, particularly those involved in rockets, missiles and ammunition, are doing exceedingly well. They are getting huge orders from multiple countries. What about valuations, though? In large caps, companies like Solar Industries, Data Patterns and others are trading at very high multiples—around 50-80x. But once you move to the small-cap space, there are many defence companies available at around 20-25 times earnings. The story has been updated to correct the name of Samit Vartak. It was earlier mentioned as Samir Vartak.
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