Why veteran investor Bharat Shah thinks the midcap-smallcap scare is outdated

What basic principle do you follow while investing? And has it changed over the decades?

My basic philosophy of investing has not dramatically altered over the years. My core principles—buying quality businesses, good management, and valuing growth—have remained constant. In a nutshell, these fundamental building blocks that were in place from the beginning have laid the foundation for my investment approach. 

Some have refined materially, some fairly, but the fundamental building blocks have been there. Just that, 35 years ago, I made mistakes which I have since refined and matured over time.

Quality is a very real issue. The quality of a business allows it to prevail and deal with the challenges or exigencies of the environment much better. Such a business becomes more predictable, durable, solid, and resilient, and all these are very important ideas for value-creation.

In the absence of quality, businesses become happenstance or chances, or they become very short-term phenomena, and that, again, is not investing. Besides, a good management goes beyond governance to include execution, adaptability, and capital allocation.

Third, businesses must grow. Growth is essential for a business’s longevity and value, as stagnation leads to decline. Growth comes from the size of the opportunity, the vast canvas it offers, and the management’s ability to harness it into growth—beyond just top-line revenue, scalability, or bottom-line profits, but also through strong cash flows.

Lastly, psychology is crucial. Markets are not designed for your success; they exploit threats and deceive the gullible, arrogant, or rigid. While fundamentals and value remain constant, market price fluctuations can provoke reactions. It takes discipline to stay the course and avoid these traps.

Do you see these building blocks in the new market entrants in the midcap and smallcap space?

One of the greatest changes in the economy and business landscape has been the rise of many good small and mid-sized businesses. This surge in entrepreneurship is vital for creating value, as successful nations throughout history are those that foster entrepreneurial spirit.

In recent years, we’ve seen a remarkable proliferation of startups and private equity-backed businesses, with unprecedented opportunities for growth and ease of doing business.

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While external challenges, like geopolitical conflicts, remain, entrepreneurship is about the capability to navigate these issues and find solutions. What is probably less appreciated is the structure of the economy, the society, the entrepreneurship, and the policy framework have all synergized and dramatically altered to support new entrepreneurship and new businesses and new ideas.

And, therefore, the diversity of choices in our stock markets has never been better than today. And, therefore, that diversity and large number of quality choices has been very rapidly emerging over the last few years. The number of companies with more than ₹1 trillion market cap has dramatically surged.

First, small and mid-sized businesses develop the confidence to find their place under the sun and grow. Second, their growth supports the entire economy as they are crucial parts of the economic structure. Third, enabling structural reforms—such as improvements in infrastructure, energy, digitization, defense, railways, logistics and manufacturing—combine strategically to create a powerful, synergistic effect.

When reforms are piecemeal, the outcome is at best arithmetic. But when synergistic, the growth is geometric. This synergy sets the stage for the emergence of many more businesses. We still have a lot to do, but we are in a fantastic place today.

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Achieving an 8.2% GDP growth rate in March, while America struggles and Europe remains stagnant, is not automatic. It results from deep structural changes in the economy, society, entrepreneurship, and the ethos of success. All said, we still find that large caps are a bit cheaper than mid-caps, and mid-caps are cheaper than small caps, which is unusual.

However, there is new dynamism and structural change in many small, mid, and large businesses. Access to capital has improved and its cost has declined materially. All these factors underpin the rise of these businesses.

Is this also reflected in the current state of the Indian stock market?

Absolutely, it reflects in the market, and therefore the traditional views that mid-caps are fleeting or small-caps are destined to fizzle out are outdated. These perspectives stem from a time when the economy and its structures were not as robust, and governance and entrepreneurial character were lacking. Consequently, markets were more short-term and fickler.

Today, there is a greater belief in the long-term, which is why valuations rise. With confidence in the future, markets become deeper and more valuable, unlike the shallow, boom-and-bust markets of the past.

We must recognize that the character of society, people’s capabilities, the regulatory and policy framework, and the nation’s overall capability are undergoing dramatic change. This transformation will elevate many small and mid-sized businesses to higher levels of evolution.

While some will falter, many will succeed. This is the journey of a great nation and economy, and I believe we are at that stage. I will keep observing and understanding these businesses because some will grow significantly and become dramatically large over time.

Where does India stand in terms of value-creation opportunities for investors, particularly within the emerging market basket?

About six years ago, I wrote an article titled ‘It’s the beginning of a golden decade of value creation’. It received a mixed feedback, but I deeply believed in it because I saw structural changes beginning to happen.

The digital payment ecosystem, GST, manufacturing and distribution efficiency, system transparency, and digitization of the tax networks were all developing. Infrastructure gaps were beginning to be addressed.

I felt that these important parts of the tapestry were being strategically filled out. If I had to write that article today, I'll change golden decade to golden decades–that is how I see the opportunity.

I think we are finally at a vantage point where the coming decade will be vastly superior to what we have seen. I have unbridled optimism about our future. I think we are in for a dramatic and positive transformation of our future.

This will lead to sustained GDP growth characterized by durability, predictability, solidity, and capital efficiency, which will reflect in business performance, cash flows, profits, and market values. Ultimately, this will create wealth for business owners and investors, driving value-creation in portfolios.

Therefore, I see unprecedented opportunities for us as a nation, market, businesses, people, and society. Globally, Europe seems frozen in time, and America faces deep structural issues and problems. The Western world, once known for policy maturity and capability, now shows a progressive decline in leadership over the past 20-30 years. This decline reflects in their markets.

Many technology firms, like Google, began as entrepreneurial ventures and are now managed professionally, proving that entrepreneurs are crucial for national value-creation. We must nurture and support them for sustained growth.

Japan took 35 years to surpass its 1989 market level, Korea is still below its past peak after 35 years, and China has seen negative returns over the past decade. India, however, has the potential for superior and durable growth. I believe the future of Indian markets will be as good as, if not better than, the past.

Markets rise and fall; corrections, even major ones of 15-20%, are normal and occur every few years. Sometimes, there are extreme swings, which are part of the market's rhythmic cycles. Volatility and disruption are inherent to markets, regardless of opinions on their current state.

But if you ask me if the market is fundamentally floating on water, disconnected to reality, my opinion is that it is not true. It is tethered to the reality. It is tethered to the fundamentals, and that is where the market is deriving its energy from. Individual pockets of excess may be there, but the market is an efficient self-correcting mechanism.

This is the first coalition government since 2014. Do you think we will see any big changes in the Budget?

I cannot speculate on the specifics until 23 July, but we can infer about possible policy directions or measures the government might take. If we look at the trends from the budgetary exercises over the past several years, there are a few clear patterns.

First, there has been a consistent focus on building productive capacity rather than just providing short-term relief. This means prioritizing capital expenditure, which supports future growth, over revenue expenditure, which only addresses immediate needs.

Second, there has been a strong emphasis on fiscal discipline. The budgetary strategies have systematically aimed to control fiscal deficits, manage the current account deficit, and stabilize inflation and the rupee.

Third, recent budgets have addressed real gaps in societal needs, focusing on essential services like housing, clean fuel, and health. These aren’t merely subsidies but crucial socio-economic investments that benefit society as a whole, even from my own capitalist perspective.

Lastly, we haven’t seen a trend towards offering freebies or subsidies that don’t create long-term value. 

While some states have provided free services like power, these invariably lead to economic distortions and eventual (ironically) social inequities. In contrast, initiatives like the solar mission create self-sustaining assets that support long-term economic and environmental benefits.

Based on these trends, it seems likely that future budgets will continue to follow these principles rather than diverging significantly from them.