'Mid- and small-cap valuations will continue to correct'

Shridatta Bhandwaldar joined Canara Robeco Mutual Fund in 2016 as a fund manager and rose through the ranks to become its Head of Equities. Presently, he oversees assets worth nearly Rs 94,956 crore across 13 schemes at the fund house. Among these, the Canara Robeco Bluechip Fund and Canara Robeco Small Cap Fund have earned four-star ratings from Value Research.

In this interview, Bhandwaldar offers his perspective on the recent decline in valuations due to the market downturn. He acknowledges that while large-cap stocks are reasonably valued, mid and small-cap valuations are still "higher by 10-15 per cent", though he expects their correction to be gradual rather than sharp. He also discusses the underperformance of his flexi-cap and small-cap funds, explaining why he is not worried about the "near-term underperformance" of the latter and the measures he is taking to improve their performance.

Given the current market correction, do you believe valuations have become more attractive now?

Markets have become attractive compared to what they were three months back. But on an absolute basis, I think large caps are at fair valuations in the context of incremental earnings growth. Their earnings growth will likely be 12-13 per cent CAGR for the next two years. But as you go into mid and small caps, I think valuations are still higher by 10-15 per cent or higher in certain pockets than historically. Our take is that they will continue correcting, but you might not get a knee-jerk or downside volatility in one short. Recently, we have seen that the broader indices corrected by 15-20 per cent in one and a half to two months. I know if the earnings don't surprise gradually, it will be more of a time correction, which adjusts to the valuations rather than a price correction. That's how we are looking, and we believe that froth has been taken out.

It seems like the small- and mid-cap indices have corrected by 15-17 per cent on an absolute basis, but some of the aggressive portfolios have corrected by 30 per cent, and some of the individual stocks have corrected by 50 per cent; there is no sign of them returning immediately because the earnings are also not coming in. So to that extent, one has to take a little longer view and invest in this part through systematic investment plans (SIPs). One should be careful about the portfolio they are choosing. For the last two years, it didn't matter what portfolio you chose; probably the riskier the portfolio you chose, the better the returns. But from here on, when the normalisation of the economy happens, the boys will be separated from the men, and you need to be in portfolios with the men rather than the boys, even in the small caps.

Canara Robeco Bluechip Fund and Canara Robeco Focused Fund have done well in 2024 after some rough patches in the previous (two to three) years. What has worked for these funds?

Canara Robeco Emerging Equities, which has performed exceptionally well over the past year, should also be included in the list. If we step back and look at what was not working in the calendar year 2023, we realise that the market was tilted toward the non-value side, so we had very limited pockets where we could play, and we were diversifying a little more than was required. If we look at the period between 2017 and 2021, the playing areas were 50-60 stocks out of the top 100 stocks. But in the calendar year 2023 and part of 2024, it shrunk to 25 stocks. The remaining 75 stocks were unsuitable for fundamental investment due to management challenges, a lack of a clear structural story or excessive cyclicality. We were diversifying and putting in a little less weight in many spaces where we had conviction. So, we realised that if we have a relatively smaller playground, we need to concentrate a little more than what we did in the earlier cycles.

We sharpened some of the names we owned and got rid of some growth-quality names that were not delivering earnings growth in a relative context. We did sharpen, but we did not concentrate. For example, if we were holding a stock with 2 per cent of the exposure, we increased it to 3 or 3.5 per cent rather than moving to 5-7 per cent or more than that. The goal was to eliminate losers in the same basket and reward winners. So, another thing is the selection of the stocks. We always focus on selection; if you get your selection right, you always get your outcomes right. I believe that portfolio managers are paid for selection. They are not paid for strategy or allocation because they have their own shortcomings.

Canara Robeco Flexicap Fund has underperformed the benchmark over one, three and five years. What do you think are the key reasons for this underperformance, and how do you plan to improve it?

I think we have started to outperform in this fund, too. However, one thing is that we did not sharpen the portfolio enough; we kept it diversified and that did not help. We have started doing so in the last 3-4 months, and it has already started showing the outcomes. So it had winners and losers, and they were cancelling each other. But if you look at three years, what has hurt us is the value rally in PSUs, small caps and mid caps. So we never run the fund with 50:50 in large cap and small and mid cap because this category is very heterogeneous. We had a large-cap orientation, and within that, we had a growth quality tilt, which did not help. So, an under-allocation in PSUs, small and mid caps did end up hurting the portfolio, and this is a very simplified explanation at a very broad level.

Naturally, we would have made selection mistakes and not sharpened them a year ago, as we did with other categories. I think that hurt us, but everything is about learning, and we learn and then move on. The process has already started in that portfolio, and I hope that for the next six months, we will again see the same sharpness in selection within our area of competence, which always helps.

However, we have retained the thought process that flexi cap is a product and, even before the re-categorisation, has been sold as a relatively conservative product. It has not been sold as a multi-cap, a large plus-mid category, a mid-cap or a small-cap fund. So why should I offer risk in that portfolio? If I have to offer risk or beta or a higher mid cap and small cap, I have other products like large & midcap or multi-cap funds. I have products in mid cap, small cap and even manufacturing. Therefore, investors have a wide range of products to choose from, allowing them to increase their exposure to risk and volatility. Should I change the core of how we have run it? We don't plan to do that. I've been running this product for about nine years, and it has outperformed the benchmarks and peers for six years.

At that point in time, we said the same thing which we are saying today: that it is a product for relatively conservative investors who want something that is a large-cap plus and not a mid-cap or small-cap product. So we will continue to run it 75:25 per cent or 70:30 per cent (large, mid and small cap). That's the band, and we will continue to run it that way.

Despite a strong five-year record, Canara Robeco Small Cap Fund has struggled in the bottom quartile for two years. What key factors led to this, and when do you anticipate a turnaround?

What has not worked for us is the allocation and selection process. Some of the allocations made to building materials and chemicals really struggled in the calendar year 2023 and part of the calendar year 2024, which was one thing that clearly hurt. Second, we probably took a call on mid-cap and small-cap IT too early as a house. In the calendar year 2022-23, we thought that their valuations had just gone through the roof, and in the 20 years, they had never traded at a premium to a large cap for such a long period. So we decided to trim some of those IT exposures in mid and small caps, but they did disproportionately well. Otherwise, when I look at the top 10 holdings and the sectoral positions, we captured the entire EMS and defence rally.

And even the domestic pharma, industrial and capital market rallies in that portfolio. But of course, we also had losers in the form of basically not participating in IT or selling it early and having some exposure to chemicals and building materials, which underperformed in that phase. I would always recommend evaluating the fund at least from a five-year perspective, as it has consistently performed well over this period. It still continues to be one of the best-performing funds since we launched, and we are not worried about the near-term underperformance.

Following the recent market correction, which sectors or themes look attractive to you right now, and which ones are still overpriced?

At this point, the market is at a very interesting phase. The sectors that are extremely attractive have their earnings growth still very low. For example, the entire consumption basket is very attractive, except for some retail companies, but unfortunately, the earnings visibility is low. Even for IT, while it has done well and is still attractive, the incremental earnings growth upgrades are not happening.

Everybody is bullish, and the US is likely to do well, but we are not seeing the upgrades as of now, barring one or two names. In my opinion, cement is particularly appealing due to its under-owned nature and the recent improvement in its numbers. That's one space where the numbers have gradually started turning around, and the valuation is attractive. Even in chemicals, the numbers have started turning around, and the valuations are attractive from a medium-term perspective.

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