Weekly Musings – NFO Pick (TRUSTMF Small Cap Fund)

24 Sep 2024 , 10:40 AM

WHY SMALL CAP COMPANIES AT THIS JUNCTURE?

In the last few months, there have been concerns over the valuations of small cap stocks, especially after its very frenetic rally over the last couple of years. However, there are several reasons for investors to prefer a small cap fund at this juncture.

• Most quality small caps offer the best growth phase for any company and this growth gradually tapers after they transform into mid-caps and large caps. The idea is to catch them young and watch them grow.
• Today, while there are 100 large caps and 150 mid-caps; there are technically over 4,700 small caps. Even if you remove the micro caps, you are still lift with large choice of stocks to create your portfolio from.
• If you look at the financials of these small caps, they have delivered ROE of over 15% and CAGR profit growth of over 20% in last 3 years. Despite that, the trailing P/E ratio is just 23X, which would be a lot more attractive if we were to consider the PEG ratio.
• The investable small cap universe has been defined as companies with a market cap of more than ₹2,000 Crore. That base has expanded from just 220 companies in the year 2020 to 788 companies today. So, there is a much wider choice available.
• The small cap theme is naturally suited to very niche themes like financialization of savings, premiumization of consumption, defence, digitization, technological disruption etc. These are not exactly large cap themes, which are commodity and BFSI driven.
• In terms of sectoral dominance, small caps dominate sectoral themes like chemicals, infrastructure, logistics, realty, capital goods, healthcare etc. Some of these high potential themes are only accessible via small caps.

Let us now look at what is changing for the smaller stocks.

CHANGING THE NARRATIVE FOR SMALL CAP STOCKS

In the last few years, it is not just the performance, but even the heft of the small caps stocks grown in the overall market. For example, in August 2022, the market cap of the small cap universe stood at about $500 Billion. In the last 2 years, their market cap has grown to $1.10 Trillion. That is substantial accretion that has happened. If you take a slightly longer perspective from 2004 to 2024, then the market cap contribution of the large caps has fallen from 83% to 62%. During the same period, the share of mid-caps has grown from 9.5% to 18.7%; while the share of small caps ahs grown from 7.2% to 19.4%. In fact, small caps have now overtaken mid-caps in terms of market cap heft.

What is really important about the small cap narrative is that it is the virtual breeding ground for multi-baggers. Consider these statistics. If you look at 2X to 3X multi-baggers over the last 5 years, then there are around 40 companies from large caps, mid-caps, and small caps each. If you look at 3X to 5X multi-baggers, then there are 64 small caps, 38 mid-caps and just 26 large caps. Finally, if you look at beyond 5X multi-baggers, then there are 60 small caps, 27 mid-caps and just 6 large caps. The message is clear. If you look at mega-baggers, the probability of finding such mega-baggers is most in the small cap space.

Finally, let us look at the 10- year period from 2014 onwards. Out of the 250 small cap stocks in 2014, a total of 3 stocks have transformed into large caps; growing nearly 43X on an average. A total of 43 stocks have transformed into mid-caps giving average growth of 16X. a total of 112 stocks remained small caps, but still gave 6X returns. Small caps, essentially, thrive on this transformation game. If you compare the Nifty Smallcap 250 TRI with the Nifty 100 TRI, then the CAGR returns since 2014 has been 14.7% for the Nifty 100, while it has been 18.2% for the Nifty Smallcap 250 TRI.

COMBINING GARV AND TV APPROACHES TO STOCK SELECTION

TRUSTMF seems to combine two essential ideas of GARV and TV for stock selection. Let us understand these two concepts.

• Growth at reasonable valuations (GARV) is an approach that prefers high growth stocks, even if them come at higher price and valuation. That is because the higher growth ensures that the valuation in PEG terms is still attractive.
• TV or the terminal value is a measure of longevity of the company. TV helps investors to capture the full value creation journey by staying invested for the long haul. It is the value of the company beyond the foreseeable horizon.

What does this combination really mean. When GARV is combined with TV, you get companies that assign a high weightage to growth and also to reasonable valuations. They are both in the top quadrant of the growth versus valuation relationship. Investors normally tend to underestimate the terminal value (TV) for high growth stocks, but that is where the true long term valuation creation lies.

PERFORMANCE OF SMALL CAP FUNDS IN INDIA

The TRUSTMF Small Cap Fund is an active equity fund that will focus purely on small cap stocks as defined by SEBI. The idea of the fund is to use bottom up stock selection strategies to generate alpha for the investors in the fund with a target to beat the Nifty Smallcap 250 TRI in terms of long term returns. Here is a quick look at how small cap funds performed in the Indian markets over 1-year, 3-years, and 5-years. While there are 24 small cap funds in all, we have only presented the top-15 funds ranked on 5-year CAGR returns. We have considered the direct plans to get over the TER bias. In all cases, growth option has been taken as the benchmark to eliminate reinvestment risk. Here are the top 15 small cap funds on 5-year returns.

Scheme Name	NAV (in ₹)	Return (%) 1-Year	Return (%) 3-Years	Return (%) 5-Years	Daily AUM (₹ in Crore)
Quant Small Cap Fund	303.15	56.22	33.59	49.76	26,505.20
Bank of India Small Cap Fund	55.49	53.75	28.46	40.97	1,474.32
Nippon India Small Cap Fund	202.20	49.46	32.65	38.41	61,470.69
Canara Robeco Small Cap Fund	45.96	44.71	27.21	37.48	12,599.25
Edelweiss Small Cap Fund	50.60	47.31	28.53	36.29	4,287.69
Tata Small Cap Fund	48.46	53.41	30.85	36.24	9,219.74
Invesco India Smallcap Fund	47.22	63.84	30.38	35.98	5,308.47
Kotak Small Cap Fund	331.87	45.21	23.72	34.86	18,107.05
HSBC Small Cap Fund	98.55	45.98	30.15	33.27	17,315.67
Union Small Cap Fund	56.40	37.09	24.09	33.00	1,668.75
DSP Small Cap Fund	221.17	41.31	26.57	32.98	16,638.75
Sundaram Small Cap Fund	298.27	44.43	26.01	32.34	3,557.12
ICICI Prudential Smallcap Fund	102.19	38.26	25.43	32.07	8,799.01
LIC MF Small Cap Fund	37.12	55.55	29.00	31.94	356.67
Axis Small Cap Fund	126.17	43.21	25.38	31.79	24,516.39

Data Source: AMFI

The table above provides the performance of the top 15 active small cap funds over 1-year, 3-years, and 5-years; with the ranking on 5-year returns to give a long term flavour. There are a total of 24 such funds in India managing a combined corpus of ₹3,21,492 Crore between them. Only the funds with 5-year track record have been considered.

• Let us first look at the returns on the above funds over a 1-year period. On a 1-year returns basis, these funds generated maximum returns of 77.40% and minimum returns of 36.57%, which is a fairly attractive worst-case scenario. The average returns over a 1-year period was 48.79%, which is impressive. There was a 100% probability of being among best performing asset class in India over a 1-year period.
• Let us first look at the returns on these funds over a 3-year period. On a 3-year returns basis, these small cap funds generated maximum returns of 33.59% CAGR and minimum returns of 19.87% CAGR , which is a healthy worst-case scenario. The average returns over a 1 year period were impressive at 27.33%. Again, there is almost 100% probability of being among the best performing asset class over a 3-year period.
• Let us finally look at the 5-year returns on small cap funds. These funds generated maximum returns of 49.76% CAGR and minimum returns of 26.31% CAGR, which is healthy worst-case scenario. The average returns since inception were impressive at 34.59%; although dispersion is high over longer time frames.

Small cap funds are a good theme and, despite valuation concerns, they have generate long term alpha for investors.

GLANCE AT THE TRUSTMF SMALL CAP FUND NFO

Here are some details of the TRUSTMF Small Cap Fund NFO you must know to decide on investing in the fund.

1. The NFO of TRUSTMF Small Cap Fund opens for subscription on October 11, 2024 and will close on October 25, 2024. Being an open-ended active small cap fund, it will reopen for sale and repurchase anywhere between 3 days and 15 days of NFO closure. The TRUSTMF Small Cap Fund is best suited to investors looking for long term outperformance with a higher exposure to smaller stocks.
2. The core focus of the TRUSTMF Small Cap Fund, being an active small cap fund, is to outperform the Nifty Smallcap 250 TRI (total returns index). The fund will invest in small cap stocks emphasizing on bottom up stock identification and investing. The focus will be on long-term capital appreciation, through an active approach to investing in small cap stocks. A holding period of, at least, 5-7 years is suggested to realize full benefits.
3. On the Standard SEBI Risk-O-Meter, the TRUSTMF Small Cap Fund will be ranked as a Very High Risk Fund. The high risk is an outcome of the predominant exposure to equities (80% to 100%) that the TRUSTMF Small Cap Fund will have. In addition, there is the risk of entering into the markets at lifetime highs as well as relatively steep valuations of small caps. Being an active fund, the risk of fund manager bias and fund manager performance also has an impact.
4. The TRUSTMF Small Cap Fund is about generating long term capital growth through an active approach to identify small caps that can transform into mid-caps and large caps over a longer time frame. It will focus on themes like chemicals, capital goods and others that are not generally part of the traditional Nifty dominant themes. While allocation will be predominantly in equities, there could be some outlays to debt also. The fund will offer growth option and the IDCW option to investors.
5. Investors can invest in the NFO of TRUSTMF Small Cap Fund in minimum size of ₹1,000 lumpsum and in multiples of ₹1 thereof. This also applies to additional purchases and switch-ins. The fund also supports the systematic investment plans (SIPs), systematic withdrawal plans (SWP), and the systematic transfer plans (STPs) programs on a structured and long term basis. The monthly SIP investments will also have a minimum tranche limit of ₹1,000 per tranche; while quarterly SIPs will have base limit of ₹3,000.
6. There is no entry load, but conditional exit load will be there to protect the interests of the continuing investors in the fund. In this case, an exit load of 1% of the redemption NAV will apply if switched within 180 days from the date of allotment. There will be no exit load after 180 days. However, leaving aside exit loads, investors must hold this fund for at least 5-7 years to realize the full potential manage to the cycles.
7. Being an equity fund, the TRUSTMF Small Cap Fund does not give any guarantee on returns and the performance of the fund is subject to the vagaries of the markets in general and the performance of small caps in particular. The TRUSTMF Small Cap Fund will be benchmarked to the Nifty Smallcap 250 Index TRI, which the fund managers will seek to outperform. However, there is a possibility that the fund may not be able to outperform the underlying benchmark index.
8. The TRUSTMF Small Cap Fund will be managed by Mihir Vora and Akash Manghani. The intent of the fund management team will be to beat the Nifty Smallcap 250 Index TRI through innovate and astute stock selection. KFIN Technologies Ltd will be the registrars to the fund.

The TRUSTMF Small Cap Fund NFO offers an opportunity for investors to participate in the upside opportunity of small cap stocks. This is a high risk segment, but if you go by history, their cumulative performance has also been commendable.

TAX TREATMENT FOR TRUSTMF SMALL CAP FUND

TRUSTMF Small Cap Fund will be classified as an equity fund for tax purposes. The tax provisions below are pursuant to the changes made in the full Union Budget presented on July 23, 2024; and changes are effective for transactions after July 23, 2024.

• Dividends declared (if any) by the fund will be taxed at the peak rate of tax applicable. In addition, if the overall dividends exceed ₹5,000 in a year, they will be subject to tax deduction at source (TDS) at the extant TDS rates.
• Time frame for classification as long term capital gains (LTCG) will remain 1 year for the TRUSTMF Small Cap Fund. STCG (held for less than 1 year) will be taxed at 20% on gains plus cess at 4%, making effective STCG rate 20.80%.
• The LTCG on the fund (1 year holding and above) will be taxed at a flat rate of 12.5%. However, threshold exemption limit has been increased from ₹1 Lakh to ₹1.25 Lakhs. In this case, the actual tax impact will be 13% after including 4% cess.

It is what you earn from the TRUSTMF Small Cap Fund in post-tax terms that matters. That is why, it is essential to understand tax implications.