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Human Psychology Drives Markets

S Naganath, Joint President & CIO, DSP Merrill Lynch Fund Managers Limited talks about the DSP Merrill Lynch funds and the role of psychology and history in studying markets

S Naganath was among the pioneers in setting up DSPML AMC in India (in 1996), where he became the chief investment officer. In between, he went to New York to work for Credit Suisse Asset Management as a portfolio manager. In mid-2002, he came back to India and joined DSPML AMC again as joint president and CIO. In a long interview with Mutual Fund Insight in October 2003, he talked about DSP Merrill Lynch funds and the role of psychology and history in studying markets.

How did you enter the fund management business?
I have a Bachelors in Commerce from Madras University and a PGDM from IIM, Ahmedabad. After IIM, I worked for a few years in Citibank. In 1994, I went to Hong Kong as an investment manager with GT Management, which was then a fairly large investor in Asia. After that, I joined Merrill Lynch Asset Management in Hong Kong. In 1996, I came back to India to help start the asset management joint venture between Merrill Lynch and DSP Merrill Lynch, where I became the chief investment officer. This venture took off in 1997 and we launched a bond fund and an equity fund.

In late 1999, I went to New York to work for Credit Suisse Asset Management as a portfolio manager in their emerging markets group focusing on a few countries in Asia such as China, Malaysia, Singapore, Hong Kong and, of course, India. In mid-2002, I came back to India and joined DSP Merrill Lynch AMC again as joint president and chief investment officer. My responsibilities are to oversee the investments function and to contribute towards overall business development.

What are your learnings from the US experience? How do you view India after being there?
The experience you gain by working in a large financial centre like New York is that you are better able to appreciate relative positioning or relative viewpoints, which I think is very important. Investing has two dimensions to it. One part is to understand the fundamentals, no doubt about it. But the other part is how fund flows behave, be it between one asset class and another, or one geography and another. This fund flow can often lay the foundation for a bull market or create conditions for a bear market, depending on the manner in which funds move. For example, India had reasonably good fundamentals in 2002, but why was the market not moving? The answer is that fund flows were less robust than they are today.

When you work in a big financial centre like New York and are looking at a region like Asia, you are also interacting with colleagues who invest in other regions and are exposed constantly to new ideas and thinking, whether it is from a strategist or an economist or portfolio managers in different geographies. Over time, you learn the art of valuing an asset or a market from a relative viewpoint, which I think is a very useful experience to have gained.

What is your investment style?
On the debt side, we have emphasised a conservative approach to investing right from the beginning. Put very simply, we are dealing with essentially two types of risk in debt—credit risk and interest rate risk. What we wanted to do was ensure that the credit risk component is as minimal as possible—we do not take too many active risks on the credit side. So, if you build a good portfolio then the credit risk part is essentially taken care of, thereby leaving you with enough time to deal with the interest rate risk part of the equation. That is where, frankly, you can express yourself in terms of a higher or lower maturity profile, depending on your view of how interest rates will move. That is what is going to largely define the portfolio return over a period of time. The philosophy of building a conservative good quality portfolio has continued and our focus remains on interest rate risk management principally. Of course, individual fixed income funds have their own fixed objectives.

On the equities side, it is a combination of a top-down and bottom-up approach. Some people follow the bottom-up approach alone and look only at companies; they do not care about the macro picture. Some people take a top-down sectoral view and don't focus on stock selection as they are more concerned about the sector selection. I think there is no one answer to which one is better—I believe that a judicious blend of the two is perhaps the best way to go forward. What we try to do is take a macro call on where the overall economy is headed in the next 12-18 months. Based on that, we try to distil a sectoral viewpoint. Which are the four or five sectors that will do very well given the macro view, and within that it boils down to stock selection.

When it comes to stock selection, there are a host of factors that come into the picture and whether a stock is undervalued, overvalued or fairly valued. I will pick on two or three points that we give importance to. Clearly, management quality is very important to us, which is a qualitative factor. Then on the financial side, we like companies that are competitively well placed in their respective areas to meet the challenges of the future. From a numerical point of view, we look very closely at the return on equity because in many ways, this number tells you how efficiently the management is utilising capital and how well it is tackling the challenges of their business environment.

What is the strategy that you follow in your equity funds?
We started in 1997 with DSPML Equity Fund, which currently has Rs 27 crore in assets. The objective of this fund was to beat the benchmark Nifty and try and obtain first quartile performance. We run a fully invested position, with approximately 95 per cent of the corpus being fully invested. The portfolio turnover is not very high; the idea being that if you have a long-term positive view of the market, this fund will remain fully invested in good quality stocks. The portfolio is therefore strategic in nature

The DSPML Opportunities Fund, which was launched in March-April 2000, has a more dynamic streak to it and the idea here is to take bold sectoral bets. Most diversified equity funds today are in the same multi-sectoral bucket. Since this fund takes more aggressive bets on sectors and stocks, you will find that the portfolio turnover will be higher than say the DSPML Equity Fund. The portfolio's positioning here, is therefore more tactical. The fund flows in this fund and the brand recall are pretty good, along with impressive fund performance.

DSPML Top 100 is a fund we launched in February-March 2003. The objective is to focus on the top 100 companies by market capitalisation so that the investor is pretty clear that this will be the universe from which we select our stocks. We will invest in approximately 25-40 stocks drawn out of this list. The reason we launched this fund was because we found that there are some investors who are not comfortable seeing mid-cap or small-cap stocks in their portfolios. Also, as a group, the top-100 universe has done very well. We pulled up some statistics and found that in calendar year 2002, while the Sensex was up only around 3.5 per cent, the top-100 universe was nearly up 40 per cent. Within the top-100, if you took out only the top 30 stocks, they were up some 57 per cent. The point is that some of the performance may not have been captured by the bellwether indices. This fund has also done well and we are positioning it against similar funds of its kind.

Then we have the DSPML Balanced Fund, which was launched in May 1999, where the performance has been very good.

More recently, we launched the DSPML Savings Plus Fund in February-March 2003, which has done very well both in terms of fund flows and performance. The structure of this fund is somewhat akin to a Monthly Income Plan. We invest up to 20 per cent in equity, with the remaining in debt. Again, the interesting part here is that we will moderate the equity component so it is not as if I will always have to maintain an equity portion. If I feel very bullish, I will take it to 20 per cent. If I feel cautious, I will scale it down; and if I feel very negative, I might even bring it down to zero. When we started, we had 10 per cent in equity, and when the markets were doing well, we took it all the way to 17-18 per cent. In September, we brought it down to 4-5 per cent. Moderation is important in such a fund. Investors in this fund would certainly like to see the benefits of equity investments coming through, but at the same time, the tolerance for downside risk is somewhat limited. So if you are trying to maximise returns, you are also assuming risk. On the other hand, if you want to just optimise it in a sense, maintain lower volatility and lower downside, and if you see that markets are running way ahead of fundamentals, and there is a potential for some kind of correction, then you might scale back.

The DSPML Technology.com Fund is pretty small at about Rs 20 crore. Since it is a sectoral fund, there are times in the year when they find favour. We haven't seen much new money coming in, nor have we seen much attrition.

What are your learnings from year 2000?
(Laughs) Well, I was in New York at the height of the tech bubble. It was interesting as there was a flurry of IPOs pretty much every day in January and February. I think that when people are in that environment, they do get carried away with the euphoria. It's only in hindsight that we are all wise about it. It is particularly difficult for those in the fund industry, because even though you are little uneasy with the valuations, or the way prices have moved, that is when the money is gushing in. And if you choose not to invest or invest very slowly, and the markets continue to move ahead, then you have underperformed. On the other hand, when the markets are down and you want to see more flows into your fund that is when nobody is willing to invest. That is an anomaly in the markets; when you would like to invest, funds flow out, and when you would like to be cautious to invest, funds flow in. The first quarter of 2000 was one such period, with money flowing into tech funds. Taking a step back now, it is easy for all of us to say that it was a mania that was perhaps not warranted by the fundamentals. Overall, I think this has had a sobering effect.

Where do you see both the debt and equity markets going from here?
On the debt side, markets are very bullish with the 10-year yield at 5.13 per cent today (October 1). Bond yields will remain soft until the end of the year perhaps. But if you have the economy growing at 6.5-7 per cent as we all expect it will, then credit demand will start picking up at some point.

Already, there are early signs that, at least, working capital demand is beginning to take off as companies, gauging an improvement in demand, want to build up inventories. And, therefore in 2004, perhaps the first or second quarter, I would expect rates to eventually bottom out. Capex-related spending by corporates will still take time, as companies will have to first pump up their capacity utilisation to extract the efficiencies from productivity gains. That might come in the middle of next year or so. So for another three-four months, the soft rates will continue and then they will bottom out, thereafter edging up, though only marginally.

We have been very bullish on equity since the beginning of 2003. At that point of time, not many people were as optimistic as we were. We had done an analysis based on fundamentals and fund flow arguments, and our assessment was that the flows into emerging markets and particularly Asia would be far better this year. At that time, we thought India would get at least three times the FII flows of last year. Last year we got $750 million, so we expected $2.25-2.3 billion. I am happy that we have got much higher than that till date.

The argument was that if we have a protracted weakness in the dollar, there would be a move to get into non-dollar assets. Dollar investors would start seeking diversification and they could go to different geographies and various asset classes. And one of them was emerging markets, where it has been a bumpy road in the last ten years with a few crises in various markets, but people now feel that they can understand those risks better. These economies are also growing faster than the developed world. More importantly, there is a lot of domestic demand that is contributing to this growth as opposed to just export-led demand, and that is true of Asia as a whole. That is where people are now increasingly looking at and institutional investors are quite excited about the 6-6.5 per cent growth in countries like China, Thailand and India. The flow of money will continue into emerging markets, particularly Asia. So, we are looking at something like 5000-plus on the Sensex as a potentially achievable target by March-April 2004.

Again, the other thing about the current rally is that it has been broad-based across sectors, with robust sector rotation, not led by a few stocks or few sectors. That points to the resilience of the market. Monsoons have been good, corporate performance is likely to get better, so all of this pretty much underwrites favourable stock market performance in the medium term.

You are an avid reader of history; how do you use that knowledge in the market?
I like reading and travelling. I have a long-standing interest in history. In terms of my work, I read a lot about economic history, especially on bubbles and manias. Generally, I go back 500-1000 years in history to see how various systems evolved. Ultimately, the markets are driven by human psychology, so that aspect may change in form but not necessarily in substance. We all react pretty much in a similar fashion to similar things in life. Lately, I have developed a liking for behavioural economics. So, history/psychology helps you at times particularly when the markets are oversold or overbought.

In terms of behavioural science, we had put out a slide in one of our presentations where we had looked at the mood swings in the market. After a long bear market, when you have the early stages of a bull market, the first response of the investor is scepticism or denial. When that market continues to jump, the next phase is bewilderment. Then when it continues to move further up, the reaction is of acceptance and awe. Likewise, when a market falls after a long bull market, the first phase is again of denial and scepticism; when it continues to fall, it is bewilderment and finally it is acceptance and shock. So when we moved from 3,000 points to 4,000 points, it was denial and scepticism; people said it was a range-bound rally etc. When it continued to hold 4,000 points and moved up, we were in the bewilderment stage and when we get to the 5,000-mark and move on, then it will be acceptance.

More importantly, if you can apply these concepts to fund flows, how investors will behave, and where they will invest in terms of asset classes, it helps. For example, I like to see fundamentals and fund flows in terms of the analogy of a sportsperson. A successful sportsperson needs two attributes-stamina and motivation. Stamina in sports is akin to fundamentals in the market; so a good physique and stamina is like robust fundamentals. Motivation is equivalent to liquidity; it ebbs and flows-one day you are motivated and one day you are not. In markets, there is liquidity in one year and not much liquidity in another. If you have a nice combination of the two, you will be able to run the optimum race. Markets can realise their full potential when both fundamentals and liquidity are present. India has a good combination today of good fundamentals and the liquidity is flush on account of FII and domestic interest.