The mirage of returns in Small and Midcaps – how does one exercise discipline

It often takes far less time to destroy something than it does to create it. That applies true on construction sites, and to reputations (as Warren Buffett famously put it – “It takes 20 years to build a reputation and just 5 minutes to destroy it.”). More pertinent even, this shares an uncanny resemblance to motions of the stock market. Such is the nature of entropy, the universal rule of order sliding towards chaos.

A common perception among investors is that risk and reward go hand-in-hand. While you and I can go down that slippery slope of citing examples for which this holds true or false, I believe that there is a method to the madness – one that would allow you to consistently generate outsized returns and protect your capital at the same time – by investing in sustainably high-ROCE stocks.

For the uninitiated, Return on Capital Employed (ROCE) is a measure of capital efficiency. Unlike gross/net margin ratios, it doesn’t merely assess profitability. It takes into account the capital used by the company to generate these returns. A high-ROCE value indicates that a greater portion of profits can be reinvested in the company for the benefit of shareholders. Businesses with high ROCE inherently have the ability to generate higher profits in relation to the capital required, creating a virtuous cycle in which profitable growth may be funded by internal accruals.

Consequently, a consistently high ROCE is a good indicator of a successful growth business.

More importantly, have companies with a greater ROCE typically outperformed the rest?

In recent history, we have been asked questions around why our mid and small cap exposure is higher than average (since inception of the fund). Was this a conscious decision to overweight mid and small caps, and considering the recent move in markets, is it time to be cautious on them. We have often maintained that we continue to invest in Cash Flow growth in businesses and categorization in terms of market cap and sectors happen to be an outcome rather than a conscious decision to overweight one. However, in order to understand the above, we wanted to more work in terms of data, to elucidate why an investor should look at growth coming from RoCE expansion as a positive sign to their portfolio.

We believe that rather of cherry-picking success stories to uncover “patterns,” we should look at how all businesses, with low and high ROCE, have performed in the past. For this, we analysed the Nifty Midcap 100 and Nifty Smallcap 100 constituents over several bear-markets over the last decade, ranging from the 2013 ‘taper tantrum’ to the 2017-18 volatility crisis and the 2020 covid-induced crash.

The constituents were segregated into the 1st quintile (top 20%) and 5th quintile (bottom 20%) based on ROCE and compared with the respective indices, from peak to trough to their recovery two years on.

Table 1: Average Midcap 100 ROCE quintile performance over last 3 bear market cycles

No investor wants to lose money and rightly so. However, there are risks and unpredictability (the unknown-unknowns) that arise every so often, that even the best of ‘pundits’ or ‘experts’ struggle to predict. Take for example 2020 – stocks would drop 35 percent in less than a month as a result of the Covid-19 lockdown, making it the fastest bear market in history.

Ergo, any investor who wishes to compound capital overtime should be willing to face volatility. As Charlie Bilello puts it, that is ‘the price of admission’. The point is, however, to lose the least and gain the most.

The Midcap 100’s 1st quintile (highest ROCE) equities have managed to keep investor losses to a minimum, while the 5th quintile (lowest ROCE) has taken the brunt of the losses. What is interesting to note is that the low RoCE businesses performed the best in the first year of recovery. It is henceforth extremely important for investors to position their portfolio towards better businesses rather than hold businesses because they have done well in the last 1 year (Do note the underperformance of poor RoCE businesses between the first and second year – as depicted in Table 1).  However, for any long-term investor, the higher RoCE businesses (seen in blue in Table 1) quintile have consistently outperformed the index as a whole, across cycles.

The Smallcap 100 index had very similar trends we noticed across cycles. Across all time periods, equities in the first quintile (highest ROCE) have beaten those in the fifth quintile (lowest ROCE) and the index.  We noticed the same trend in small caps too where the 1^st quintile (highest) RoCE businesses significantly outperformed the lowest RoCE businesses, and this comes through significantly from the first to second year period (post the trough). Over a 2 year period, its interesting to note the outperformance of the higher RoCE businesses (65.9% return vs 24.5% return on the index and this compares starkly to the lower RoCE businesses which tend to destroy capital over time).

Table 2: Average Smallcap 100 ROCE quintile performance over last 3 bear market cycles

Price variations during downturns reveal more about a company’s quality than price movements during a bull market. The results have been consistent throughout all of the cycles we’ve looked at over the previous decade.

So, what should you as an investor do?

The ROCE patterns for each company over time speak volumes about the organization’s capital allocation ability. This, as well as the promoter’s or management’s ability to grow without leveraging the balance sheet, are important factors to evaluate. We recently discussed why investing in high-cash-flow growing businesses may appear expensive at first, but generate returns that outperform the market. In practice, it’s also important to think about businesses as a whole and how they are positioned in their respective industries.

To summarise, every investor should not look at headline small-cap and mid-cap risk, instead go deeper into the quality of the business (measured by cash flow growth and RoCE) which will determine their holding power beyond 2 years.

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