Q. After 2013, the mid- and micro-cap segments have outperformed. But, over the past six months, things have not been so great for the markets. How do you gauge the situation?
Specifically for mid-caps, when we are taking positions, there is much more of bottom-up stock picking. It doesn’t matter if it is a bull market or bear market. We hope that these companies will outperform the segment and the market. Here the selection criteria are simple: We look for managements that are stable and can perform over a period of time, and we look for interesting business ideas with growth potential.
We had to shut our Micro Cap Fund to new investors last year because, over the previous three years, the return on investment (RoI) was exactly the same. Nothing had changed in the fundamental properties of the portfolio, but the price-earnings (PE) multiple went up dramatically. We actually look more at price-book value than at PE multiples. Even that has gone from 2 to 2.5 times. We saw that we would be paying a lot more, with the same set of cash flows, at a time when growth hadn’t picked up.
But now a year has passed and we are getting to a level where we are debating when to re-open the Micro Cap Fund.
Q. But you have expanded your micro-cap portfolio with around 50 stocks over the last one year?
That’s true. When we started the fund, we were [worth] hardly Rs 300 crore. We could take a concentrated approach to investing; we could manage to maintain a portfolio of a few stocks. But that had to change as money began to pour into the portfolio. As the fund has grown, we had to change our approach. When we stopped new investments into the fund, its size was around Rs 1,800 crore. We also saw a lot of our microcap stocks ending up as mid-cap stocks; they performed so well that we had to sell them. Bajaj Finance, a company that we would have loved to hold forever, saw a dramatic rise in its market capitalisation to around Rs 25,000 crore. We bought it as a micro-cap and now it is a large-cap.
Q. But to maintain liquidity, do you need to keep some mid-cap or large-cap stocks in the portfolio?
Liquidity is always a challenge for mid- and micro-cap funds. When we stopped taking new investments into our micro-cap fund, we launched a three-year, close-ended fund.
Our idea was that it would be more flexible than a micro-cap fund. In this close-ended fund we would not get into a Bajaj Finance kind of situation. The market has also changed over the past few months. Even the large-cap stock valuations are looking attractive now.
Q. Over the last few years, the focus has been on mid-caps. This segment has now been overvalued. Will it be a good idea to have a long-term position on mid-caps?
The minute you get into a mid-cap or micro-cap fund, you have to be a long-term investor. We don’t want investors to look at the past one year’s returns and get into our funds. In the very short run, these funds can be extremely volatile and can lose more value. The relative valuation between large-caps and micro-caps is not off ering a high margin of safety.
What we are saying is that mid-cap and micro-cap funds are products for long-term investing. We will open these funds only for a certain amount of time. It is not that every micro-cap will under-perform, and if they do, then we will put more money in quality stocks. But we are telling investors that this is not a one-year product; it is for the very long term. Over five years, micro-caps are not a problem even if you are buying at the top end of the valuation.
Q. Could there be a 2013-like scenario again, where small- and mid-caps did not perform at all?
Not as much as earlier. In 2013, we saw domestic investors wanting to get out of the market at all costs. Promoters who had pledged shares were getting hammered. There were a lot of negative sentiments about micro-caps. Now, it is very different. People want to come in and not rush out immediately.
Relative to 2013, I don’t think we will see the same viciousness of the fall. We have moved to a point where mid-caps are at their lowest discounted levels, relative to large-caps. That is also an extreme. I think large-caps will do better in the near-term.
Large-caps going up and mid-caps performing in a more modest fashion will create a gap over a six-month cycle. Then these companies can continue to perform.
Even in 2013, it was not that every mid-cap got hammered. It was more of the cyclical mid-caps that faced the problem. The higher RoI mid-caps performed right through that cycle.
Q. But market visibility for mid-caps and large-caps has not been there for three or four quarters. Investors are uncertain about taking long-term positions.
As far as we are concerned, if we can find a decent management in a business that we are confident will grow over time, we are happy to own these companies, and if their stocks prices come down, we are happy to buy more. The true value of the business gets built up over that holding period.
If you think in terms of quarters, you will start making mistakes.
Q. How do you read the global situation? The Chinese yuan and US interests rates are foxing the market.
Most people analyse these [global] problems on hindsight and start getting really scared. Let’s look at the earlier global problems: 2008 was the worst, but in around nine months the market had recovered to pre-crash levels; in 2013 it took three months to recover.
A month ago, investors were asking if I would like to buy in case of a correction. Corrections have reasons; this time it is a global reason. Now that you see the correction, you don’t invest because all the new data points scare you. Six months later, when the market has forgotten this event and is rising, you will get in at a point that is higher than even today.
These global events keep coming. If you are a long-term guy, you should be happy about corrections.
Q. In your micro-cap, much of the top holding has not changed. Indoco remedies or SRF has been with you for long.
Yes that’s true. We are actually happy to add into the same names if the prices fall.
Q. How do you assess the earnings growth situation? It is not happening.
You are right about that. It has been disappointing. We were hoping there will be a pick-up. After seven years of 7 percent growth, we believe that, as time passes, we will see a probability of earnings growth picking up. We are optimistic. Look at it from the government’s point of view: Last year it was about fixing deficits; this year it is about giving orders; next year you will see the effect of money flowing into the system. Earnings should improve over time.
Q. But why do you say that earnings will improve?
Let’s look at the index. Two-thirds of it is into defensive business. So I’m including private banks, discretionary companies and pharma companies. Most of them are growing at a base of 10 percent. We are not disputing if a Maruti will deliver 10 percent growth. We believe there is a good part of the market that is growing in the 10 to 15 percent range already.
The problem is the remaining one-third of the market. Here you have oil companies, utilities etc. There you had, in some cases, de-growth. Say Cairn. I think commodities have also corrected dramatically. We don’t see further corrections. In a lot of commodities, shutdowns have started. From here, it is unlikely that all these companies will see their earnings fall by 50 percent. So, our feeling is that this one-third of the index will start contributing. And the two-third is stable.
Can the earnings swing from 7 percent to 16 percent in a year? At some point we feel that it can happen. It is a matter of time. A lot of pain has already been felt by the commodities segment. The earnings is what the market finally needs. If the market falls now, it is good. It is falling at a time when the earnings cycle is better in the next three years. That makes valuations cheaper and equities will perform better.
(This story appears in the 02 October, 2015 issue of Forbes India. To visit our Archives, click here.)