In an interview with Outlook Money,R. Janakiraman Fund manager, Franklin India Smaller Companies Fund, shares his views on the small – cap funds and their investors. Excerpts:
x What is the investment approach of this fund? How are small-cap stocks selected and how different is this approach from, say, picking a mid- or a large-cap stock?
The overall investment strategy of Franklin India Smaller Companies Fund (FISCF) is in line with the Franklin Equity (India) style of investing. The fund follows a bottom-up approach to stock selection across industries with an aim to provide adequate diversification. Our stock picking is focused on merits of individual businesses with focus on long term performance.
There is no difference in the analytical framework used to assess a business at Franklin, be it large-cap or small-cap. In case of the latter, the extent of public information tends to be lesser vis-à-vis a large-cap stock and hence calls for more judgement. Our disciplined investment approach helps in such a case.
x What kind of stocks get shortlisted and what gets avoided?
The fund focuses on investing in businesses with an acceptable level of quality. These are characterised by an attractive return on capital, relatively lower capital intensity, ability to generate free cash flow, attractive growth potential and capable management. The list is not exhaustive but illustrates the idea adequately. Exceptions to this happen on a tactical basis. In general, the ‘quality compounders’ account for a large part of the portfolio.
Businesses that do not have the ability to generate free cash flow are the ones we try to avoid. Such businesses tend to be very capital intensive, generate poor return on capital, are very cyclical and have limited entry barriers.
x What has resulted in the superior performance of this fund in the past one year?
Our approach is to construct a well-diversified portfolio of small- and mid-cap stocks that have an attractive business with sound fundamentals. Significant amount of effort goes into identifying such good quality businesses. These businesses have the ability to compound earnings at an attractive rate over a long period of time. Identifying such companies and remaining invested in them for a long time has been the key reason for the fund’s performance.
x What is your advice to investors in a small-cap fund?
Small-cap companies offer good opportunities but are also characterised by a higher degree of volatility in their operating performance. This leads to commensurate volatility in their asset prices as well, and is compounded by lower liquidity.
Long-term investment horizon helps an investor to absorb this higher volatility and reap higher returns. Investors in a small-cap fund should be aware of this interplay between returns, volatility and required timeframe. Our advice would be to invest in line with one’s financial goals. Investing through the systematic route and diversifying across asset classes is the best way to deal with market volatility.