Covid-19 is leading to rapid consolidation across a range of sectors in India, including sectors in which well-run small cap companies participate. Whilst the ability of Consistent Compounders like Asian Paints, HDFC Bank and Page Industries to consolidate market share during times of economic distress is well known, the rise of smaller consolidators from our Little Champs Portfolio like GMM Pfaudler (mkt share:65%), Alkyl Amines (mkt share:50-55%) and Garware Technical Fibres (mkt share: 60-70%) and DCB Bank has been a revelation over the past six months.

India’s Little Champions are surprising us
Whilst in business circles, it has long been a cliché to say “When the going gets tough, the tough get going”, over the last six months as Covid has hammered the Indian economy, the performance of some of the champion franchises in our country has been reassuringly strong. We had expected to see powerful well run franchises like Asian Paints, HDFC Bank, Nestle, Titan and Bajaj Finance to perform way better than their rivals and on that count, these firms have not disappointed us (a point we have noted in our 6^th April and 1^st May newsletters.

The more positive surprise came has from firms far smaller than the titans mentioned in the preceding sentence – firms like GMM Pfaudler (mkt cap $800 mn), Alkyl Amines (mkt cap $630 mn), Garware Technical Fibres (mkt cap $440 mn) and DCB Bank (mkt cap $330 mn). The ability of such small firms – with sub-$1bn market caps – to protect their balance sheets and their franchises in the face of a sharp economic downturn suggests that management talent is now spreading beyond the well-known Consistent Compounders and percolating into the better run small companies.

For example, GMM Pfaudler’s capital allocation in recent years has been almost exemplary. Thanks to strong barriers to entry (around reputation and world class technology), the company is the preferred supplier of glass lined vessels to the premier Indian pharma & chemical companies. As a result, its pre-tax ROCEs tend to be around 30%, well above its cost of capital. That in turn implies that free cashflow generation has not been a problem for this firm. In fact, entering the current FY, the company had net cash of Rs 110 crores. In spite of the sustained entreaties of investment bankers, GMM Pfaudler had carefully cultivated this cash pile over several years. Then, when the Covid crisis created the perfect opportunity to deploy this cash, we were pleased to see that the management rose to the occasion. The other large global player in India, De Dietrich, a French company, exited India and GMM stepped into to buy its plant & order book for Rs 53 crores (implied P/Sales multiple on the deal on 1x). Post this acquisition, GMM has an almost complete hammerlock on an essential B2B product which is in short supply and where the barriers to entry (around regulation and technology) are very high.

Channel checks point to a gradual economic normalisation
My colleagues’ channel checks and recent management commentary suggest demand recovering quickly across a significant number of smaller firms in India. For example, in the pharma & chemicals sector, our channel checks and recent management commentary suggests that pharma companies, agrochemicals and personal care industries have witnessed significant normalisation in their operations. Examples of what we have heard from well-run companies in these sectors:

• “We have an order backlog of Rs350 crores on April 1^st which is 40% higher than previous year” – A leading supplier of process equipments to pharma/agro-chem industries (a portfolio company) in 4QFY20 results conference call
• “In the pharma industry, more and more intermediates that go into the API could be manufactured in India (shift from China). That can give good long-term growth to the industry” – Executive director of a raw material supplier to Pharma/Agro-chem industry (a portfolio company).

We have received similar inputs from the better run auto ancillary & light industrial manufacturing companies. While it may be still early days, we also hear newsflow (from the media as well as from management of credible lenders like Bajaj Finance and HDFC Bank) about more and more MSMEs opting out of the moratorium particularly in the southern part of India. Similarly, our checks also suggest that banks and NBFCs are starting to lend in sectors where they are gaining confidence about the recoverability of the loans – for instance, the tractor segment.

The strange world of Indian small caps
In fact, if we take a step back from the company-specific commentary and look at the big picture, a very interesting picture emerges regarding Indian small caps.

Small firms’ revenues and profits tend to be more volatile than those of larger firms due to dependence on: (a) a single line of business; (b) a small group of people running the show; and (c) limited free float & trading volumes which accentuates the good or bad impacts of any macro/company specific developments. Naturally, therefore, investors expect higher returns from smallcaps (relative to larger caps) to compensate for the higher uncertainty involved in small cap investing.

However, an analysis of the BSE SmallCap’s performance over the last 14 years shows that it does NOT provide this extra return that investors expect to get for the extra risk they are taking. From September 2005 to December 2019, the index has delivered a total return CAGR of 8.9% compared to the Nifty’s 13.0% and BSE500’s 12.5% over the same period (these returns include dividends & buybacks).

The above explained challenges in the broader small cap space, does not mean that there is no money to be made in small caps. In fact, what my colleagues are finding is that there is an enormous amount of money to be made by investing in high quality small caps. So how does one identify high quality small caps?

At Marcellus, we use the following two quantitative frameworks to arrive a shortlist of companies:

1. Evaluating the accounting quality of a company needs to be a cornerstone of any investment process in India. We have developed a set of 12 ratios that help to grade companies on their accounting quality. The selection of these ratios has been inspired by Howard Schilit’s legendary book on forensic accounting called ‘Financial Shenanigans’. We use this framework to eliminate around half of the small cap universe.
2. Our competitive advantage/capital allocation framework uses financial parameters like revenue growth, consistency in gross margin, consistency in interest coverage, improvement in working capital and improvement in fixed assets turnover to rank the companies which clear our forensic framework explained above. We then select companies which score above average on all the above five individual parameters AND deliver metrics above our thresholds on latest year RoCE and net debt-equity levels.

Thanks to these frameworks, our small cap portfolio has delivered a PBT growth of 1% in FY20 compared to the BSE Smallcap’s median decline of 10-15%. Furthermore, our small cap portfolio companies have been able to maintain healthy RoCE (19% pre-tax) and debt levels (net cash equity of 0.1x) in FY20 at the portfolio level. This outperformance in fundamentals is nicely reflected in outperformance in stock prices – our portfolio is outperforming the BSE1500 by around 15% points with share price volatility less than that of the index.

The only bit of bad news is that we have had to shut our small cap portfolio (Little Champs) to inflows from eager clients as liquidity in these stocks is still pitifully low. For clients who wanted to but could not invest in Little Champs, we will come back to the market later on this year with an equally high quality product based on our proprietary forensic accounting and capital allocation models.

Disclosure: Asian Paints, HDFC Bank, Nestle, Titan, Bajaj Finance, GMM Pfaudler, Garware Technical Fibres and Alkyl Amines are part of several portfolios managed by Marcellus Investment Managers.

Saurabh Mukherjea is the CIO at Marcellus Investment Managers (www.marcellus.in). His next book, ‘The Victory Project: Six Steps to Peak Potential’, will be published in August by Penguin. <