Fund manager explains why small and mid-cap funds gave over 60 per cent returns in 2023

Some of Mahindra Manulife MF's equity funds - such as their small-cap (72 per cent returns last year), mid-cap (60 per cent) and multi-cap (54 per cent) offerings - had a remarkable 2023.

Given this context, we recently sat with Krishna Sanghavi, the fund house's chief investment officer - equity, to understand the reason behind the success. Not just that, he even spoke about the fund house's investment philosophy and the selection criteria for small- and mid-caps. Here's the edited transcript.

Interview with Krishna Sanghavi, CIO- Equity at Mahindra Manulife MF Indian markets have been volatile after witnessing a rally in the last few days. Will the rally from last year continue, or will there be a correction?
From a macro perspective, Indian markets are currently trading at premium valuations, similar to several risk assets globally. From a micro angle, there are adequate spaces that offer value, perhaps more in large-caps compared to mid and small-caps.

In terms of market directions, apart from pure domestic factors, international factors, mainly how the global economy and global markets led by the US behave, will be important. The US, with over 25 per cent of the world's gross domestic product (GDP) and around 50 per cent of the world's market capitalisation, sets the tone for global equity markets, including India. So, with the US markets remaining in good sentiments, we (the Indian markets) will be fine. If the USA faces worries, we'll face a similar mood in India. Over time, we have experienced that risk appetite transmits quite fast across financial markets as money is fungible across markets.

Can you provide insight into the investment philosophy of the fund house and how you select stocks?
We at Mahindra Manulife use the GCMV investment framework that evaluates/analyses companies on four variables, before the company forms a part of our investment universe. These are Growth, Cash flow, Management and Valuations.

Considering that India is a growth economy, we look at how a company is likely to grow along and participate with India's growth trajectory. We look at whether there is a large business opportunity to grow in the next 5-10 years, whether the growth is coming from penetration or pricing or control over resources.

Cash flow is the next variable. We prefer those companies that generate cash flows and that can reasonably finance the growth opportunities. We prefer companies who invest in capex over those who have to invest in working capital. We are not averse to debt capital as some businesses also require debt capital, but the ability of a company to generate equity financing from operations is what we like to track.

Management quality is perhaps the most important variable as that is something that can convert opportunities in existing business lines as well as change directions once they spot fresh opportunities that the business environment presents.

Valuations can be seen as the core of equity markets. Over time, markets have taught us to respect valuations. Honestly, valuation is the toughest part of the evaluation process as it contains a mixture of narratives, human sentiments, flows and monetary policy factors. The last 10-15 years of easy monetary policy have made some new ways of adjusting valuations as the cost of the money went down significantly. On valuations, we look at whether a company has realisable value in the next 12-24 months. We usually do not favour companies with deep value but no potential catalyst for value realisations in these 12-18-24 months.

Once the companies are filtered based on this GCMV framework, it depends on the fund managers to choose these companies as a part of the portfolio construct based on the fund mandate's relative preferences across companies.

Mahindra Manulife Mid Cap and Small Cap Fund saw strong returns last year. What factors led to the outperformance?
We made reasonable gains from the re-rating of a few businesses. If we look sectorally, companies in power, capital goods, metals and corporate lenders have seen a new growth path on earnings and valuation re-rating in the last 1-2 years.

For power sector companies, the idea behind investing was that India is currently running a very tight supply, and we may need more power for the economy's needs. Indian power companies would need to invest for capacity growth now and profits later. This is a good case of growth & re-investing of cash flow, as the majority of companies have enough cash flow to meet their equity financing needs. Valuations were in favour, too. Similar to power, quite a few core sectors (like metals) can have a supply constraint in FY27 and beyond if new capacities are not created by then. We also invested in power finance companies, a natural beneficiary of the fresh capacity addition in power.

Another example can be public sector (PSU) banks. They had a tough time from 2014 to 2020 on asset quality issues. But, in the last 2-3 years, the business environment for PSU banks improved with corporate deleveraging, NCLT-led balance sheet improvement, technology-led efficiencies and capital available for reinvestment.

How big is your investment team (analysts and fund managers), and how have you delegated the fund management responsibilities among them?
Currently, we have four fund managers and five analysts, one of whom also manages a fund. Each fund manager manages 3-4 funds with a reasonably similar mandate. The analyst team is structured based on themes such as consumers, financials, industrial and infrastructure, global trade and ESG. Fund managers also cover a few sectors.

When evaluating mid- and small-cap companies, how do you assess the quality and capability of the management team?
There are a few factors that we look at in companies, especially in the mid- and small-cap space. If the company has a 10- to 15-year operating history, that's an advantage. It will give a clear picture of how this company has managed past business cycles.

We also evaluate how and why these companies fared during the cycles. Furthermore, we try to understand how the management behaved during those business cycles. The history of delivery versus promises can be analysed further.

Corporate governance also plays an important part, like tax evasion or frequent changes in key personnel or auditors. Many companies can have a growth mindset, but a growth mindset accompanied by good governance is important. We do try to speak with multiple stakeholders like vendors, customers or even competitors as a part of evaluation. But honestly, it's not an easy exercise, and one may not always get the perfect answer.

In terms of corporate connect, there are conference calls, post-quarterly results, and analyst meets, which we attend to understand the business and financials. In a few companies, plant visits also help.

Can you provide some examples of instances where your assessment of the management has played a crucial role in your investment decision?
One of the biggest changes in the investing mindset in India in the last 2-3 years has been how we look at the management quality of public sector companies.

Historically, there had been quite a bit of scepticism. But there has been a different thought process and approach in the last 2-3 years. Many things have changed. In a PSU, the ownership is with the government, and they have been successful in placing the right people in the right jobs. PSUs have benefitted from the growth vision laid by the government as owners.

What criteria do you use to determine when to exit a mid- or small-cap company?
Well, there are no rules in markets for when to sell. What makes us buy, we can quantify, but what makes us sell is quite a challenge to quantify. But some broad thoughts are delivery of expectations, valuations, change in hypothesis and alternate opportunities.

Many times, companies meet our original expectations, and we tend to evaluate for exit (if we believe the fair potential is captured) or stay invested (if we believe there is potential for growth continuity).

At times, there can be events that may require re-assessment of the original hypothesis on investing in a company (change in management, regulatory actions, corporate governance, etc), and we may exit at times.

At other times, markets offer alternate opportunities, and as a part of portfolio construction, we may trim or exit a company on relative valuations and upside potential.

Also read: Interview with Harsha Upadhyaya of Kotak Mahindra AMC