The small-cap magician

SBI Small Cap Fund has not just beaten its category and benchmark over several time frames but has also proved to be good at containing downside. In this interaction with R Srinivasan, Head of Equity, SBI Mutual Fund, we asked him to share his secret sauce for picking small caps that perform but don't crash in a bear market. We also asked him how to avoid wealth-destroyers.

R Srinivasan:

As a fund house, our stock-selection process is biased towards quality and growth - to the extent possible! As a style, 'quality and growth,' I think, tends to outperform weak markets. Maybe that partly explains why we have done better than the benchmark in the last couple of years. The lack of ideas, especially high-conviction ones, also led us to be a lot more conservative, which also should have helped outperform a benchmark that's done poorly. Before that, we had the benefit of size and a few lucky stock picks, such as Graphite. I wish we had a secret sauce! Remember Po's conversation with his adoptive father in Kung Fu Panda, "There is no secret ingredient."

Our 'absolute return' stock-selection philosophy looks for three variables - a strong business, a good management team and reasonable valuations.

What's a strong business?

• It's something that has competitive advantages or economic moats.
• Two, it needs to or needs to be able to generate a reasonably high return on capital.
• Three, it has to be scalable. To be able to generate high returns on capital and at the same time grow at a fast clip is like having the cake and eating it too.
• Four, low capital intensity
• Five, high cash conversion
• Six, pricing power
• Seven, longevity or a low risk of business disruption. Etc.

Managements can be cross-referenced for integrity, capability and vision through their track record. We look for transparency, accountability and clarity of thought in our interactions and analysis. A good price is something that gives you a margin of safety. That is not only in terms of P/E and price-to-book ratios but also in terms of the stability of the business model and the earlier factors put together. This becomes tougher, I guess, in untested or relatively immature businesses in small and mid caps. In this context, we try and think of these not in black and white but in different shades of grey. If you get the drift, it's about weighing these different variables for their intensity or closeness to where you want them to be and choosing the best combination.

The above framework, I think, helps reduce the 'wealth-destroying' attributors in the portfolio though if you are in the business of risk, it's impossible to completely avoid them. I must add here, we also have an internal forensic framework that tries to weed out companies that deviate in their financial parameters and relative transparency. This check keeps the analyst on his toes and brings forth existing or potential irregularities that may otherwise be difficult to catch.