'We are extremely conscious of portfolio overlap'

As stock markets reach new highs, some fund managers are becoming cautious. But not S. Krishna Kumar, the affable but reticent Chief Investment Officer - Equity at Sundaram Mutual Fund. In a wide-ranging interview with Kumar Shankar Roy, Krishna Kumar emphasizes how now is not the time to be weak. "We have put the worst behind us and have emerged unscathed from domestic and global issues," he says. The top money manager also shares the 5S methodology, says why mid-caps are still attractive, and how he would like investors to focus more on the quality of the product they are investing in and not get distracted by macro noise.   

Edited excerpts

Sundaram Select Mid Cap says it own stocks of companies that exhibit the ability to grow in a sustainable manner. How do you select these companies? Which parameters do you look at and why?
We follow a 5S methodology and a GARP (Growth at a Reasonable Price) framework when we select stocks. Initially stocks are screened by our Research team based on various factors like macro inputs, sell side inputs, fundamental screeners etc. Once these stocks are screened, they are subject to rigorous analysis based on the above mentioned frameworks and finally passed on to the Investment Committee for approval. Only when the IC approves the stock does it form part of the approved universe from where the Fund manager can buy the stock. We are process oriented as a fund house and this has helped us identify winners consistently.

Just to expand on 5S – Most of our winners have these elements in them. To elucidate – Simple business – this essentially underlines our circle of competence and makes it easier for us to have a handle on the company- businesses which are simple to understand.  The next is Scalable business – which is extremely important because we pride ourselves on selecting tomorrow’s large caps and these companies should be able to grow at a fairly fast clip in order to achieve that. That can only happen if they are in a scalable segment. Let us take the example of Bajaj Finance – which has transitioned to a large cap from its humble small cap beginnings. It is a simple and immensely scalable business model with multiple legs to growth like consumer durable financing, LAP, loans to professionals, cash EMI and so forth.

Further, a strong management at the helm which is our third “S” i.e. Sound management is the key to manage growth. We would like companies to be run by management high on corporate governance which have shareholder interests at heart. These managements would help eliminate the threat of destroying shareholder value by fraud or misallocation of capital through unwise corporate decisions like unnecessary diversification, high leverage, etc.

The fourth “S” is Sustainable Competitive Advantage – which is what creates multi-baggers. Most of our winners in the past have a “moat” which can be in the form of distribution strength, technological know-how or an MNC parentage with strong product pipeline which enables the company to stay ahead of competition, have pricing power, steadily grow revenues and profits.

The last “S” is Sustainable Cash Flows & return ratios. As we know cash flows are the lifeblood of any business and cash flows are more genuine and difficult to manipulate than paper profits. Hence, we look at these more closely in a company business model. Also, healthy cash flows help a company better sustain a downturn and act quickly in case of inorganic acquisitions. It also frees companies from the perils of excess financial leverage.

The overlay of GARP helps us look at growth companies and yet not go overboard and pay too much for the same.

The midcap space is full of good and bad companies. What are the no-go areas of the fund? Are their any tell-tale signs that you see and then totally avoid those companies
We certainly reject companies with less than stellar corporate governance practices. We generally avoid companies in sectors which we cannot fully understand. Too many moving parts to a company becomes difficult to track. If you look close enough, there are many signs which lead to these conclusions like adverse financial ratios, higher sales but not matching cash flows, ill-timed and unrelated diversifications, management neither ploughing cash back in business or paying out as dividend and so forth.

Some fund houses rank companies by market cap; others use the absolute levels to consider midcaps. How large is your mid-cap stock universe? What is your definition of a mid-cap, small-cap, and large-cap?
We define our mid-cap universe as all those companies that have a market capitalisation less than the 50th ranked stock by market cap in descending order. Our large cap universe consists of the top 50 largest listed stocks. Extending on similar lines, small caps are all those stocks that have a market cap below that of the 100th stock. These are defined levels of market cap which are floating, not a restrictive universe of the stocks themselves. For instance assume the 100th stock’s market cap is ~Rs20000cr and 51st is ~Rs50000cr. This means I would invest in stocks across indices (listed of course) falling in the market cap below 50000cr.

While that’s a broader spectrum, the fund (Say Select Midcap) targets to invest predominantly in companies that have an market cap between Rs5000-20000 crs., with current weighted average weighted market cap being ~Rs13000 crs., while the median market cap is ~10,000crs.

At present none of Sundaram Select Midcap top holdings individually hold more than 5% of the portfolio. Is that a conscious decision and why?
It is a conscious decision mainly due to the size of the fund and focus on diversification. Our risk management practices from the start have always focused on downside protection from single stock specific events and thus we have taken this call.

It's often said that mid-cap stock space is risky and over-valued. How do you look at valuations today compared to 1 year back? 
Valuations of the mid-cap indices are slightly above median levels and yes midcaps have had a healthy run up over the last few years. Having said that, we have to look at things holistically i.e. how much of growth in earnings has been factored by the market. Because we are at inflection point in earnings and now it should really take off as per market expectations which would mean valuations would look increasingly comfortable. Also, historically, midcaps have given a decent risk adjusted performance over the longer term. We need to think long term as an investor and hold the right funds/stocks.

An investor in our midcap portfolio gets access to a group of 50-60 stocks which together at a weighted aggregate basis demonstrate strong earnings growth at reasonable valuations. The strategy is tuned to strike the right balance of growth and valuations in the portfolio construct. One should not forget that quality is never cheap.

Scaleable business model, good cash flow generation and promoter quality are said to be important for assessing a business. Are there definite metrics for these three factors, or they are a matter of subjective opinion of the fund manager?
Investing is not an exact science. We cannot run algorithms to define exactly a scalable business model, etc. Yes, we do have some quantitative metrics to measure each of these aspects but a lot of fine tuning comes from experience and assessed on a case to case basis. On cash flow, we look at operating cash flows only as its natural for high growth companies to use reasonable leverage for growth capex. Promoter and management quality assessment is lot softer and is tracked by their intent, actions and capital allocation decisions.

Benchmarks have gained prominence when comparing individual fund performance. How do you look at benchmarks - are you benchmark constrained or do you take full freedom in terms of holdings?
Benchmarks are important to compare performance and to judge how consistently the fund has generated alpha. A relevant benchmark is extremely important. We are in this space to generate returns for the client on a consistent basis and are not benchmark constrained. In fact, four of our top five holdings in Select Midcap are non-benchmark holdings – just as an example and this trend would follow in other funds as well. This underlines the fact that we are true bottom-up stock pickers. Our index overlap has been very moderate.

There is one school of thought that says the rally in small and midcap funds is going to over, and it will be now large-caps that will out-perform. Do you concur with this view?
We look at markets holistically and we would refrain from segmenting businesses just by their market capitalisation. We do not concur with this view. Each segment is important and has its own place in asset allocation. Also, just to satisfy the quant oriented readers – one year forward PE of both large caps and midcaps are ~17x with midcaps consensus earnings estimate nearly double that of large caps which goes to show that when cycles turn, mid and small caps should rally harder than large caps. History has shown us that regular investing and staying through an economic expansion in small –midcap funds have delivered significant alpha.

Moving on to Sundaram S.M.I.L.E Fund, this product has had an impressive long-term track record. But of late, some say its recent performance has seen a dip when compared to category returns or other stellar small-cap funds. Do you agree?
I would tend to disagree. SMILE is a small cap fund. It is subject to volatility but if the holding period is longer, say 3 years and more, it is actually a stellar performance. If we look at 3 year rolling returns from March 2010 till Jan 2017, we have outperformed our benchmark (BSE Smallcap Index) in 100% of the observations. Our average return is much higher than benchmark in the same time frame and we protect downside better too with a lower minimum return than benchmark while outperforming on the upside. We cannot comment on the competition but suffice to say we are comfortably generating alpha consistently in this fund.

An open-ended fund's job is to manage inflows and outflows and deliver optimal returns. Recently, some funds have stopped taking fresh inflows. Do you think such actions benefit investors? Are we in line with global best practices? 
I would not like to comment on individual fund practices. It is up to the fund house to decide how comfortable they are with inflows/outflows. Our view is that we would like to keep our schemes open and leave the call to the investor on entering and exiting the market. We would endeavour within the scheme to always create value. As said always time in the markets is more important than timing the markets.

Investors essentially buy portfolios when they invest. Across industry, we have seen some schemes having 70-90% overlap with parent fund house's schemes. At Sundaram, how do you manage portfolio overlap?
We are extremely conscious of portfolio overlap. We can assess the same via the differentiated top holdings across our schemes. Not only our schemes but across the industry, each portfolio has its own mandate and the style would be different. Also, even if two schemes are bullish on the same theme, care is taken to buy a different stock from the same theme for the other funds as per their respective mandates. For example, if I am bullish on Speciality chemicals I would buy SRF in one scheme whilst buying Navin Fluorine for the other scheme.

In the Budget, there has been a proposal to create an integrated oil company. Do you think there can be a consolidation of PSU oil companies that will be rewarding for investors?
I am not positive on large scale integration as business drivers and dynamics are different. Selective consolidation based on individual merits is to be pursued without destroying shareholder value.

Some fund managers have taken a cautious view on NBFCs and PSU banks. How do you view that space?
We tend to look at stocks from a bottom-up basis but we are largely of the view that for the sector, the worst in terms of asset quality is nearly over. Things should look up now albeit slowly. We are selective in our picks and would like stocks which have a diversified and high quality book as well as decent valuations.

Post demonetization, there has been sluggish earnings from some companies. However, the government in its latest GDP data release has showed that demonetisation impact was minimal. Some economists have indicated that this GDP growth was possible to an extent because of changed 'base'. How should MF investors view the situation?
We would like our investors to focus more on the quality of the product they are investing into than getting distracted by macro noise. Despite the disagreements on the different base of GDP one thing, we can agree on is the fact that our GDP continues to grow at a much healthier clip than rest of the world which means that corporate earnings should follow suite and thereby benefit earnings. India is one of the best growth stories in global investing and hence will remain attractive to investors.

For MF investors, what would be the advice for the rest of the year in terms of equity funds?
We have put the worst behind us and have emerged unscathed from domestic and global issues. Now is the time to be in equities and remain invested for the long term to reap benefits.