Avoid chasing small-cap outperformers; valuations look attractive for long-term investors: Pratik Dharmshi, Union MF

With small-cap valuations turning more reasonable and earnings growth improving, Pratik Dharmshi, Fund Manager – Equity at Union AMC, remains constructive on the segment. He recommends focusing on quality businesses with sustainable earnings potential, avoiding the chase for recent outperformers, and maintaining a 5-7 year investment horizon while staying mindful of liquidity and volatility risks.

Edited excerpts on a chat with Pratik Dharmshi on small-cap strategy, valuations, earnings growth, investment opportunities, and the outlook for the segment.

Q: How are you viewing the current equity market and what is your strategy at these levels? What market triggers over the next six to 12 months could change your current asset-allocation strategy?

Pratik Dharmshi: We remain positive on equities across market capitalisations as the risk-reward has turned favourable. We are seeing signs of earnings growth recovering strongly, while valuations have become more reasonable, leading to better risk reward for long-term investors.


Our approach remains focused on identifying and investing in quality businesses demonstrating healthy earnings growth from medium to long term perspective. However, geopolitical developments remain an important monitorable. Any escalation in global tensions leading to higher crude oil prices could rekindle inflationary pressures and impact interest rates, potentially resulting in a more risk-off environment. We continue to monitor these factors closely while maintaining a long-term investment perspective.

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Q: Union Small Cap Fund has outperformed its benchmark and category average across multiple periods. What has driven this consistency, and which parts of the investment strategy have contributed most to the outperformance?

Pratik Dharmshi: Our investment philosophy is centred around identifying high-quality businesses with strong growth potential, healthy return ratios and robust balance sheets. We look for companies that are market leaders or gaining market share, operate in large addressable markets, and are led by capable management teams with strong execution capabilities.

We focus and adhere to this framework across market cycles. In the small-cap segment, disciplined stock selection is critical, and we remain focused on businesses that have potential to compound earnings sustainably over the long term.

Q: The fund has a sizeable allocation to capital goods, financials, healthcare and auto components. What is the current sector strategy, and where are you finding the most attractive opportunities?

Pratik Dharmshi: Our sector allocation remains dynamic and is driven by the company's earnings growth, valuations and the underlying industry cycle. We continuously evaluate sectors through a bottom-up lens and allocate capital where we see a favourable combination of growth potential and valuation comfort.

Currently, we continue to find attractive opportunities in capital goods, healthcare, capital markets, precision engineering and Contract Development and Manufacturing Organization (CDMO) businesses, where structural growth drivers and industry tailwinds remain supportive.

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Q: With valuations still elevated in some pockets, how should investors identify opportunities without chasing recent market performers?

Pratik Dharmshi: Every market cycle will have pockets where valuations appear elevated. Rather than evaluating businesses solely on traditional valuation metrics, it is important to assess valuations in the context of earnings growth potential.

We therefore focus on valuation relative to growth prospects, alongside business quality and return ratios. Investors should avoid chasing recent outperformers and instead focus on identifying fundamentally strong businesses that could deliver sustainable earnings growth over the long term.

Q: What are the biggest risks you see for small-cap funds over the next three to five years, and how is Union Small Cap Fund positioned to handle a sharp market correction?

Pratik Dharmshi: Liquidity remains one of the key factors investors should be mindful of when investing in small-cap companies.

At Union Small Cap Fund, we place significant emphasis on liquidity, alongside stock and sector diversification, before initiating any position. This disciplined approach helps us build a portfolio that is better equipped to navigate periods of market volatility and sharp drawdowns.

Q: For investors starting an investment today, what investment horizon and portfolio allocation should they ideally have, and what return expectations would be more realistic going forward?

Pratik Dharmshi: While risk and return go hand in hand, investors should not allocate to small caps solely in pursuit of returns. Volatility is an integral part of small cap investing and thus one should consider it with a long term time horizon.

Given the nature of the asset class, we believe investors should approach small-cap investing with a long-term horizon of at least five to seven years. The longer the investment horizon, the higher the probability of benefiting from the wealth-creation potential of quality small-cap businesses. Rather than focusing on short-term return expectations, investors should remain committed to their long-term financial goals.

Q: What is your outlook on small caps over the next three to five years, particularly in terms of earnings growth, valuations and risk-reward?

Pratik Dharmshi: Based on our proprietary in-house Fair Value Spectrum, the market currently falls within the 'Very Attractive' zone from a long-term perspective. Earnings growth has continued to improve, while valuations have become more reasonable, leading to a favourable risk-reward setup for investors.

Over the next three to five years, we remain constructive on the small-cap segment, supported by improving corporate earnings, ongoing economic growth and opportunities emerging across sectors. While periods of volatility are inevitable, we believe patient investors with a long-term investment horizon are likely to be well placed to benefit from the growth potential that quality small-cap businesses can offer.

(Disclaimer: Recommendations, suggestions, views and opinions given by the experts are their own. These do not represent the views of The Economic Times)

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