Mrinal Singh is Deputy Chief Investment Officer - Equity at ICICI Prudential AMC. At the Morningstar Investment Conference he participated on a panel moderated by Madhusudan Kela, the chief investment strategist at Reliance Capital. Below is an excerpt .
How you are you reconciling the mid-cap valuation of 25 P/E and earnings not catching up for last two years? We keep saying it will happen in the next quarter but it has not happened for eight quarters.
It's not only that the earnings have not come, they have declined. FY16 compared to FY15 on the BSE Midcap, the earnings have declined 12% to 15% and P/Es have expanded. Clearly, liquidity is having its play over there.
I am definitely not excited about the mid-cap space. And clearly, for the last one year, liquidity is making us look like fools. As a fund manager, we say mid caps are not the right place to be and it seems quite weird trailing P/Es on midcap indexes on 33 times. So what will it take for midcap index to converge to the large-cap index over the next one year, historically speaking, the asking rate is 80% earnings growth!
How you are managing with daily inflows?
In such times come, we get into capital preservation mode.
Mandates restrict the amount of cash. But besides cash, we would tend to look for very high quality strong businesses which could typically provide liquidity if there are some corrections.
But if you go into so-called defensive stocks and the market keeps running and your peer group outperforms, at what stage do you join the bandwagon? Or will you just be left out?
It's delicate. It is very testing. You have to remain relevant. And the business can have its own pressures when your ranking in the peers falls, particularly in the near term. But you cannot and should not compromise on your long-term benefits for your investors. Every time I face that dilemma, I focus on what is the right thing to do. I try not to get swayed by what the market is proposing in terms of greed and fear. Find what you think will make you reasonable money. The idea is to keep doing the right things, because if you drift, there is a bigger trouble.
What is your perspective of your overall portfolio before getting into a company? Sector allocations? Risk control? How do you take that call?
I tend to take strong deviations. I manage risk by having a very favorable cost of acquisition. So, I am very focused on what I am paying to acquire that stock. I typically tend to work with a very high margin of safety with my assumptions. I tend to put assumptions as far as possible in terms of the projection. And I tend to have lesser number of assumptions because they are the source of problems. Then I arrive at the price where I think the risk/reward is very favorable. If I get that price and I think the business is solvent, it could be a long-term winner. In such a case, I tend to take a very strong outsized position if the price is extremely attractive.
How do you decide what kind of position to take? Does only the entry level of the price decides that or your bullishness about that company over a longer period of time?
Every business presents itself a set of risk that the business cannot manage. For example, an exporter has a currency risk. If you're an exporter, a strong rupee will hurt. They have to just take that risk. But at a portfolio level, I can deal with it. So, I tend to see what quantum of that risk is manageable or diversifiable in my other holdings in the portfolio.
So you hedge with the importer?
I won't hedge with the importer. But I look at my current holdings. Which companies are negatively correlated on currency to the companies that I am looking to buy? So, I can scale it up all the way because I will be able to manage. This is a good company having a bad time. This is a risk they can't manage, but I can manage. If this negative correlation is played well, we create a portfolio of decent businesses which we have accumulated over a period of time through various bad and good cycles. And over a period of time this value accrues to – and it reflects in the NAV.
I tend to manage risk at a diversified level on the portfolio.
I tend to manage risk hugely by optimizing my cost of acquisition.
If the business is of superior quality, if the long-term prospects are very good, I would tend to have higher weight, let's say, maybe 5% or 6%. But if it is a mid-cap, and I think that we can hold it for 3-5 years and it could double or triple, then even 3% is good enough because it will generate decent sufficient alpha. The idea is to find quite a few of them. And then if we can diversify that risk, find the negative correlation I think we'll sail fine.
Give me an example of what you will expect to go up 5x or 10x? Or, you start with a 0.5% or 1% position, how do you scale it to 4% or 5% or 6%? Or, when it already become 10x, where do you get that conviction to continue to hold it even when the valuations are not in your favour? Like Eicher Motors is not cheap by any standard - where do you get the conviction to hold that kind of company?
To begin with, they don't come across as multi-baggers of 5x or 10x. It looks cheap. Sometimes what happens, the situation falls so well in place for that sector and that company is so well placed that it just surpasses what you thought they will do. In terms of the thought process, I'm very happy if I can see with my assumptions even a doubler.
Doubler in five years?
Because if you're going to do 20% -- doubler in 5 years means you're going to do 15%+, so with my safety of assumptions, if I get names like these, I know there is alpha to be generated out of them.
The index itself has done 15% in the last 25 years. Your alpha would not have been generated with this thought process.
The thing I need to emphasize is with my assumptions and I've generally seen if I've got that comfortably with…
Are you saying that your assumptions are always conservative?
Very, very conservative. So, once that tick box is there, I know we'll easily make that. And I've generally believed if you get certain 15% to 20% kind of CAGR returns, they need not be every year, it could be bunched up at one juncture, they will generate alpha.
Any theme or sector which you are betting on today? Which you think can become outsized from an India perspective or from an opportunity perspective?
These kinds of multi-baggers typically have some traits. Those traits are very obvious. They are in a space where the opportunity size is going to expand multi-fold. Definitely, you are not going to see them where the addressable market is completed penetrated unless you bring an innovation in terms of some category, or like Apple you design a new category itself. So, it's a combination of what the opportunity size looks like and how that company is placed in that. Let's say, for example, the tech in the mid-90s. You knew the opportunity size is multi-fold. There are a set of names, which will – one will grow faster, other will grow slower, but this space will become big. It seems like infrastructure is the space now. Clearly, the opportunity size is multi-fold.
Within that, are you bullish on any particular theme – power, roads, construction companies….?
A combination of power, utilities, and construction. This looks like a space wherein the investment will continue to happen for years and years. And if you get the right kind of names which are most efficient capital allocators, best executors, I guess – and if you look at comparable data, I think we are – per capita power generation is one-third of Thailand. I am not putting China into picture. So, clearly, at one juncture if Make in India or manufacturing growth happens, we are going to see power, utilities and cap goods getting ordered.
Does the management quality in this sector worry you?
The challenge is to find good quality of earnings. Infrastucture is inherently a leverage business. It is a high beta to the cycle itself. You don't get debt-free infra companies. So, it is more challenging for an investor like me to play the cycle right, get the right companies, get comfort with the management, but I think the rewards could be worthwhile.
Regret or Mistake?
In the small companies, getting the management assessment right is extremely important. A mediocre or inferior management can actually goof up a very good business. 2008-2009 - bought two companies in the same sector. We didn't make any money in one of the stocks, and I have kept on looking back and realized that we completely got the management assessment wrong in that one.