Prime Recommendation: Union Small Cap – A small-cap fund without size constraint

Small cap companies are not particularly attractive post the March lows. And yet, after almost 2 years of underperformance, this segment is seeing a new set of companies rallying swiftly, to make up for the years of suppressed performance. And several of them are backed by fundamentals.

 If you therefore decide to ride this new wave with a small-cap fund, it is not that easy. You may have to wonder whether the fund you pick will restrict inflows in a while or suffer in performance if its AUM grows rapidly.

So, this time around, in our quarterly review, we dug deeper into the small-cap space to see if we can overcome this constraint without compromising on the quality of the portfolio. And we think we have the one.

Why this is a risky bet and why we chose it

Union Small Cap is the new addition to our Prime Funds’ list. It is a high-risk bet, even in the small-cap space, for the following reasons:

• it is an emerging performer and not time-tested.
• It has seen a marked improvement since the addition of seasoned fund manager Vinay Paharia in April 2018. Its performance may therefore hinge on fund management stability.
• It is from a fund house that, not so long ago, has been at the bottom of performance chart across equity products but seeing an uptick now. The longer-term rolling returns chart below will tell you the fund’s noticeable underperformance over the category average and how this has steadily narrowed and then moved to a zone of outperformance now.

These risks notwithstanding, we added Union Small Cap for the following reasons:

• Steady improvement in our ratings chart, buttressed by a mix of high quality and high growth companies in its portfolio.
• Addition of seasoned fund manager Vinay Paharia in April 2018 and a visible difference in portfolio make up and performance a year after his entry.
• A nimble AUM size that allows navigation of the small-cap space, without fear of impact cost or liquidity.

These points are detailed below.

Turnaround in performance

Union Small Cap beat the small-cap category average 87% of the times when 1-year returns were rolled daily between 2016-20. As the chart below will show you, the fund was marginally underperforming SBI Small Cap and significantly trailing Axis Small Cap. This gap started narrowing in 2020. The fund raced ahead post the correction.

But the chart will also tell you that there is little comfort to take from its past performance. What lends comfort is the changes it made to its portfolio, especially from mid-2018, after Vinay Paharia joined the team. Portfolio turnover can give a good insight into changes that a new fund manager may bring about. Between July 2018 and June 2019, the portfolio turnover stood at 92%, far higher than the average 48% for the six months ending March 2018 (before the entry of the new fund manager cum CIO).  

In the revamped portfolio, quality and growth took precedence over valuation. And we think this laid the foundation for the fund’s recent outperformance. While many stocks were added, stocks with ripe valuations or underperformers also exited the portfolio over the above-mentioned period. As a result, while the fund did fall more than top peers in the March 2020 correction, it rose quickly in the ensuing rally, thanks to the quality portfolio that we discuss in the next section.

Resilient portfolio

If you scan the portfolio of Union Small Cap, you will see quite a few stocks that doubled in the last 6 months. You will find strong resilience in the earnings of these stocks even in the Covid-19 hit June quarter.

About 30% of the stocks saw a growth in earnings in the June quarter over a year ago, suggesting that the stocks’ rally was backed by sound growth stories. Pharma and healthcare stocks such as Alembic Pharmaceuticals, IPCA Laboratories and Laurus Labs, JB Chemicals & Pharmaceuticals, chemical plays such as PI Industries, tech plays such as Indiamart Intermesh, Birlasoft or Tata Elxsi are few examples of an earnings resilient story that the fund has drawn for itself over the past year and a half.

The current macro environment offers a good opportunity to test a company’s resilience in a slowdown phase and on this metric, the fund’s portfolio offers comfort that it has been filtered with sound metrics. While earnings for the fund’s portfolio fell by 23% over a year ago in the June quarter, it was a far better show than the 50% earnings fall of bellwether companies in Nifty 50.

Overall, this portfolio rehash along with tactical opportunities in the form of IPOs helped the fund shore up performance.

No size constraint

You may be aware that many of the top performing small-cap funds have restrictions on inflows. Higher inflows in small-cap funds cause 2 kinds of challenges to fund houses: one, finding quality opportunities in the small-cap space; two, deploying money or exiting stocks without incurring heavy impact cost. Union Small Cap scores on this front. Sample the data below of AUM size of some of the popular funds.

You will see that Union Small Cap has significant leeway to navigate this space without fear of stock liquidity. To put this in perspective, the fund can technically liquidate its entire portfolio (based on individual stock volumes and its own size) in 3.2 days, as opposed to 13 days for Nippon Small Cap, 24 days for Axis Small Cap or 39 days for HDFC Small Cap.

Suitability

We have highlighted the risks in this fund upfront. The reason for the same is that you should best view this as a dark horse bet. Take not more than 5-8% exposure and that too through SIPs and see how it performs. We will not hesitate to call out on any management change or changes in the AMC itself. Hence do not view this as a ‘buy & hold’ long-term candidate. Check for our review quarterly or half yearly on our MF Review Tool.

As a fund with small AUM size, expense ratio is not low. Go for the direct route where possible.

With inputs from Anush Raj P