One of the biggest mistakes that trips up investors in a bull market is the temptation to jump into momentum stocks or those belonging to fancied investment themes out of a FOMO (fear of missing out) feeling. Professional fund managers aren't immune to this temptation.
Therefore, when markets appear overheated, fund managers can play a big role in containing risks by staying away from stocks that are driven by pure momentum, fanciful 'ideas' or operator-driven activity. The ability to sift companies with unsustainable earnings, doubtful fundamentals and governance risks from the scores of new ideas that keep popping up in a bull market is critical to keeping a lid on risks.
Asked how Franklin Templeton filters out doubtful ideas, Roshi Jain says, "If there's one thing we do really well at FT, it is keeping governance risks at bay. We look at the quality of management, how it has dealt with leverage, how it has allocated capital in the past. But going wholly by the track record over the last 10 or 15 years may not work with many smaller companies because the management would have changed, the opportunity set would have changed and so would the external environment. So, our process has really internalised the governance aspect over time. This is a concern mainly with mid and small-cap stocks rather than with large-caps. In our mid and small-cap portfolios, we ensure that we don't dilute standards of quality or overpay for any of the names."
Chandresh Nigam, CEO of Axis Mutual Fund believes that it is a stringent focus on the quality of companies that acts as the best risk-control strategy. "As markets head higher, we are seeing a shortening of business cycles and greater vulnerability to disruptors. So, we have been focusing even more on quality businesses than before. By high quality, I mean businesses with sustainable pricing power, engagement with customers and strong brands. We essentially look for businesses that generate high returns on equity and have resilience to disruption and cycles. We have found that in India typically only 25 per cent of the businesses earn returns higher than the cost of capital. They have created 100 per cent of the market wealth over the long term, while others have destroyed wealth."
However, Rajeev Thakkar of Parag Parikh Mutual Fund makes the point that risk containment also means keeping a close watch on valuations, even for quality stocks. "We typically have a valuation range for each holding, which helps with 'sell' decisions. While good businesses will continue to deliver growth, sometimes the market gets too far ahead of itself in extrapolating that growth. For instance, if you bought Infosys in 1999 or 2000, its profits kept growing even after the dot-com crash, but those stock prices didn't come back for a very long time. That's what very expensive valuations can do to your returns. You will have such excesses happening in a bull market. In such cases, we will not continue to hold on the business at any price."
He adds, making a good point, "One difference between mutual funds and individuals owning stocks is that the individual can fall back on his original acquisition price. He can say, 'I bought this stock at Rs 100, so if it rises to Rs 1,000, I don't mind a 20 per cent fall to Rs 800. But in a mutual fund, there is money coming in every month. So I can't say, as a fund manager, that my original buy price was Rs 10 and so I can take a 20 per cent decline. We don't want to own stocks that can cause a big drawdown to new investors."
One way to avoid the risks of your fund picking up lemons in a bull market is to place your bets on schemes managed by seasoned managers. A manager who has navigated two or three complete market cycles is unlikely to be taken in easily by the superficial investment themes of euphoric markets.