Are the frontline indices (at all-time highs) far removed from underlying growth?
While the frontline indices like S&P BSE Sensex and Nifty 50 are making newer highs, the mid and small-cap segments of the markets have seen a lot of volatility in the last few quarters. They have underperformed the narrow large-cap indices as select large-cap stocks have driven the markets higher. The market seems to be rewarding stocks which have demonstrated consistent performance. This has led to a significant polarisation of the market whereby the indices are driven by only a few stocks. This has been further accentuated by the fact that incremental flows have also substantially gone to these select large-caps.
Has the extent of consumption slowdown caught you by surprise?
The consumption slowdown has been mainly due to the strong growth witnessed between 2015 and 2018 which appears to have created a large base. Good monsoon, higher MSP (minimum support price), easy availability of finance together led to higher demand for both discretionary and non-discretionary consumer goods.
While slowdown which we believe is cyclical did not catch us by surprise, the intensity of slowdown in certain pockets is indeed quite surprising. While in the near term, consumption is unlikely to rebound, we believe, with the good monsoons, consumption is expected to revive farm production for at least the next couple of seasons. This is likely to drive consumption demand over the next 12 to 18 months.
Is the ‘quality’ basket commanding too hefty a premium?
The markets have been giving a premium to companies which have demonstrated consistent performance. In some cases, this has led to valuations of ‘quality’ stocks rising to extreme levels. However, as the flows into emerging markets have improved and gradual risk on sentiments has returned and markets have become more rational, we are seeing stock price performance becoming broader over the past 3-4 months.
Does the correction in the broader markets set the stage for a rally in this segment?
The relative overvaluation of mid-caps over large -caps has corrected and now the mid-cap indices are trading at a small discount to the large-cap index. Over the past quarter, we have seen the breadth in the markets improve and smaller large-caps and mid-caps have also been part of the rally. Relatively attractive valuation of mid-caps coupled with the strong fundamental story behind many mid-cap stocks and the improving breadth in the markets make it a good investment case from a medium to long-term perspective.
What will be your approach to the upcoming mid-cap fund given the tighter definitions for this category?
We will probably have 50-60 stocks in the portfolio, a mid-cap universe of 150 stocks gives us enough options to pick. Besides, we have 35% of the portfolio where we have flexibility to pick stocks from a broader list. Besides stock selection, sizing of positions and points of entry and exit in stocks also contribute to returns and as such should help in differentiating our performance.
We will follow a bottom up approach to stock selection and will aim to build a diversified portfolio. The universe of stocks will be selected to include companies having a robust business model and enjoying sustainable competitive advantages with earnings expected to grow better. To control risk, the exposure to a single stock– mid or small–will be capped to 4% of the portfolio.
How has slowdown impacted the business profile of mid and small sized businesses?
All businesses have upto some extent been impacted by the slowdown over the past few quarters. Mid-sized businesses have particularly been impacted with respect to stress on the working capital as payment terms have elongated including in some cases monies locked up in GST etc. Further, slowdown of disbursals by NBFCs and banks to small and mid-sized companies has made things difficult for them. However, these companies are seeing an improvement in availability of credit after RBI rate cuts.
What types of businesses provide the best opportunities within the mid-cap space?
Well run mid-sized companies that have features of a large company and efficient capital allocation while being run by a team executing to deliver growth. Potential opportunities in mid-caps would be in companies which are seeing higher than estimated earnings growth, companies undergoing business transformation or refocusing their business on high growth areas. There is also potential in companies focusing on value migration (shift to higher value products) leading to improving margins or those where intrinsic value is being unlocked as a result of corporate actions etc. New sectors like healthcare, logistics, fin-techs, etc also provide good investment opportunities.
Principal AMC has no offering in the large cap segment, except for the index fund. Is this owing to the shrinking alpha potential?
Alpha is traditionally generated from asset allocation and stock selection. The Sebi categorisation has narrowed the universe for large cap funds to top 100 companies. This is, incidentally, also the most efficient segment. Therefore, generating alpha would become more challenging in this category.
However, we believe that a research driven stock selection investment process would help deliver alpha even in the large-cap segment. We do not have an actively managed fund in the large-cap category but we are regularly evaluating opportunities and do not rule out introducing a large-cap fund at a later stage.