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The runway for mid- and small-cap companies is long but it is not infinite

LiveMint logoLiveMint 01-05-2017 Kayezad E. Adajania

According to Morningstar India, mid-cap funds constituted 11% of the overall equity fund assets under management in 2014; this moved up to 16% in 2015 and currently stands at 20%. Mid- and small-cap funds have been getting a lot of inflows as compared to large-cap flows. Are we building ourselves a bubble in the mid-cap space? Are investors unfairly ignoring large-cap stocks at the cost of mid-cap stocks? Anand Radhakrishnan, chief investment officer-Franklin Equity, Franklin Templeton Investments—India, who manages Franklin Templeton’s large-cap oriented funds puts things in perspective in a chat with Mint. Edited excerpts:

People have been investing a lot in mid- and small-cap stocks in the past couple of years. Few seem to be attracted to large-cap stocks at present. Is there danger in this approach?

On the one hand, widening of the market is good. We want more companies to get listed, more sustainable businesses to emerge, markets to be accommodative of small- and mid- sized companies that are new or niche businesses, and are capable of growing. A healthy appetite for such companies works in the interest of the markets. But there need not be an unbridled optimism, or no ceiling of valuations, of businesses in that space. There is a belief in the marketplace that the runway for mid- and small- sized companies is longer and wider and therefore they can run much longer than some of their larger peers. While technically true, that runway is not an infinite one. It is a bit longer than that of the larger peers and therefore one can give such companies a longer period of growth, but that’s about it. I think the market seems to be ignoring this fact at this point of time.

Investors tend to crowd around ideas that have worked well in the past and this is what is probably leading to more inflows into mid- and small- cap segments. Foreigners are also increasingly coming to the view that larger companies can be bought through exchange-traded funds whereas to make the most out of Indian equity markets, one needs to have 5-10 mid-sized companies. It is tough to say when this will change; whether the markets would be driven fundamentally or by liquidity or equity flows.

You manage the portfolio of Franklin India Bluechip Fund very conservatively. You have private sector banks, not much of state-owned banks; no State Bank of India (SBI) like some of your peers who feel state-owned banks are now turning around. You hold very little of infrastructure and cyclical stocks. Why are you so conservative? Don’t you think economy would recover and position yourself accordingly?

Fill the flask with big rocks first, and then the smaller pebbles and then the sand. We want to give as much money as possible to our best ideas: well-respected managements, proven businesses, companies with great cash flows, ability to defend market share, and competitive managements.

Then, you look at the untested companies that you’d be careful about but at the same time know that you want to be accommodative of such ideas, because you never know…you have to account for possibilities of a turnaround in such companies, businesses, but you don’t want to bet your shirt on it. So, you like to be more deliberate and careful. These become the smaller pebbles in the jar. If I am not confident, then I take a smaller position in them and watch them. As my conviction levels improve, I invest more. Similarly, some of the large ones may drop out as they also phase out. Strategic shifts of the portfolio happen slowly.

I am intrigued to see Yes Bank as one of your top holdings while many are warming up to SBI. What does your analysis of the banking sector say?

The credit growth—around 4.9%—has been very poor. For an economy whose nominal growth rate is expected to be closer to 10%, (6% real growth plus 4% inflation), having a nominal credit growth of 5% is unsustainable. So, we have to budget for a higher credit growth. The economy has hit the bottom in terms of credit growth. Within that big picture, you’ll see private banks gaining market share from the state-owned banks, like it has been over the past two decades, both in terms of deposits and credit growth. The more the number of ideas you have, if you like such a theme, the better it is because I’d like to diversify. One HDFC Bank doing good is not enough, so another Kotak Mahindra Bank, another IndusInd Bank helps and then a Yes Bank helps even further.

To be honest, of all the bank sector holdings, Yes Bank is the riskiest holding. Internally, we have debated it ad nauseam. Over the years, the riskiness has reduced as the bank grew its retail business, opened more branches, ramped up the current account savings account (CASA) ratio; it is also building granular rather than lumpy lending to risky assets...risk has—and still will—progressively come down and valuations will improve. So, it is a combination of a fast-growing bank (at a pace that is faster than many of its private sector peers) but where there is still some risk perception. As it diversifies into more streams of revenue and lending, the risk perception should come down. It’s a conscious risk, which we have budgeted for and also understand. The risk we don’t understand is when we buy state-owned banks. We don’t know who they are lending to, we don’t know how long the top management is going to be there, the chairman keeps on rotating, the culture there is based on seniority, incentives are misaligned, and so on. I would not be very happy with that kind of risk.

Remember, just because something is cheap, doesn’t mean it will work well over the long period. In finance, we want managers who take prudent risks and don’t lose capital. We don’t want banks to be saddled with non-performing assets (NPA) because every such NPA pulls its capital down. We want bankers who differentiate good credit from the bad. HDFC Bank, Kotak Mahindra Bank, and so on have avoided temptations of lending to bubbles like real estate or steel companies.

There is a lot of buzz with the entry of Reliance Jio. You have Bharti Airtel Ltd in your portfolio. Is that cause for worry?

There is no cause for worry. About 3-5 years ago, we used to have 7% of Franklin India Bluechip Fund’s corpus in Bharti Airtel, and that was cause for worry as it was significantly pulling down the performance, even without Reliance Jio around the corner. At that time, there was intense competition between Bharti Airtel, Idea Cellular, Vodafone and Telenor. We thought that was unsustainable. The sector would consolidate, etc., which actually happened. But by the time the sector consolidated, Reliance Jio entered and changed entire dynamics. It entered the sector investing higher than the highest invested capital of an existing firm. It invested about Rs2 lakh crore in an industry where the largest player had invested about Rs1.5 lakh crore. We have progressively reduced our exposure to Airtel, which we still feel is one of the best managed companies in the country. But under the onslaught of price competition in the sector, the economics of the sector has become very poor. If some companies are free to invest lakhs of crore of rupees, there is no path to profitability under the current circumstances.

But you still have exposure to Bharti Airtel.

It is moderate. Franklin India Bluechip Fund’s entire exposure to the telecom sector is only 3.5% and all of it is in Airtel. An exposure of 3.5% to this sector is the risk we can take. If this doesn’t work, we will figure out what to do. We’ll keep a watch. We are wiser now. Perhaps a nil exposure to this sector could be the nicest thing to do, but there is still some hope.

The universe of large-sized companies is universe and the information on them is very easily available. You have many competitors. How do you manage?

This comes from deeper understanding of the businesses and our willingness to ride out the shorter-term cycles, that is to be contrarian. We have one of the largest research teams in the Indian mutual funds industry. We never chase momentum stocks, never succumb to pressure in terms of what works in the market and never chase performance. For example, the past six months have been great for commodities stocks, but that doesn’t mean I should now invest in them, considering I have not yet. If I have missed it, I have missed it; I won’t chase it. If I should have bought them, I should have bought them one and half years before not now. We are willing to resist the temptation to succumb to the pressure. We are willing to play longer term compounding stories than short term cyclical stories. We are willing to pay for quality rather than try to find cheap stocks. We think value is different from cheap. And value means you have to pay for it.

Some other large-cap funds invest 20% in mid-cap scrips and are therefore quasi large-cap funds. Globally, such funds would not be called large-cap funds; they would be called diversified equity funds whereas in India they pass through the filtration because everyone has their own definition of classification of funds. But excesses in rising markets also come back to haunt us in falling markets. Sometimes, fund managers keep on adding midcap stocks, chasing performance, in a large-cap fund. When things turn around, you also tend to capture a bit of downside. If Franklin India Bluechip would have lagged these funds in rising markets as a result, we would also claw our way back during falling markets. Yes, it’s tough. The peers are pretty competitive and do all the tricks in the trade to stay ahead. And we also have to be aware of it and be on our toes, within our disciplined mandate and not violate any rules.

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