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Liquidity driven returns are scary

R. Srinivasan, Head of Equity, SBI Mutual Fund talks about how he studies, monitors and decides his investments

Liquidity driven returns are scary

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Reticent and media-shy R Srinivasan, Head of Equity at SBI Mutual Fund, is not one of those fund managers you can spot on TV channels giving eloquent bytes. Given his distinguished experience in managing investments and special skills in small-cap stocks, Kumar Shankar Roy reached out to him to understand how he studies, monitors and decides his investments. In this interview, Srinivasan, who directly manages over Rs 25,700 crore across different schemes, talks about trade-offs involved in stock selection, his biggest investment successes and much more.

How do you look at risks? How difficult is it to manage money for others in mutual funds?
Broadly speaking, we have two philosophies as a fund house. One is a relative-return philosophy and the other is an absolute return (in a long-only context) philosophy.

The former is largely applicable to our large-cap strategies. In such funds, we have internal tracking-error constraints, and risks, for all practical purposes, its volatility. The attempt here is to generate better risk-adjusted returns.

In the latter philosophy, which is largely applicable to mid and small caps, risk is looked at differently, it is the likelihood of losing capital. In such cases, we do not bother about volatility (rather it is an opportunity) and focus a lot more on the business outlook, management capabilities and valuations.

Conceptually, we think equities are long-term investments and long-term starts at five or seven years. The longer your perspective is, the lower the technical risks (read volatility). In this case, the risk is effectively going wrong in the assessment of a business or 'not knowing what you're doing'.

We have been in a bull market for some years. How has your investment philosophy evolved over the last two decades?
The multiple philosophies we run as a fund house are mapped into our internal templates. These are in the form of constraints as to what a fund manager can and cannot do. These philosophies are not supposed to change with the market trend. They do evolve, however. Over the last many years, the only meaningful change we have made to the templates has been in terms of cash holdings, we have reduced the upper cap on cash across funds. Most of everything else has remained the same.

If we talk about small caps, there is a huge universe out there littered with promises and also problems. How do you distinguish between them?
The process itself is not conceptually different from what it is for large caps. The difference may be in terms of the time and effort required to research small-cap ideas and the high rate of rejection. We also face this problem of not finding enough liquidity or of the efforts being disproportionate to the size of our assets. Having said that, we have, willingly, as a fund house, dedicated resources to this space in our search for excess returns.

What kind of traits does a small-cap company exhibit to get your attention? Do you go by quant-like metrics or by qualitative factors?
We look at five variables while selecting a stock: competitive advantage, return on capital, growth, management and valuation. While you would ideally want all of these to be in your favour, they typically never are and hence, you have got to figure out the relative intensity of each of these factors and get an overall picture. This applies to small caps, too. We do not run quant models, but do use screens to generate ideas. Qualitative research commands prominence because, more often than not, we are betting on the management to execute and deliver.

A lot of business models in the small-cap world are yet to be tested. How do you make a choice?
I'd rather say most of the business models are quite 'old-economish' and fairly tested. What they might not have is a competitive advantage, which makes it tough to assess terminal value. The ability of the promoter and/or management to scale up is also a challenge. As I had mentioned earlier, we look at various key factors and make a decision; valuation is often an attractive feature while making a choice.

Stock selection is a function of the relative strength of many factors. What are the trade-offs involved?
There's a trade-off on traditional risk; small caps, being illiquid, tend to be quite volatile. Management quality, I reckon, is far more important. When valuations are cheap, they are generally offset by lack of competitive advantages. In general, markets are fairly efficient and hence every positive factor will have a negative trade-off. It's about figuring out the balance.

Company management and vision is often one of the biggest things that small-cap fund managers see. How do you arrive at your decision about management quality and management performance?
It is a qualitative exercise and hence prone to assessment risks. But generally speaking, managements can be cross-referenced for their integrity and capability through their track record.

In our meetings with them, we look for transparency and clarity of thought, the basis for capital allocation decisions and the long-term vision.

Please describe your biggest investment successes
The top five return attributors in the SBI Small and Midcap Fund, for the last three years have been Graphite India, Manpasand Beverages, RK Forgings, Avanti Feeds and Techno Electric.

Except for Manpasand, all the other ideas were based largely on valuation. We got plain lucky on Graphite. Our thesis was largely capital protection based on a strong balance sheet, an oligopolistic sector globally (getting further consolidated) and absolute valuations. Out of the blue, graphite electrode prices have hit the roof and the company is seeing a cash-flow bonanza and the same is being reflected in the stock price. Manpasand was a bet largely on the promoter and his track record. RK Forgings was cheap and at an attractive point in the cycle. Avanti Feeds had strong competitive advantages (rare in a small-cap stock) and was trading at very low single-digit multiples. Techno was a bet on the sector, the management and valuations.

How do you use research and process to drill down small-cap stocks?
We have a large and capable investment team. We run screeners and get leads from our meetings with companies, industry experts and analyst peers. If the ideas pass through the basic qualitative and quantitative checks, we probe further, meet the management, speak to competitors and take a call based on the factors mentioned above. Needless to say, the expected return from a small-cap stock is meaningfully higher than that of the average market.

When do you exit from a stock?
We sell in three instances. One, when there is a better opportunity (since we do not take cash calls). Two, when our investment thesis goes for a toss. And three, when the stock seems overpriced.

Small-cap investing is not a zero-error profession. With the benefit of hindsight, can you take us through some of your small-cap investments that you could have done better?
The fund has done way better than our most optimistic expectation. Most regrets are around having sold off earlier but that's only in hindsight because we had replaced them with seemingly better ideas. Errors of omission are huge and that's something we need to work better on as a team.

How important is liquidity of a stock when it comes to small caps?
Liquidity is important for public markets. We have got used to buying illiquid stuff not because we want to, but because we don't have a choice. It's scary to think nowadays that returns could be a function of liquidity rather the lack of it. We are wary of it and try to mitigate it in two ways: one, by looking for ideas where loss of capital is minimal and two, by demanding a larger probability outcome.

Even a good-quality company early in its business life will not show stable traits of business. What are the factors that convince you to stay put?
You seem to have made an implicit assumption that small-cap companies are all in the early stages of their business lives. That's not necessarily true; there are quite a few mature business models among small caps, like auto ancillaries or some consumer-facing companies.

Coming to the question in question, stability is an inherent trait of quality. While early-stage businesses may not display stability, qualitatively, they do reflect traits of stability. The factors that convince us to stay put are the same ones we evaluate when we buy the stock - competitive advantage, return on capital, growth, management, and valuations - the only differentiating factor being incremental change which we'd like to be positive.

Markets are awash with liquidity. Is there too much money chasing good small caps?
Yes, there is.

Do valuations in small-caps ever impact your ability to find new ideas?
They haven't so far. The universe of companies is quite large and we believe 25 to 30 stocks represent a well-diversified portfolio. If for anything, the challenge is liquidity.

Do you buy small-cap stocks with no institutional holdings? If so, why?
Yes. Why not? We are an institution, too. And someone has to buy first.

This column appeared in the November 2017 Issue of Wealth Insight.