From CDMO to aerospace: How Vikas Khemani finds India’s next big themes

Dalal Street's top stock picker Vikas Khemani’s investment playbook is built around identifying long-term themes before they become market consensus. Carnelian’s founder says its early bets on contract development and manufacturing organisations (CDMOs) and aerospace emerged from years of research into China-plus-one and India’s growing role in global supply chains.

Now, as Carnelian has ventured into mutual fund business by launching a small-cap fund with a ₹5,000 crore cap, Khemani is focusing on manufacturing, financials and IT while warning investors against confusing market capitalisation with valuation. In an interview, he explains how the fund plans to manage size, assess expensive growth opportunities and position for the next market re-rating.

Edited excerpts from a chat:


Carnelian Smallcap NFO feels a little like an IPO where you have to get an allotment as you have a cap of Rs 5,000 crore. So are you likely to close the fund before the scheduled last date of October 30? Also help us understand the thought process behind the AUM capping.

Vikas Khemani: Yes, we could close it before the last date. That is the plan, but we will see what happens.

We conducted a number of interviews and surveys with partners, distributors and investors. A common concern was that the size of many existing small-cap funds has become a challenge. We asked what the ideal size would be, and the feedback was ₹5,000 crore to ₹10,000 crore.

We therefore decided to put a cap on the initial lump-sum mobilisation and balance that with SIP performance and continuing flows. The cap is also a message to the market that we are working with a defined limit and are not chasing AUM.

Even if the initial mobilisation is capped at ₹5,000 crore, capital appreciation and SIP inflows could take the assets even higher. How will you manage that?

Vikas Khemani: SIP money comes in an orderly manner; it does not arrive as one large amount. Those flows will continue, and we will have to manage them. The idea is to communicate the limit we are working with right now.

We can also manage the portfolio within the regulatory framework. The portfolio need not remain static. Depending on the circumstances, we can use the flexibility available to us, including maintaining some cash or shifting exposure towards mid-caps within the permitted limits.

The objective is to remain disciplined. We can also launch other products over time and guide investors towards those products where appropriate, so that the overall balance is maintained.

Read more: Gold, global equities, largecaps, midcaps and smallcaps: Samco CEO Jimet Modi’s five-way portfolio formula

Some fund managers and distributors privately admit that fund size becomes a problem in the small- and mid-cap space. You are admitting that openly. This is also probably for the first time where an equity fund is limiting AUM.

Vikas Khemani: At least in the equity space, this is among the first such instances. A very large fund can become difficult to manage in this segment. Even if a fund has the resources, it may not be able to deploy capital in the same way once it becomes very large.

What will the portfolio structure look like? Will it have 30 to 50 stocks? You have referred to a universe of around 1,000 stocks.

Vikas Khemani: We expect the portfolio to have around 30 to 50 stocks. Generally, we will not go beyond a 5% weight in a single stock.

Typically, in the portfolios we manage, the top 10 stocks account for around 50% of the portfolio, sometimes even more. In this fund, given the diversified structure, the top 10 stocks may account for around 25% to 30%.

If an investor has ₹1 crore and can choose between your PMS and the small-cap mutual fund, how should they decide?

Vikas Khemani: The PMS is meant for investors with a larger amount of capital and a higher risk appetite. Through the mutual fund, we are trying to reach investors with smaller ticket sizes.

The philosophy is similar, but the portfolio construction is different. The PMS is more concentrated, while the mutual fund will be more diversified. An investor who is comfortable with a higher level of risk may choose the PMS; someone looking for a more diversified route may choose the mutual fund.

What kind of drawdown should investors expect?

Vikas Khemani: That depends on the market. A typical small-cap fund can see a drawdown of 25% to 30%. During the tariff-related episode last year, our portfolio also fell by around 25% to 30%, but it recovered.

Within a universe of about 1,000 stocks, where do you see the biggest opportunities?

Vikas Khemani: Manufacturing is an area we are very positive about. Within manufacturing, there are opportunities in auto components, chemicals and capital goods. Manufacturing’s contribution to GDP is currently around 15% to 16%, and there is a broader opportunity set across the sector.

We also look at consumer financials and the consumer space. Within financials, the opportunity could be in smaller private banks, NBFCs, wealth management companies, capital market businesses, insurance companies and mutual fund businesses. We evaluate all of them, but the approach ultimately comes down to bottom-up stock picking.

Are there some pockets of the market you think could be in an euphoria stage? What do you think about CDMO stocks at this stage as we picked the theme much earlier than the market?

Vikas Khemani: Growth stories take time to play out. Sometimes, if you exit too early, a stock can become a five-bagger or a ten-bagger after you sell it. You do not want to exit early when you have been fortunate enough to identify a good business.

Even when valuations are high or close to peak levels in the near term, the long-term opportunity may not have disappeared. We may not buy more at those levels, and in some cases we may trim a position, but that does not necessarily mean we will exit completely.

What about aerospace? You were invested in the space earlier. Are you still holding those investments?

Vikas Khemani: Yes, we are still holding some of them. However, it is difficult to find new ideas in aerospace at this stage.

Beyond CDMO and aerospace, are power-capex, defence and data-centre businesses also areas where valuations have become excessive?

Vikas Khemani: You have to avoid overvaluation. At the same time, there are interesting opportunities in chemicals and financials where the risk-reward can still be attractive. There are several sub-segments in which one can find specific, niche ideas. Ultimately, we need to identify 20 to 30 good companies.

Valuation is an art. You cannot simply say that a company should trade at 25 times earnings without considering its growth. If growth is high, you have to pay for it. The important thing is to understand the risk-reward rather than apply a single valuation rule to every company.

Read more: ETMarkets Smart Talk | Earnings growth, ROCE and cash flows are key to identifying future wealth creators: Aditya Khemani

Does that mean you do not rely on spreadsheets and financial metrics?

Vikas Khemani: We do use spreadsheets. After developing an investment thesis, we put the assumptions into the model and assess what could happen. We ask what happens if the thesis does not play out, and then evaluate the risk-reward.

You should never invest based on an impression. You have to do the work, put the numbers down and assess whether the opportunity still makes sense.

Some of the businesses linked to defence, aerospace, CDMO and data centres look expensive today, even if the long-term opportunity is genuine. How do you deal with that dilemma?

Vikas Khemani: When the market environment is bad, it can give you an opportunity to buy good companies at better valuations. We often track stocks that we like but cannot buy because the valuations are too high. When the opportunity comes, we act.

The process involves reading, discussion and internal research. It is about connecting the dots. You have to think differently from the market. When everyone was buying renewable energy companies, for instance, we looked at thermal power because we believed that a power shortage could not be addressed by renewable power alone and that thermal power would continue to play a role.

You identified CDMO and aerospace before they became widely discussed. What was the original investment thesis?

Vikas Khemani: CDMO was part of our China-plus-one research. It was clear that companies globally were looking to diversify their supply chains away from China and were exploring alternative manufacturing locations.

These trends do not play out overnight. They can take two, three or four years to gain momentum, and they may continue for 10 or 20 years. What happened in IT could happen in CDMO as well. Once you have that perspective, you do not worry excessively about short-term developments.

We began buying in CDMO around 2022 and 2023. In aerospace, the opportunity had also become visible earlier, around 2020 and 2021. We could see customers coming to India and looking for sourcing opportunities. The market often expects numbers to arrive quickly, but these opportunities take time to translate into financial performance.

What is your outlook for the broader market, including the Nifty and Sensex?

Vikas Khemani: The current environment reminds me of 2022. That year also began on a positive note, before supply-chain issues, inflation and interest-rate concerns affected sentiment. I remember writing a note in September 2022 referring to building a vintage. The following years—2023 and 2024—turned out to be strong years, and that vintage generated more than 20% returns.

The current environment also has high oil prices, inflation, interest-rate concerns and geopolitical conflict. Sentiment is poor, but these factors do not last forever. Growth is happening, GST collections are rising and corporate earnings are growing at around 15%.

Investing is not about three months; it is about three to five years. Investors need to be positioned for the eventual re-rating rather than focus only on the current sentiment.

Is the mid-cap space the most overvalued part of the market at present?

Vikas Khemani: I do not look at it that way. Small-cap does not automatically mean expensive, and large-cap does not automatically mean cheap. That is a fundamental mistake many people make.

The focus should be on where the growth is and what investors are paying for that growth. We do not pay excessive attention to the market-cap category. The approach has to be bottom-up; stock picking is the key.

I also do not think mid-caps are uniformly expensive. One has to be prepared for the day when the market re-rates. Markets can rise sharply over a short period without an obvious reason, so the portfolio needs to be positioned in advance.

You are positive on IT as well. Have you increased your exposure?

Vikas Khemani: We are positive on IT and have increased our exposure slightly. When concerns about artificial intelligence emerged, our view was that AI would not disrupt the IT sector in the way the market feared, and we therefore remained interested.

People also said business-process outsourcing companies would be disrupted. We looked at the companies that were hiring more and asked why they were hiring. That helped us assess the underlying opportunity.

The erosion in the IT sector has been sentiment-led to a significant extent. Some companies may return to their earlier levels over the next one or two years, although not necessarily the entire sector. Mid- and small-cap IT companies may grow faster, while some large companies could face challenges; nevertheless, some large companies will also do well.

What is your outlook on banks?

Vikas Khemani: We bought companies at around 16 times earnings that were growing at about 20%. The approach is evidence-based investing.

Large private banks are an important part of the market. If the outlook for banks and IT improves, the market as a whole can do well. We continue to assess opportunities and are not sitting on cash because we do not have ideas. We have ideas; we are evaluating them continuously.