Carnelian’s Vikas Khemani on small-caps, valuations and market risks
Mumbai: Carnelian Mutual Fund is the latest entrant in India’s ₹82-trillion mutual fund industry. The fund house has launched a small-cap fund as its maiden equity offering, at a time when the segment has seen volatility amid valuation concerns, global uncertainty and crude oil prices.
Vikas Khemani, founder and chief investment officer at Carnelian Asset Management and Advisors, explains why he remains bullish on the market and small-caps, while cautioning investors against overlooking their risk-taking capacity when allocating to the segment.
Edited excerpts:
You have entered the mutual fund industry with a small-cap fund. Why did you choose this category to start with?
We recently received approval from the Securities and Exchange Board of India (Sebi) and launched our small-cap fund. Carnelian began with portfolio management services (PMS) and alternative investment funds (AIFs), serving high-net-worth individuals and family offices. Over the past seven years, we believe we have built the ability to generate superior risk-adjusted alpha across our products. We wanted to take that institutional investment capability to a wider retail audience, and mutual funds provide a platform to do so.
We chose small-caps because, in an emerging economy, they can offer attractive long-term opportunities over a five-to-ten-year horizon. They also require deep research. The performance gap between the top and bottom quartiles of small-cap stocks can be significant, making professional analysis especially valuable. Our forensic research includes assessing the quality of a business and its management. Over the next three to six months, subject to approvals and market conditions, we plan to build a focused range of around four or five relevant schemes rather than launch a large number of products.
Small-caps have been volatile and their valuations appear elevated. How do you view the opportunity today?
Small-caps can trade at a premium because their growth prospects are higher. Valuation needs to be assessed in relation to the growth a company is delivering or is likely to deliver; the price an investor is willing to pay should reflect that outlook.
New sectors and businesses often emerge outside the large- and mid-cap universe. Many private-sector banks, non-banking financial companies (NBFCs), insurers and capital-market businesses began as smaller companies before growing into large-caps. Similar opportunities have emerged in IT and pharmaceuticals, and we see them today in manufacturing and other areas.
Small-caps can be fertile ground for multi-baggers, but investors must avoid poor-quality management and weak business models and be prepared for volatility, including that caused by illiquidity. Even good businesses can fall sharply during market corrections. We see the recent correction as creating opportunities to buy some quality businesses at more reasonable valuations. Investors considering this segment should have a five-to-ten-year horizon and the ability to withstand volatility.
Why is there a size-based flow-cap on the small cap fund?
We heard concerns from distributors and other market participants that some small-cap funds have become so large that their size can affect performance. For a large fund, building even a small portfolio position can require a substantial investment, making it harder to accumulate shares without increasing market impact costs. We wanted to reflect that concern in our product design. Our focus is on generating alpha, not accumulating assets under management (AUM). Systematic investment plans (SIPs) will continue, but lump-sum investments will be stopped once the fund reaches the stated limit of ₹5,000 crore.
What is your outlook on the market amid rising bond yields, inflationary pressures and the possible fallout of a weak monsoon?
The past two years have been difficult for markets, with macroeconomic concerns including tariffs, war, oil prices, supply-chain disruptions, interest rates and inflation. Such periods occur periodically.
Despite the macro concerns, several indicators of Indian economic activity remain robust. Corporate balance sheets are also in much better shape than they were in 2008, in our view, leaving companies better placed to weather a difficult global environment.
We believe the current period could prove to be a good vintage for deploying capital. Valuations have corrected, with many mid- and small-cap stocks down 30-40%, and we see opportunities for investors who can take a longer-term view.
Which sectors look attractive, and where are you exercising caution?
Manufacturing is a major area of opportunity for us. In our view, India’s free-trade agreements have opened access to additional markets worth around $1.5 trillion. Combined with currency depreciation, this could support the manufacturing sector over the next eight to ten years. Areas within manufacturing include auto components, chemicals, electronics manufacturing and capital goods.
We also see opportunities in financials, where valuations have corrected over the past two years, and in select mid- and small-cap IT companies that may be able to grow at 15-20% at reasonable valuations. There are also stock-specific opportunities in consumer businesses and services.
We generally avoid many commodity businesses and segments where valuations appear excessively exuberant. We have been cautious about parts of aerospace and defence where valuations have become stretched. This is not a blanket exclusion: our decisions are based on bottom-up, stock-specific risk-reward assessments.
How do you assess promoter quality and corporate governance, particularly in small- and mid-caps?
Management quality is critical regardless of market capitalisation. Large companies can also destroy shareholder value, but the issue can be more pronounced in small- and mid-caps because these businesses may not have established long operating histories.
Our process includes detailed forensic research and ecosystem checks. We may speak to suppliers, channel partners and former employees, and examine the company’s culture, compliance standards and whether management is willing to cut corners. The aim is to understand the quality and conduct of the people running the business.
Investors must also understand the business model, not just the sector label. For example, NBFCs include microfinance, gold finance, secured lending and unsecured lending, each with a different risk profile and potential outcome. A sound investment requires a combination of good management, a business model the investor understands and an appropriate valuation. That combination sounds simple, but it is not easy to achieve.
Investors often rush into mid- and small-caps after strong returns. What should they consider before allocating to these segments?
Investors should follow their own investment goals rather than be guided by short-term greed or recent returns. Asset allocation should reflect their objectives, time horizon and ability to handle volatility. Someone comfortable with volatility may be able to allocate more to small-caps, while someone with lower tolerance should lean more towards large-caps.
Investors should understand their own risk tolerance before looking at what others are doing. Direct equity investing, particularly in small-caps, requires specialised knowledge of the company, its business model and its risk-reward profile. Investing on tips without understanding those factors can lead to poor outcomes. Direct investing may be appropriate for those who understand what they are doing; others should be cautious.
Which other mutual fund schemes are you planning to launch?
We do not want to launch dozens of schemes that confuse investors. We plan to build a focused range of around four or five products, potentially including flexi-cap, mid-cap and large-cap funds, as well as a balanced-advantage fund. We will not rush to gather assets or launch products that we believe may be unsuitable for investors. Once the core range is in place, we may also explore the specialised investment fund (SIF) category, which we believe is relevant.
With the mutual fund industry nearing 60 fund houses, why should investors consider Carnelian?
The mutual fund industry has been built in large part by institutionally owned platforms that helped establish governance and trust. Those firms have done important work, but their scale can naturally lead to a different approach from that of a newer, founder-led and entrepreneur-led AMC.
We see room for newer players to innovate and focus on alpha and investor outcomes. In that sense, we think of Carnelian as a small-cap player in the AMC industry: an entrepreneurial platform with the potential to pursue differentiated opportunities. Our investment philosophy has served clients in our alternative-investment businesses, and we intend to apply the same philosophy in mutual funds.
We believe India’s mutual fund industry could grow three- to four-fold over the next decade, creating room for more participants. Our aim is to build a high-quality AMC known for performance, practices and innovation. Ultimately, investors will have to assess whether we are good enough to serve their interests.