“First, disruptive products are simpler and cheaper; they generally promise lower margins, not greater profits. Second, disruptive technologies typically are commercialized in emerging or insignificant markets. And third, leading firms’ most profitable customers generally don’t want, and indeed initially can’t use, products based on disruptive technologies.” – Clayton Christensen in The Innovator’s Dilemma

Please note that Christensen uses products and technologies as an interchangeable term. He also says that the disruptive product is a ‘marketing problem’ and not a ‘technological one’. Because all disruptive products (or technologies) initially appear to have a tiny market and smaller margins – these are typically incubated by smaller companies. Often the leaders, even if they see this opportunity, reject the idea!

India’s diversity and complexity offer a fertile ground for more such ideas, which at the onset appear to be very small, regional, and non-scalable. Even historically, we have seen smaller companies seizing these opportunities and becoming large. Now, technology and rising income (the $2500 per capita market offers a very different level of scalability than the $500 per capita market) act like a J-Curve for faster growth and scalability of smaller companies.

Two to three decades ago, decorative paints were considered a small market. Few believed Indians would move up the premium curve. Most of the country used pigments mixed in lime to paint their homes. Asian Paints was a mid-cap then.

In 1999-2000, the market cap of Asian Paints was ~$200m, just 2% of the largest consumer company then, Hindustan Unilever. Today Asian Paints’s market cap is $35bn, more than 50% of Unilever’s! Titan was a tiny cap during 2001-4 (the lowest was in 2001, a market cap of $25m, vs $40bn now!) when it entered the jewellery segment and changed the industry. While India always offered a large market in the space, no one at that time believed that the country would ever evolve from mom-and-pop jewelers and pay for design or brand! Electric fans and ceramic tiles were considered less profitable than staples. Most multinational companies were focused on making Indians consume cereals, protein bars, and chocolates rather than seeing the opportunity in local snacks and mithai. Who could have imagined that 2 BFSI companies focused on catering to the needs of just one state (Rajasthan) would emerge as among the most respected players in the space?

Three huge changes in the business environment have now enabled the faster rise of smaller companies, with presumably smaller and lower profitable market segments.

1. Technology – Technology has enabled seamless payments (UPI), distribution and logistics (through aggregators), and last-mile delivery (delivery players).2. Rising per capita income – This, plus increased exposure to global (travel, OTT) experiences, has made the consumer more conscious of brand and quality. An increase in spending power has resulted in faster growth of ‘small’ markets or niche products.

3. The spending patterns of millennials and Gen Z are very different. Today’s youth is not scared to spend on better products and lifestyles.

India has broken out of its Brahmanical restraint value system!

In many cases, larger players smell the coffee after the market becomes large. They try to compete using balance sheet muscle power. For example – Dr. Lal and Metropolis established how diagnostics can be offered as a premium service and created national brands. Larger players are entering the space now. Grasim now believes that paints are a logical adjacency to cement. Aditya Birla Fashion tried breaking into (earlier considered small) the innerwear market, once Page demonstrated scale.

Today’s small company entrepreneurs are also more focused on value and wealth creation. Markets are offering that opportunity. There is much better capital allocation discipline than in the past. Many young companies bring in venture capital or private equity investors at an early stage, who help convert dreams into visions and ideas into execution.

Are mid and small-cap stocks a bubble?

Three-year returns (2021-2023) for mid and small-cap indices are 2x that of Nifty, delivering 120-130% return vs 60% for the Nifty. The extent and strength of the outperformance now mirror the 2013-2017 period, which was followed by a very poor performance for the space (the mid-cap index saw a fall of ~50% from the 2017 peak to Covid lows in March 2020). The fear is that this outperformance is driven by unprecedented inflows into small and mid-cap funds. Hence, it is important to look at the numbers behind the narrative.

A recent study published by Ambit Asset Management observes that the last 3 years’ Nifty smallcap 250’s earnings growth outpaced Nift100 by 1.5x. Small-Cap earnings growth is 20% p.a. vs 12.6% for Nifty100. FCF growth is stronger at 51% and debt-to-equity crashed to 0.2x from 1.3x. Mid-cap earnings growth is even higher at 30% p.a.

Chart: Small cap FCF growth and D/E. Source: Ambit Asset Management

The scalability challenge

Most small companies begin like a rock band, in a garage. A few friends or siblings get together and start the business. After a level of success, one needs to professionalize, get external talent and clearly define roles. This is the glass ceiling between remaining small or breaking into a large company. Asian Paints is a fine example of a company started by 4 friends, which professionalized at the right time. A few solo artists also make it big, but then the ‘founder’ has to be as good as Taylor Swift! I will write more on this in a subsequent article.

For now, the market is (rightly) rewarding the smaller companies for their faster growth, flexible approach, better capital allocation, and return ratios. In many sectors, second-liners now command a premium valuation to leaders.

The following lines recited by Sanjay Agarwal, AU Bank’s Founder and MD & CEO, the last I met him, capture the excitement and the opportunity: “Ab virasat tai nahi karegi safalta ke makam ko, udaan tai karegi ki aasmaan kiska hai” (Success can no longer just be inherited, your own ‘flight path’ will determine who reaches the sky).