Vihang Naik, Fund Manager, L&T Mutual Fund, chats with Ravi Samalad about how he is navigating the mid and small cap space.
Mid and small cap funds collectively received net inflows of Rs 1,447 crore in April 2019. In May, around 50% of the total net inflows in equities came in mid and small cap funds (Rs 2,689 crore). Do you think this segment has turned attractive now?
Mid and small caps peaked in January 2018. There has been a sharp correction since then, about 20% in mid cap and 30% in the small cap index. From a forward basis, valuations have corrected from 25-26 PE to forward PE of 15-17 in mid-caps. These are not expensive valuations. That said, in markets things never stay at fair value. The pendulum swings from euphoria to despondency. I feel it is a good time to take exposure in mid and small caps. It is heartening to see that we are seeing inflows in this space at a time when the asset class is not doing well. This goes to show the effort of the industry in educating investors.
L&T Mid Cap Fund is overweight commodities as compared to the benchmark. What kind of companies within these sectors you think are doing well?
In commodities we hardly have any metals, but we have cement stocks. Cement is a commodity in a sense. However, it is a very local commodity. Unlike other commodities, cement possesses certain unique characteristics. For example, if you have overcapacity in the South that doesn’t affect prices in East or North. You can make good margins in East and North despite having overcapacity in South. That’s not the case with metals. Overcapacity in one part of the world can affect prices thousands of kilometers away. Both India and China have about the same population. However, China’s largest cement company is almost the size of whole cement industry in India. If we have the same kind of urbanization over next couple of decades, cement as an industry will do well. It is one of the best ways to take exposure to the capex cycle/real estate boom since the sector has low leverage and good cash flows.
L&T Mid Cap Fund has exposure to construction and related chemicals. Do you have a positive view on the retail constructions sector?
We have built this portfolio bottom up. We like companies which have strong entry barriers or moats. For example, in India, paints industry is an oligopoly. Think of all consumer goods that touch your life and think of the largest players in those industries. Almost all categories have multi-national companies (MNCs) at the top.
Indian companies have not been able to protect their market shares because MNCs have bigger budgets for brand creation and research and development (R&D). Paints is one sector where MNCs have not been able to dent Indian firm’s market share. The top two players of the organized paints industry are Indian companies. MNCs on the other hand are smaller players. Characteristics like strong distribution and channel loyalty have allowed incumbents to be more powerful than the challengers. This is why we like paints sector and home improvement is an ongoing theme. It’s a very small market. The profit pool of the sector is less than $500m. We see a long growth trajectory here.
What makes you bullish on real estate sector?
We do own a bit of real estate even though these stocks look expensive on past earnings. When you buy a property in any Tier I city, it costs at least Rs 1 crore. You spend about Rs 1 lakh painting the house, which is about 1% of the cost of the house. The largest paint company in India has a market cap of Rs 1.3 lakh crore. All the real estate companies put together have about the same market cap. This tells you about the ownership in the real estate sector and the kind of pain the sector has gone through. Recent stress in the sector will ensure that only players with strong balance sheet and good brand will survive. When we see demand revival at the horizon, these players will benefit disproportionately.
L&T Mid Cap Fund has increased exposure to regional banks from 8% in March 2018 to 14% as on April 2019. What makes you bullish on these banks?
Private banking has strong tailwinds. Most capital-intensive sectors in India were dominated by government owned companies. Take telecom for instance. Because of efficiency issues, today they are almost non-existent. The same is happening in a slower pace in the banking space. You have PSUs which used to command almost 100% market share a few decades ago and now have 65% asset share. This share is being taken over by private players. In these private players as well, the larger players are facing base effect issues. We have few regional/emerging banks which are doing good business in their own focus areas. Valuations are not expensive if you take growth and quality of these businesses into account. This is why we are bullish on the space.
How do you evaluate companies from a liquidity perspective?
Peter Lynch said, “In stocks as in romance, ease of divorce is not a sound basis for commitment.” You buy stocks because you expect them to do well and you want to stay with them. You don’t buy stocks because it is going to be easy to sell them. Many stocks don’t have much liquidity before the thesis plays out. After the thesis plays out, everybody comes to buy. If you go wrong in your thesis, that’s when the liquidity hurts you. Thus, we try to focus on getting it right rather than focusing on liquidity. That said, we don’t want a large part of our portfolio to be invested in illiquid stocks because if we face redemptions, it could be a problem.
L&T Mid Cap Fund is holding 8% in cash. Are you waiting for new opportunities?
We have always had cash levels of up to 5% in this fund for two reasons. Firstly, for capitalizing on sudden opportunities. For example, when Indian Army did the first surgical strike, some sugar stocks hit lower circuits. Sugar has nothing to do with surgical strikes. If you have cash, then you can capitalize on such opportunities very quickly. If you are 100% invested, you will sell something to buy something. The second reason is for redemptions. Sudden redemptions can impact the Net Asset Value (NAV) if you don’t have cash. The cash holding is high because we are getting good inflows in this fund. The easiest thing for any fund manager when the fund is getting inflows is to buy existing stocks proportionately. In such a scenario, there is an upward pressure on the prices of your own holdings. This artificially inflates the NAV. Although it improves the fund’s current performance, it comes at the cost of future returns. We are looking to deploy the excess cash soon.
What filters do you look at why adding new stocks in your Focused Fund, which is constrained by the mandate to hold up to 30 stocks? Do you offload existing holdings to make space for new scrips?
I will take you through our thought process in the L&T Midcap fund. We follow a 70-30 strategy in which 70% of the fund is invested in high quality companies at a reasonable price. We look for three filters in such companies: 1) Entry barriers 2) Scalable opportunities and 3) Reasonable price. The remaining 30% of the portfolio is invested in deep value with visible catalyst. This is the more interesting part of the portfolio where you look at sectors which are out of favor. But there is a difference between deep value and value traps. What differentiates between the two is some catalyst on the horizon which can take deep value to fair value. These are companies where investors and analysts have lost interest and have low ownership. Whenever catalyst comes in, these stocks can be multi baggers. These are not great quality companies. These are not indefinite holdings as well. This is the riskier part of the portfolio. So we diversify this risk by taking a basket approach. In the markets like the last 1.5 years, good quality companies don’t fall as much because there is earnings power. In markets where you have good tailwinds, 30% value part can give you disproportionate gains. We follow the same strategy in Focused fund as well with larger exposures to individual stocks.
