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WF: With BSE Midcap Index trading at 31x trailing PE and BSE SmallCap Index trading at 68x trailing PE, concerns are very high about these segments being in "bubble zone". Yet, many fund managers tell us that they continue to see value from a bottom up perspective. Can you please help us understand this situation better?
Sunil: The mid and small cap indices are perhaps not very representative of their segments as there are many constituents which distort the indices - both on the upside as well as the downside. We have some established players, we have companies which have gone through challenging times but where the future prospects look good and we have some large loss making companies (especially some PSU Banks that are part of the midcap index) that bring down the average earnings of the index and therefore increase the index PE. When you see the actual composition of these indices, and you look at the opportunity set beyond these companies, you will agree with the view that a bottoms up perspective is a far better way to look at mid and small caps, rather than the indices.
Having said that, it is a fact that there is too much money currently chasing good quality stocks in this space. Mutual funds that focus on this space have done very well and are getting strong inflows as a consequence, you have PMS services that are attracting lot of money into products that focus on this segment and you have HNIs and ultra HNIs who track this space and build portfolios with such stocks. Fact is that this segment is no longer cheap. You don't find screaming buys any longer.
There are however two different perspectives we must keep in mind when considering midcaps. The first is the relative valuation. Now, the way one usually sees relative valuation of large vs midcaps within a sector is to compare PE multiples. But, at a time when the economy is coming out of a challenging phase, comparing PE multiples may not be the best metric. If you take cement companies, large cement companies are available today at 250 million dollars per million tonnes, while their midcap counterparts are available at 70 to 80 million dollars per million tonnes of capacity. At the same time, a PE comparison will not show up this valuation gap since smaller cement companies took a bigger hit on profits in a high interest rate and lower demand environment which existed in recent years.
That brings me to the next perspective, which is related to the first. Ultimately, you are a buyer of equity when you are optimistic about future prospects, and if you are indeed optimistic about future prospects for the economy, it is hard not to be more optimistic about midcaps creating more wealth in an upcycle. Their earnings will grow faster than large caps as demand picks up, as operating leverage kicks in and as interest costs moderate.
If you keep these perspectives in mind, you will appreciate why we say that index PEs are misleading and why we believe bottoms-up opportunities continue to exist in the mid and small caps spaces. We invest in midcap themes where we see a clear structural story playing out over the next 3-4 years, which will enable these companies to grow much faster than broad market and their large cap counterparts.
WF: Indices usually are made up of the most popular and liquid names of any market segment. Does this mean that all the liquid and popular names in mid and small caps are very expensive and that search for value is taking fund managers into riskier and more illiquid terrain?
Sunil: Frankly, this is where experience comes into play. We are very clear that we don't mind sacrificing 1 or 2 percent in returns, in order to be fully comfortable about where we are investing. One has to be careful about this aspect, and my advice to our distributor partners is to carefully review portfolios of midcap funds going forward, before firming up your recommendations.
We don't mind buying a stock we like maybe even 10% higher than the ideal price we want to buy it at, but on the other hand, we steer clear of buying into momentum of a stock that we are not very comfortable with - even if the momentum appears strong.
WF: How are you navigating your way in this valuation rich space of mid and small caps when managing the portfolios of your Mid and Small Cap Fund and your Small Cap Fund? Which segments/pockets do you find the risk-reward equation attractive?
Sunil: In our Small Cap Fund, we had put in place restriction on high value investments since May 2014 and primarily taking in money through SIPs. The flows are moderated as a consequence, and we are very comfortable with it. In the Mid and Small Cap Fund, we have been early investors in the chemicals space and continue to have our conviction in some of our early buys in this segment. In financials, we are optimistic about some old gen banks that are coming out of their challenges and look promising along with few niche NBFCs plays. We are positive on midcap cement companies as these are trading at a significant discount to the market cap/tonne valuation of their large cap counterparts.
WF: A lot is being said about India undergoing a transformational change - perhaps the first time since 1991. New ideas and themes in such a scenario usually manifest themselves first in the mid and small caps spaces. If you were to pick 2-3 such promising themes, what would they be?
Sunil: The first theme is the shift from physical to financial savings. We believe the life insurance, asset management and wealth management spaces can comfortably grow at 20-25% p.a. for the next few years. One can't directly buy into such companies yet, but there are ways to participate in these themes by considering their holding companies. But, this is a space that will continue to throw up lot of interesting investment opportunities going forward, especially as many of them get listed. Some may directly become large caps, some may be within the midcaps space - but as a theme, this is one to track closely.
Next theme I see as very promising is listing of fast growing domestic brands across a variety of segments - shoes, building materials, household goods, retail chains and many others. Niche logistics players also look very interesting as they capitalize on the e-commerce boom. While e-comm players themselves will move towards listing, they are well funded by PE players and one would therefore have to carefully evaluate listing valuations.
So, what you are going to see in the coming couple of years is many popular domestic brands in a variety of businesses getting listed - some of which could offer exciting growth opportunities over this market cycle.
Staying with the new listings theme, I think there will be good opportunities coming up in the construction and infra spaces. Many of the existing listed players have made a lot of mistakes and over-leveraged their balance sheets. However, some of the names that may get listed in the future are cleaner as of now, and can therefore offer a much better way to participate in the construction and infra boom, without the baggage of weak balance sheets.
WF: How has fund performance of your Mid and Small Cap Fund been in recent years and what steps are you taking to maintain alpha generation going forward?
Sunil: Although the mid and small caps space often tends to get lumped into one segment, we see it as three distinct segments and have three funds that focus on the three different segments. We have our Small Cap Fund which invests purely in small caps. Then we have our Mid and Small Cap Fund which invests predominantly in smaller midcaps and in some midcaps and then we have our Growth Fund which focuses more on the larger midcaps.
Our Small Cap Fund continues to perform well vs benchmark as well as within the category. Likewise, our Mid and Small Cap Fund also stacks up quite well within the peer group of midcap funds. As of April 21, 2017, Reliance Small Cap Fund has delivered 3 year (CAGR) returns of 38% while the Mid & Small Cap Fund generated 28% (CAGR) for the same period as compared the benchmark indices which generated ~ 26% (CAGR) returns for the 3-year period.
One perspective I wish to however reiterate here is, like I mentioned earlier, is that it is very important when evaluating funds in this space, to not only look at returns, but also portfolio quality. At a time when the segment has momentum, one has to be extra careful about staying away from poorer quality stocks which may have current momentum but nothing much more backing them.
WF: Many advisors are switching out from mid cap funds, booking healthy profits and switching into either large cap funds or balanced funds as a risk control measure amidst rising market valuations. If you were an advisor, would do you likewise?
Sunil: So, I will go back to the point I made earlier about equity investing. If you are an equity investor, you have to be optimistic about markets going up. And, if you believe markets will go up, midcaps will outperform large caps. If you believe markets will correct 10%, midcaps will perhaps correct 15%. That is the nature of mid and small caps - they move faster in both directions.
Can the market correct 3-5% in the near term? Yes, it is possible. And, if that happens, can midcaps correct 10%? Yes, clearly they can, as there is a lot of optimism that has been built into many of the midcap stocks valuations right now.
But, if you take a 3 year view, would you say markets should go up? Yes, there is every reason to believe so. If that be the case, midcaps should rise faster than largecaps over the next 3 years. That said, the extent of outperformance can be tempered down, given the run up we have seen in midcaps in the last couple of years.
So really the call that an advisor has to take now is whether he is looking at a near term perspective or a long term perspective. If the prospect of near term volatility is worrying more than the prospect of long term gains, protection is called for, else, go for a portfolio which can generate higher alpha over the next 3 years.
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