Making Fewer Mistakes

SBI Magnum Midcap fund has been the top performer in the mid and small cap category. What do you attribute this performance to?
In the last three years we invested in companies where growth was visible, companies which were leaders in their sectors and in many cases strong brands. I think this strategy has helped us to deliver superior returns in the three year and one year time frame. In most cases, the growth was not dependent on macro environment or government policy decisions, but was a consequence of the company's own respective demand dynamics. This has worked for us. Apart from that, I would also say that, we were cautious about restricting mistakes at the stock selection stage in terms of portfolio composition as the impact costs of switching in and out of mid cap stocks are higher due to low liquidity in the mid cap stocks. Avoiding sectors like PSU financials, private sector power generation and utilities and metals helped significantly in terms of portfolio performance. So, not only investing in good companies but also avoiding big mistakes equally helped the overall performance.

We have been overweight on consumer discretionary businesses in the portfolio because growth visibility over there was better and these were generally high cash generating businesses. We identified companies which were leaders among the sectors which ensured both scale as well as growth opportunity. We invested in companies like Motherson Sumi Systems, Page Industries, P&G Health, Glaxo Consumer, United Breweries, MRF, PVR and UTV Software. We also invested in Pharma companies, some of which were long term growth stories like IPCA Laboratories and Divis Laboratories and also where there was positive change in the business dynamics like Alembic Pharma, Aurobindo Pharma, Indoco Remedies and Natco Pharma. Also, we exited stocks where fundamentals have deteriorated and there was negative change in business environment like CCCL, JMC Projects, and Elecon Engineering etc. We decided to book loss and deploy the money into other attractive investment opportunities. In hindsight, we had invested in sectors that were growing like consumer discretionary, healthcare, IT mid cap that helped the fund.

What is the strategy adopted in managing the fund?
It is a largely a bottom up fund with a focus on generating absolute positive returns over a three year period. We do not have any bias towards sectors and would look for any positive change in sector dynamics for increasing allocation to a particular sector apart from greater emphasis on investing in structural growth stories.

There is lot of emphasis on stock selection. Some of the basic criteria are that the company's long term growth potential is better than its large peers in the sector and also some of the similar sized peers across sectors. The business is scalable and management is competent and focused on executing the growth strategy well. Return ratios like, return on equity (ROEs), return on investment (ROIs) and return on capital employed (ROCE) are important especially improving trend there. We prefer capital light business models where the need to come to the market frequently to fund growth is less. This is very important in case of mid cap companies as many a times businesses stagnate for want of capital if the equity market conditions are not conducive to raise capital.

We also avoid companies which raise excess capital when the going is good and run into the risk of misallocation of capital at a later date. We also look for a reasonably decent size of the promoter holding in case of mid cap companies as we believe that if the growth opportunity is big, the promoters would believe in that and would like to hold high stake in it. Low promoter holding generally indicates low confidence levels of promoters and as such investments in such companies require a critical look.

Making fewer mistakes at stock selection level is very important to us and we believe it is okay to let go of some investment opportunities where we do not find the margin of safety based on some of the above criteria. Preservation of capital is very important to us while we continuously strive to make money on new investment ideas.

What kind of stocks never enter your portfolio?
There is nothing like never entering into any particular stocks, but we generally stay away from companies where there is concern about corporate governance issues or companies where there is disregard towards minority shareholders. As mentioned earlier, we generally avoid companies with low promoter shareholding (less than 15-20%), companies which repetitively come to the market to raise equity, companies where there is serious misallocation of capital etc.

How long is your mid and small cap watch list which are not in your portfolio? How do they enter your portfolio?
The mid cap universe for us is any stock below the top 100 stocks in terms of market capitalisation. So, the opportunity to invest is very wide. We have a universe of about 200 stocks into our active coverage by the internal research team, apart from which there would be another 50-60 stocks which would be on our active radar to identify investible opportunities. As fund managers we identify the sectors where there is strong growth opportunity, while our internal research team looks for the new stock ideas. Participation in primary market offerings also offers another opportunity to identify stocks at early stage to enter the portfolio. We emphasise on meeting senior and middle level management, various business heads, doing third party and channel checks and detailed analysis of past financials and annual reports to gain understanding of the businesses and identify investment opportunities.

When do you sell a stock?
There are several reasons on why we sell a particular stock or even reduce its holding. Firstly, whenever there is any adverse change in business fundamentals and lower possibility of improvement over the next 12-18 months, we sell the stock irrespective of where it is trading. Secondly, when a stock has run up too fast and valuations are much higher than its historical average, we would tend to book profits, at least partly. Also, selling is triggered if we are likely to breach our internal sector or stock allocation limits due to sharp appreciation in stock where we have significant holding. We also need to sell out of stocks in many cases where they appreciate to become large cap stocks due to restriction on large cap holding in our portfolio. We think such an exercise, forces us to continuously look for new investible ideas and reduce the concentration risk in the portfolio.