Mid- and small-cap portfolios that Manish Sonthalia, Head - Equity, PMS, Motilal Oswal AMC have seen returns decline in the recent market correction. He insists that staying invested through cycles is important and there is no such thing as just-in-time investing.
Subscribe to the free Value Research Insight newsletter
Have we seen the bottom for mid- and small-cap stock prices in June?
We have already seen the bottom. Many technical factors were involved. We saw a lot of capital moving out of mid- and small-cap stocks, which had come in the last two years. If you are supposed to fall within the regulatory definition of large-, mid- and small-cap, there are likely to be hiccups. A lot of capital had to move out of mid- and small-caps and go into large-caps which is what was happening.
Within large-caps, there were four or five stocks where many were underweight. With decent numbers being delivered by these stocks, some capital will move towards large-cap stocks. All this was happening in a very short time. Retail investors also buy these mid-caps and many are funded on margin. If there is collateral damage in any of them, margin calls get triggered. These are technical factors; in the long term, it's all about earnings and financial numbers.
The shift in buying, thanks to the change in mutual fund guidelines, was a one-time event. Isn't that money unlikely to come back in a big way from where it went out?
Two years ago, our GDP was $2 trillion. If 30% is the savings rate, we should have saved around $600 billion. Now we are $2.5 trillion and if the savings rate is the same, we are at around $750 billion of savings. Equities will get their share.
The guidelines say that 80% will be invested in the first 100 stocks by market capitalisation, and 20% can be invested in others. In a mid-cap fund, 65% must fall within the mid-cap defined segment and 35% can be in others. The passivisation of the Indian mutual fund industry has been triggered. When you have the entire industry buying within a limited set of stocks, how can you generate alpha? Alpha will now come from alternate investment funds, portfolio management schemes and advisory. The source of generating this alpha are stocks which will be under-tracked. This is where money can be made. The overall pie, however, will continue to grow.
The India Opportunity Portfolio (1), which is one of your mid-cap strategies, has seen significant underperformance over the last few months. What has caused that?
It is now a small-cap portfolio post the reclassification. Before the underperformance came, the portfolio was outperforming by a big margin. In 2017, the portfolio gave 65% return and the outperformance was 22-25%. Corpus only comes with return. We were sure, however, that such extraordinary returns will revert to mean. The returns were front-ended and earnings were still to catch up.
We have followed that philosophy. If you are sure about a company, stay put. You must evaluate performance over a cycle, not daily. Let's say you invested after the portfolio had returned 65% in the previous year and then when you came in you got a negative alpha of 7-8%, you must stay with the product. The PE has come down because of market conditions. When earnings growth starts to kick in, your buying price will be justified. I have not changed any stock in that portfolio. Stocks are bought for at least three years. With this recent pull back, prices are coming back.
When your top holding falls 20-30%, how do you maintain patience and what do you do to keep the conviction?
We question the assumptions more conservatively. As a thumb rule, we always aspire to achieve portfolio earnings growth of 18-24%, which is to say the portfolio on a weighted earnings basis should be doubling profits every 3-4 years. Stock prices and earnings move in tandem.
Now it's such a situation that earnings growth will accelerate, thanks to a low base, and valuations have halved. My biggest conviction is on India Opportunity Portfolio. We look out for individual companies doubling their profits every 3-4 years and the portfolio aggregate returns doubling in 3-4 years.
Other than rebalancing due to allocations moving up, we follow a buy and hold.
When do you exit or switch stocks?
We try to buy early before the market factors in the earnings potential. Sometimes markets will reward you front-ended. If a stock price moves up beyond its justifiable earnings or much before earnings growth has come, it is tempting to sell and buy it back at a later stage. I don't do this. If I believe growth in a company will last for say 10 years, but in the near-term, markets have become very euphoric, despite the incentive to sell I am willing to live through price and time correction for the next nine years of earnings growth.
How often have things gone wrong?
If our assumptions have not played out over a period of three years, as a rule we believe that perhaps the markets know better. It may mean that I have not understood the business properly, we can exit the stock. The day I realise that there is a corporate governance issue, or I haven't understood the stock, it's time to exit. But I must understand and it's not hearsay.
What is the biggest challenge today-valuations, ideation or earnings growth?
It is getting the investors convinced that this is not time to sell, it is time to buy. When you have the least conviction in the market, you get maximum interest and when you have high conviction, you get least interest. That is the biggest challenge. It's always a herd mentality, sell mid-caps and buy large-caps if large-caps are doing well, the outcome is likely to be opposite. There is nothing called just-in-time investing, you must spend time in the market. I am talking about running businesses with ample growth.
In arrangement with HT Syndication | MINT