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Getting S Nagnath for an interview was no easy task. Being the President and CIO, DSP Merrill Lynch Mutual Fund, his work involves business and investment oversight coupled with extensive travelling

Getting S Nagnath for an interview was no easy task. Being the President and CIO, DSP Merrill Lynch Mutual Fund, his work involves business and investment oversight coupled with extensive travelling. And, being extremely articulate, he is often hunted by the media. Despite that, he graciously spoke to us at length about his views on certain sectors and his new fund. Towards the end of last year, you launched a mid- and small-cap fund. Why a micro fund now in less than a year? The market capitalisation spectrum comprises large-, mid-, small- and micro-cap stocks. In our Top 100 Equity fund, we target the large-caps which are the top 100 companies in terms of market capitalisation. The companies in the 100 to 200 range represent the mid-cap segment. Those in the 200 to 300 range represent the small-cap segment. We define micro caps as a segment representing the 300th company downwards in terms of market cap, which is where the micro cap fund will focus. Why was it targeted as a small, close-ended fund? This micro-cap segment has the potential to deliver good returns if you do the right stock picking. But these companies are small in size and will be illiquid at various points in time. If we approach it from the context of a large fund, then taking a meaningful position is difficult since liquidity would be an issue. So we felt the best way to approach it is by going through a three-year close-ended structure with a cap of around Rs 500 crore. How much did you raise? About Rs 322 crore. Would you advice a retail investor to avoid picking micro-caps on his own? It is the prerogative of the investor. If they are willing to put in the effort and spend time researching a stock, study market trends and have the ability to analyse a stock, sure, why not? That is true for any investment in the stock market. What do you look for in a micro-cap? The key pointers that one needs to look at are, is the business in a high growth area? Is the company well positioned to ride that wave of growth? Can it scale up this growth to its advantage in the years ahead so it transforms itself from a micro-cap to a mid-cap and eventually a large-cap? These are the issues we address. The kind of business model we are looking at is one where as the business scales up, the company continues to maintain significant market share in the concerned industry or segment and the return parameters continue to remain fairly robust. This will lead not to an arithmetical but an exponential increase in market capitalisation. Isn't micro-investing fraught with risks? There are always risks. Some companies may not scale up to the level we are anticipating. But over time, if you have more winners and less of those that do not perform as per expectations, you still come out on top. Look at private equity investing. If you invest in 10 to 20 companies and you get three or four that are multi, multi-baggers and the rest do not perform, you still end up with a reasonably good return on a CAGR basis. I think a similar approach would typify the risk in this market space. So you would not say that this fund is more risky than your other funds? Risk itself does not portray where you stand. You must look at risk in the context of return. If you are looking at large-cap stocks today, the story is well told and everyone knows these companies. So at this level, our earnings expectation is that they will probably grow at 15 per cent CAGR over the next 5 to 10 years. And even if there is no significant PE rating, the market return will probably approximate 15 per cent. In fact, over the 20-year period from 1985 to 2005, market returns were around 15.5 per cent CAGR. Corporate earnings were also in that range. As you move down the capitalisation chain, the return expectation rises. The key lies in choosing good stocks that will do well. It is not that every stock will be a multi bagger. But by and large, given the degree of experience we have in analysing companies and sectors over the years, we are likely to make some very good choices. And in this context, the return profile is likely to be better than that of large- and mid-cap companies. Of course, there will be a certain degree of volatility to account for the illiquidity and so on and so forth. But remember, over long periods of time, the element of volatility smoothens out. So when we define risk, we talk about it in the context of expected return. And, we talk about risk and volatility of return in the context of the time period of investment. So if you take a short-term time frame of a few months, there will be liquidity issues and price volatility. But if you take a 5 or 10 year time frame, the volatility will not be substantially different from other larger market cap stocks. Besides the regular SEBI guidelines, what risk management measures do you have in place? We have a risk management team of four - headed by a risk manager. They monitor the fund's portfolios and run the portfolio matrix through various parameters. Does your AMC have a particular investment style? We are essentially bottom-up stock pickers with a degree of top-down macro analysis. Not pure bottom-up or top-down. Around 60 per cent of our effort is bottom-up stock picking and the remaining 40 is top-down analysis, sectoral trends, macro analysis, etc. In India, we have not as yet gotten into that growth-value select focus verticals that you find in other global markets. But broadly I would say that we are growth investors. But within that, there is a segment called Growth At a Reasonably Price which is a nomenclature used in the West - GARP. We are in that category. Some of your large-cap funds have huge portfolios of around 60 stocks. Why such diversification? There could be some positions that are in the process of being sold out or some miniscule IPO allotments. But, for a large-cap, diversified equity fund with a largish corpus, 50 to 60 stocks is a ballpark number. So your mid-cap and micro-cap funds will have as many, if not more? Possible, given the level of liquidity and turnover etc. Let's say you have a Rs 1,500 crore fund and you want to put 3 per cent in one stock. That would amount to Rs 45 crore. For that kind of a position size in a mid cap stock, you have to have a reasonably high degree of market turnover on a daily basis. So the number of stocks may be a little more. What are your views on the tech sector? People are taking a pessimistic view given the rupee appreciation. We believe that some of that may be borne out in the quarter's results. So we will wait and see. In the long term, we are bullish on the sector. If you look at the hiring plans of tech companies, it is stupendous compared to what we saw three years ago. So that tells us that there is a high degree of confidence on part of the companies about their pipeline of business. So while the rupee appreciation is a near-term negative, over the medium- to long-term we see no major problem in terms of revenue growth. Why don't you have aviation stocks in your currently portfolios? I think we have to increase our understanding of the sector a little more. At the moment, the listed opportunities are few. And in the context of extremely high competition and high fuel prices, it is better to wait and watch. Construction is not your favourite sector but is in your portfolios. How bullish are you on it? We are very bullish on basic engineering and capital goods as a sector. So construction as a sector by itself may not have a huge weightage, but we classify it as part of engineering and capital goods. Anything to do with capex spending by the corporate sector, infrastructure development by the government or private sector, we are very bullish on. We are also very bullish on energy and oil & gas. What do you look for in real estate stocks? This is a new sector like aviation. So people are trying to get their analysis right. It depends on how the company is focused. Is it more commercial, residential or retail? Which is more lucrative? How big is the land bank? How much of it is legacy and how much is paid for? How much has been purchased at old prices and how much at recent ones? All this will determine profitability projections over the next three to five years. If it looks good we buy, if not we don't buy. What are your views on real estate as a sector? My view on real estate is like the pharma sector, you cannot take a general view. You have to look at it company by company. The sector began to boom in 2005 so it is almost two-and-a-half years by now. But we are still in the early stages of a real estate boom specially if you look at what has been happening in the real estate sector in China, Asia or even the Middle East and the UK. I think given the level of high demand and low supply, there is lot more room for the sector to grow. If I take a medium- to long-term view, I am very bullish on it. Although, one has to be very careful on how you pick stocks. You can have a positive view on the sector but when it comes to stocks, you have to ask some hard questions in terms of business approach and land bank valuation. What are you wary of in today's market? Locally there is nothing to worry about. I think earnings growth will continue to chug along. If it was 33-35 per cent last year - fiscal '07, it should be 15-16 per cent this year, after accounting for an increase in interest rates and other factors. In that context, the broader market indices are more or less there in terms of fair valuation. You can always have an overshoot or undershoot based on liquidity inflows. What is probably of some worry is the external market environment. If crude heads back to $70-80 per barrel, higher inflationary concerns will create a situation where liquidity tightens. If US long-bond yields actually start moving up again, triggering an increase in credit spreads for emerging market debt, it could trigger a negative sentiment towards emerging market equities. In the next three to four months we should see a higher degree of volatility in these segments. Since we are one of those markets that has attracted a sufficiently large amount of inflows, we could have some degree of ripple effect. Your funds have done very well. What's the secret? Our funds have done well across themes, sectors and market cap. It boils down to skillful stock picking and sectoral allocation. I have to give my team full credit. We currently have three fund managers, three analysts, and one dealer. Anup Maheshwari, head of equities and corporate strategy, has been in the business for almost 12 years and has a great track record. Soumendra Lahiri - Co Head of Equities, a talented stock picker, has around 12 years of experience. Apoorva Shah, another fund manager has around 16 years of experience. It's a talented team, having years of experience across market cycles and understands different sectors very well. How involved are you in the investment process? Since I have the oversight of the investment process - fixed income and equity - my job is to largely provide the macro inputs. I look at the broad macro trends, market direction of trends, global liquidity trends, currency, inflation, interest rates and some sectoral trends. We do have periodic review meetings. Even the stock picking ideas are debated and discussed but the final decision is left to the fund manager.