Beyond the Numbers: A Value Investor's Perspective on the Quant Small Cap Fund

If you make a list of the fastest growing mutual funds in India, it will be difficult to leave out one name i.e. Quant Mutual Fund.

The fund house's rise has been nothing short of meteoric. Last I heard, the fund was sitting on a cumulative AUM of a whopping Rs 840 billion and in no mood to slow down anytime soon.

The fund's explosive rise is not without reason though. It has racked up impressive performances across most of its schemes, with quite a few of its funds featuring consistently among the top-ranking mutual fund schemes in India.

But the past few days have been tumultuous for the fund house.

SEBI, the capital market regulator, has launched a probe into the fund house over allegations of front running.

In fact, SEBI's investigation unit even conducted search operations in Quant Mutual Fund House's premises in Hyderabad and Mumbai.

Luckily for Quant, the development hasn't led to mass redemptions from its funds. Most of its investors seem to be adopting a 'wait and watch' policy and are willing to be patient.

This development diverted my attention towards the kind of stocks the fund holds in its various schemes. So I took a deeper look at them.

I wanted to see what's under the hood of one of the most successful fund houses in recent years.

Specifically, I delved deep into the small cap offering i.e. the Quant Small Cap Fund. Here's what I found.

The fund has compounded at a CAGR of 34.4% over the last 3 years, much better than the BSE Small Cap index, which has given a CAGR of almost 28% during the same period.

Hence, Quant Small Cap Fund has certainly outperformed its relevant benchmark index by a good margin.

Here are the top 11 holdings of the fund in descending order i.e. starting from the highest to the lowest.

Company name	% of Assets	Current PE (x)	10 Yr Median PE	Current PBV (x)	10 Year Median PBV
Reliance Industries	9.5%	28.3	20.0	2.5	2.0
Jio Financial Services	5.9%	142.1	141.4	1.6	1.5
IRB Infrastructure Developers	3.8%	65.5	14.1	2.9	1.4
HDFC Bank	3.5%	20.3	25.4	2.9	4.3
Bikaji Foods International	3.2%	67.9	75.7	14.8	12.0
Aegis Logistics	3.1%	50.1	32.8	7.5	5.4
Housing & Urban Development Corporation Ltd	2.9%	26.0	6.6	3.3	0.7
RBL Bank	2.8%	12.2	23.0	1.0	1.1
National Aluminium Company	2.7%	17.4	13.2	2.4	1.1
Arvind Ltd	2.5%	27.8	8.6	2.6	0.9
Adani Power	2.3%	13.4	15.4	6.5	2.8

Source: ACE Equity, screener.in, groww.in, Equitymaster
Bikaji data is from 22 November onwards. Jio data is from 24 April onwards. RBL Bank data is from 16 September onwards.

First things first. More than 40% of the fund's corpus is invested in the top 11 stocks. Nearly 10% is in the behemoth Reliance Industries and another 3.5% in HDFC Bank. The other stocks are mostly from the small cap space.

Currently, there are only 4 stocks (highlighted in green) out of 11 that are trading lower than their long-term PE multiples and only two stocks (highlighted in green) that are trading lower than the PBV multiples.

There are a few stocks like IRB Infra, Aegis Logistics, HUDCO and Arvind Ltd where the gap between the current PE and PBV ratio and the long-term average is huge.

In other words, these stocks are trading at a significant premium to their long-term valuation multiples.

Why is this relevant?

Well, simply because returns from stocks mainly come from two sources i.e. expansion in the valuation multiples and growth in earnings.

Since these 4 stocks are already trading at lofty valuation multiples vis-a-vis their historical averages, most of the growth in the share price will likely come from growth in earnings.

Thus, these stocks need to show strong earnings growth going forward. Failure to do so may result in their valuation multiples getting compressed, which in turn could lead to a significant stock price correction.

You see, the Oracle of Omaha, Warren Buffett, likes to divide businesses into three distinct categories i.e. great, good, and gruesome.

The great businesses are the best of the best. They have strong competitive advantages and are known for their longevity and top-class management.

Such businesses, Buffett believes, once bought, should never be sold. You should keep holding on to them as long as you are convinced their moat, or their competitive advantage is intact.

In the Indian context, such stocks would be the likes of TCS, Asian Paints, and Pidilite.

Then there are the good businesses which are not as strong as the great ones but still generate a decent return on capital and are also long lasting.

The difference between the good and the great is that the latter are usually cash generation machines that throw off a lot of cash even after accounting for growth while the former require a decent amount of capital for growth.

Great businesses can pay 50%, 60%, and even 70% of profits as dividends. The good businesses can pay only 15-20% profits as dividends. The rest they need to tuck away for reinvesting back into the business.

And then there are the gruesome businesses which not only are frequently loss making but where investing capital is akin to throwing good money after bad.

They are capital guzzlers and still have no profit to show for it. The airline industry is a classic example of gruesome businesses.

Now, coming back to Quant Small Cap fund and its top holdings, I don't see any great business on the list to be honest. May be there's one or at most two businesses that can be termed as borderline great.

Thankfully though, none of the 11 businesses on the list are gruesome either. Almost all the businesses are profit making and are not wealth destroyers.

Thus, it can be concluded that most of the top holdings of Quant Small Cap fund are good businesses that will be around for quite some time to come.

However, the thing with a good business is that one must buy them at attractive valuations to earn market beating returns from them.

And as we just saw, most of the stocks on the list are not attractively priced at the current juncture. They are trading at a premium, some significantly so, to their historical valuations.

In other words, the growth over the next 2-3 years seem to be already reflecting in their share prices.

So, here are my broad takeaways. If I were to launch a small cap mutual fund today, will I have the same stocks in the portfolio as the list above? Well, I don't think so.

As I have a value bias, I would have selected good stocks no doubt but the ones that are trading either at a discount to their long-term valuation multiples or at least close to them. I would have ensured a decent margin of safety.

However, what if there was little to no margin of safety available like it is today? What if most good stocks were trading at expensive valuations?

Well, in that case, I would have preferred to have a significant cash component and would have waited for the small cap index to come back to its senses.

Of course, I would have lagged if the small cap index kept on going higher, but it is a price one has to pay if one intends to outperform the benchmark index from a long-term perspective.

One must be disciplined and even a contrarian if the situation calls for it. Short term pain for long term gain.

Having said that, I am viewing everything from a value investing lens and hence, have come to the conclusion that I did.

However, there are other ways of investing and beating the market that the fund managers over at Quant Small Cap fund may have perhaps figured out. And if their recent track record is any indication, it is even working for them.

However, I will stick to what I know and understand. Therefore, from that vantage point, the risk-reward equation across a lot of the top holdings in the fund does not seem to be in favour of the investors at the moment.

Happy Investing.

Warm regards,


Rahul Shah
Editor and Research Analyst, Profit Hunter
Equitymaster Research Private Limited (formerly Equitymaster Agora Research Private Limited) (Research Analyst)