Why funds seldom find multi-baggers

Many smart equity investors I have known over the years look down upon mutual funds as an equity vehicle. And they have a good reason to. Compared to the returns that they've personally earned on some of their successful stock picks, returns on diversified equity funds look quite tame.

For those who were lucky enough to own some of the top wealth creators of the last ten years, the returns have been nothing short of spectacular. Adjusting the stock price for bonuses and splits, Ajanta Pharma, an Indian formulations maker, has seen its stock shoot up from Rs 13 in August 2007 to Rs 1,200 by August 2017, making it a 90-bagger. Air-cooler manufacturer Symphony has seen its price gallop from Rs 2 ten years ago to Rs 1,200 in 2017. Eicher Motors, owner of the Royal Enfield brand, has seen its stock price spiral all the way from Rs 350 to Rs 31,000, an 88 times gain. Why, even larger consumer companies have managed to deliver ten-bagger returns in this decade. Titan Company has gone from Rs 62 to Rs 620 and Asian Paints has shot up from less than Rs 100 to Rs 1,100.

A stock that delivers tenfold returns in ten years has effectively delivered a 26 per cent CAGR. But if you look back at equity-fund returns in the last ten years, they fall far short of this number. Large-cap equity funds have averaged a 10.4 per cent CAGR, multi-cap funds have delivered 12.3 per cent and mid-cap funds have managed a 13.98 per cent CAGR.

Why the lag
But why are there so many multi-bagger stocks but no multi-bagger mutual funds? Are these highly paid fund managers not smart enough to identify such stocks? That's not true because seasoned fund managers are quite respected and even looked up to by do-it-yourself investors. In fact, many of the multi-bagger stocks mentioned above have figured in fund portfolios from time to time.

But if you really think through it, there could be three reasons why diversified equity funds find it difficult to match the performance of smart individual investors.

Doing nothing
To begin with, earning multi-bagger returns from equities calls for long periods of doing nothing. If you look into the share-price graph of multi-bagger stocks over the years, you will realise that these stocks did not make their returns in a steady fashion over the ten-year period. They spent many years doing nothing, suddenly shot up like meteors, suffered big setbacks, and then picked up and began sprinting again.

Take the blockbuster Ajanta Pharma. For an investor who bought it in 2007 at Rs 13, the stock did nothing, drifting aimlessly sideways until November 2009. But investors who lost patience and decided to switch to a better performer would have missed out on the big move that followed. From December 2009, it began a slow creep upwards, and over the next four years managed to rise to Rs 380 by December 2013. Thereafter, it was on steroids and shot up to Rs 1,600 by August 2015. Over the next five months, it suffered a nasty crash, losing 30 per cent to Rs 1,170 and severely underperforming the BSE MidCap index. But investors who panicked and bailed out then, missed out on the 75 per cent rally that followed, all the way to Rs 2,050 levels. In the last one year, the stock has again slumped by 42 per cent to Rs 1,200 levels. For one year, this stock is down by 38 per cent while the BSE MidCap index is up 17 per cent.

The roller-coaster journey of Ajanta Pharma tells us just how much pain and uncertainty an investor has to go through to earn a ninety-fold return from a stock. Earning those returns means holding onto the stock through big upmoves (without booking profits), suffering sharp crashes (without bailing out) and living through long spells when the stock severely underperforms both the benchmark and peers in the sector.

Now, assuming a fund manager had the foresight to buy Ajanta Pharma in August 2007, would he have held onto the stock till date? Quite unlikely, given that he would have been answerable to his investors for underperformance against the benchmark and his competitors over every quarter, half year, year and three-year and five-year period in these ten years. Had he held onto Ajanta as his top holding from 2007 to 2009, investors would have wanted him to sell the stock for a better performer. Had he held onto it in 2013 to 2015, the temptation would have been high to book profits. Had he hung on for the last year, he would owe repeated explanations to his fund investors on why he still owns a stock that is so sharply underperforming the BSE MidCap index.

In short, because equity-fund managers are so accountable to their investors for short-term performance, they miss out on long-term opportunities. Direct-equity investors do not suffer from this handicap because they're only accountable to themselves on performance. They can take a call to do nothing about an underperformer for years together.

Diversification
The second aspect on which equity-fund managers' hands are tied relative to individual investors is in avoiding concentrated bets. In the interests of ensuring that equity funds remain low-risk vehicles and don't take on oversized risks, SEBI regulations require equity funds to cap their individual stock exposures at no more than 10 per cent at any given point in time.

This rule, while it is sensible and protects investors from any big investment mistakes made by the fund manager, also caps the fund's ability to fully ride its winning bets. One of the cardinal rules of successful stock-market investing is to let your winning bets run and cut losses quickly on your losers.

The 10 per cent cap on individual stocks means that equity-fund managers cannot let their winning stocks gallop incessantly over the years. Every time the stock exceeds 10 per cent of the portfolio by weight, the fund has to forcibly book profits on part of the holding. This effectively means that, even where the fund manager has unearthed a multi-bagger and is quite bullish about its prospects, he cannot afford to let it occupy an outsized weight in his portfolio.

Individual investors can easily do this. In fact, most successful equity investors do have some duds in their portfolios. But it is by hanging on patiently to their winners and letting them compound over the years, that they rake in such high gains.

Holding cash
Smart stock market investors know that one of the big secrets to making money in the market is to know when to invest and when to keep away. When valuations for the market as a whole are sky-high, when good opportunities are hard to come by or when they don't like the price they're forced to pay, smart investors simply sit on cash or go on a vacation.

But equity-fund managers don't have that luxury. Most equity-fund houses in India cap the aggregate cash positions by investment mandate. With their mandate requiring them to be fully invested, they have a duty to find new stocks in all kinds of market conditions. It also doesn't help that the bulk of inflows into equity funds flood in only in rising markets and not in sideways or falling ones.

Even schemes which do have a mandate to take cash calls are quite petrified of exercising this option because if the market zooms up, their investors will blame them for underperformance! Individual investors have no such constraints and can happily park half their net worth in debt until a correction happens and better buying opportunities emerge.

So does all this mean that you are better off being a do-it-yourself investor instead of entrusting your wealth to a professional fund manager? Not at all.

For every multi-bagger stock that multiplied money for the do-it-yourself investor, there may have been a dozen duds that decimated his wealth. Persisting through such odds requires both unrelenting passion and a strong stomach for risks. Holding onto a stock for years also requires you to devote many hours to studying the markets, the sector and the business, and keeping track of every little development in it. Only this can help you develop the conviction to take concentrated bets on your portfolio. Often, such passion for stock picking can only be found in full-time investors who devote every waking hour to equity research. For those of us who have other professions to pursue, taking the mutual fund route is the next best alternative. But if we want our overall return experience from equity funds to improve, we must stop obsessing about short-term performance and pressuring fund houses over it.

Whether you're selecting a new fund for your portfolio or evaluating your existing ones, take stock of performance over three-, five- and ten-year periods. Don't be in a hurry to jump ship if the fund has slipped behind its benchmark or peers for a quarter or two.

And if you own a scheme with a seasoned fund manager, give him the benefit of doubt when he underperforms in a rising market or takes a cash call. In the long run, he may come up with the next Ajanta Pharma.