smallcases in focus: Growth & Income – AWI – FMCG Tracker

Introduction

In recent months, the prospects of a global economic recovery, after pandemic induced collapse, have worsened and the outlook has deteriorated. According to the IMF, global GDP growth for both 2022 and 2023 is going to be 3.6%. This is 0.8 and 0.2 percentage points lower than in the January forecast, respectively. Russia’s invasion of Ukraine, frequent lockdowns in China and tightening of monetary policy in many countries has affected global economic growth.    

Tracking this news, stock markets have been recording poor performance. Nifty 100 has been down 4.83% so far this year, in the broader market Nifty 500 is down ~6%. Foreign portfolio investors have pulled out more than Rs.1,65,000 crore from the equity markets this year. 

Windmill Capital has offerings across sector trackers, rule-based models, theme-oriented smallcases, smart beta smallcases and dynamic asset allocation strategies. Within these categories, some smallcases work very well during times of high market volatility. This month, let’s discuss 3 such smallcases.

Growth & Income

When a fund manager attempts to create a model-based portfolio of stocks, she usually screens for stocks that exhibit specific characteristics such as growth, momentum, value, etc. One example of this behavior is value investing. Fundamentally strong undervalued companies, i.e ones that have a low PE ratio compared to their peers, tend to outperform in the long run. What happens when the screening criteria consist of multiple factors like growth, value, quality and dividend payout? We end up with the Growth & Income smallcase! 

Growth & Income smallcase is based on the investment criterion set out by Kevin Matras, in his international bestseller “Finding #1 Stocks: Screening, Back-testing, and Time-Proven Strategies”. The criteria used to shortlist stocks have been modified to suit Indian markets.

We use a diverse set of factors while picking stocks for this smallcase. Earnings per share growth, return on equity, dividend per share growth all indicate the fundamental performance of the company. Further, only companies that have low price to operating cash flow compared to industry peers are shortlisted. 

One distinct aspect of the smallcase has been the self-selection of smallcap companies into the basket. 

We shortlisted the stocks that were part of the smallcase over the previous 4 years and using SEBI guidelines classified them as large, mid and smallcap. Historically, the smallcase has been smallcap heavy.

When one is smaller in size, it is easier to record higher growth relative to peers. Hence smallcap companies are more likely to record higher earnings per share growth compared to their larger peers. This growth is also likely to fuel growth in dividends per share. Not many analysts research smallcap companies and put out reports analyzing their business performance. Hence smallcap companies tend to be valued lower compared to their peers. A combination of these factors results in more small-cap companies being selected for Growth & Income smallcase.

Moving onto the performance aspect, the smallcase has consistently beaten the performance of equity smallcap companies since 2018.

It is important to note that, the smallcase has beaten the performance of equity smallcap on a risk-adjusted basis as well and at a lower drawdown of 52.4% compared to 65% of the smallcap universe. Drawdown measures the downside risk of a stock / portfolio.

Lets take a look at the performance of the smallcase during bull and bear phases:

From the charts it becomes clear that during bear phases Growth & Income smallcase had lower drawdown compared to Equity smallcap. Because of this recovery is quicker and during bull phases the smallcase has managed to match the returns of Equity smallcap. 

However, investors need to consider the fact that pure equity smallcap heavy smallcase like this one has a significant risk of drawdown in the short term and is only suitable for long-term investors with a higher risk appetite.

All Weather Investing

On May 4th RBI announced that it would be increasing the repo rate by 40 basis (100 basis points = 1 percentage point) points 4.4%. In response, Nifty 50 dropped by 392 points and closed down by 2.3%. Since then, Nifty 50 has been trading flat. Rising crude oil price, war in Ukraine and spike in inflation have all combined to pull markets down.  Nifty 50 is down by 4.4% since the start of the year. During the same period gold prices in India have gone up by 5.7%. 

An investor who had exposure only to equity instruments would have suffered a loss during the period, whereas an investor with exposure only to gold would have made a profit. An investor with a diversified portfolio of stocks and gold would have done better.  The table below presents another problem. The portfolio profit/loss will vary depending on the weightage assigned to the instruments.

This is the problem we were looking to solve when we conceived the All Weather Investing smallcase. An automated product that could be used by investors in all circumstances–whether the markets are up or down. The requirements were:

• Passive investment strategy
• Diversification across multiple asset classes
• Dynamic asset allocation

During periods of heightened market volatility, All Weather Investing’s algorithm provides signals to shift the allocation towards safer asset classes like gold and fixed income. Alternatively when volatility is low, portfolio weight is tilted towards equity. This smallcase will generate equity (stock market-like) returns over the long term, but will also significantly reduce fluctuations to provide a smooth wealth creation journey. 

The below illustrates the performance of AWI against equity large caps since the former’s inception in July 2018.

The risk adjusted returns data indicates that the AWI generated significantly more returns per unit of risk compared to Equity Large Cap. All this comes with a lesser drawdown of ~16% vs ~38% of equity large cap. 

Another important aspect that we need to explore is whether AWI is recession proof?

As is evident from the charts above, the AWI has remained flat during bear phases of the market. This is because the asset allocation algorithm is able to reasonably predict the start of the bear phase and signals that weights of equities should be pared down and weights of gold and fixed income needs to be increased. This allows the smallcase to effectively protect the accumulated capital. Similarly based on signals received, equities are weighted heavier at the onset of the bull phase. However due to the presence of gold and fixed income instruments, during bull phase returns, the smallcase will not soar as much as that of equities. So does the smallcase always offer positive returns? No! It only reduces the extent and frequency of negative returns. The smallcase significantly minimizes the damage that a sudden market fall or a prolonged recession can have on one’s portfolio.

To summarize, the benefits of investing in All Weather Investing smallcase are:

• Consistent returns
• Low volatility
• Lowered risk of loss

Regardless of whether you are a novice investor easily overwhelmed by investing jargon, seasoned investor seeking to create wealth over the long term or a risk averse worrier about market movements, the All Weather Investing smallcase is a great investment option

FMCG Tracker

Fast-moving consumer goods (FMCG) companies sell articles like packaged food & beverages, personal care items like soaps & deodorants and household items like washing powder & mosquito repellant. These articles are used by average consumers every day. In the short term, demand for these products does not grow exponentially or fall sharply due to economic conditions. In addition, the operations of FMCG companies are not capital intensive and they have a short cash conversion cycle. So these companies have relatively low debt and high return on equity. 

Due to these aspects, stock prices of FMCG companies usually are not very volatile and the sector is considered a defensive play. This can be seen from the performance of the FMCG tracker during the COVID crisis and the recent volatility induced by Russia – Ukraine war, high oil prices, and inflation.

The smallcase also has a lower drawdown of 30.5% compared to 38.1% of equity large cap. 

Lastly, we also have the low risk smart beta smallcase. This smallcase screens for the least volatile stocks among the top 150 market cap stocks. The smallcase uses  a maximum diversification weighting scheme. We had discussed this smallcase in the previous month’s newsletter. You can read about it here. 

From the above discussion it is evident that some portfolios, be it pure-equity to asset allocation to tracker etc. can give comfort in these volatile markets because of the rules they follow and select stocks/ETFs which display characteristics to relatively outperform the broader markets. Investors can consult their financial advisors before investing in such smallcases during the current uncertain environment.