The Mutual Fund Show: Why DSP Mutual Fund Has Opened Its Small-Cap Fund For Lump-Sum Investments
Indian markets have tumbled in the last month and a half, tracking the worst global selloff since the 2008 global economic crisis, amid concerns about the economic impact of the novel coronavirus outbreak.
Small caps, which had fallen in the last two years, plunged further. DSP Mutual Fund thinks valuations have turned attractive, at least for select stocks. And the asset manager has restarted accepting lump sum investments for its small-cap fund for the first time since February 2017.
“In the last three years since we stopped accepting all flows into the fund, we’ve seen that the valuation multiples have more than halved whereas the operating companies continue to fulfill the criteria that we have,” Kalpen Parekh, president of DSP Investment Managers said on this week’s The Mutual Fund Show. “We feel that these are good times as you’re getting good companies at reasonably low prices and cheap valuations.”
Watch the full conversation here:
What’s the thesis? Why is it that you have decided to accept lump-sum investments all over again?
Parekh: Our thesis is basically about the whole approach of managing our small-cap fund at DSP. The fund is around 13 years old now. The small-cap index from which we do a selection of good companies through a fairly scientific investment philosophy framework is now almost at 2007’s price. So, we are seeing 13 years of low returns from the index.
The small-cap fund like you’ve started off by saying while the name is small, the volatility is always large. Hence, calibrating your entry and exit becomes very important. Somewhere early in 2017, Vineet, who heads equity and manages the fund (has been managing it for a long-time), highlighted that I would like to stop taking money in the fund because it was Rs 7,000 crore in size and that was a very euphoric phase. Prices were going up every day and it was not a buyers’ market, it was a sellers’ market. Someone who wanted to sell stocks was getting the advantage of that.
So we decided to stop taking all flows into the fund—whether it was a lump sum or even new SIPs. Since then, exactly three years and one month has passed and we’ve seen valuation multiples almost have more than halved whereas the operating companies continue to fulfill the criteria that we have for any company across the universe of funds.
So you are getting good companies at reasonably low prices and cheap valuations. We feel that these are good times. Small-caps have very quick or volatile cycles. It’s better to raise money when it becomes a buyers’ market when you are able to buy companies of your choice in meaningful chunks and you are at a cycle low- so that when the next round begins and when the next five-year cycle phases out, investors get an advantage of that.
We feel money raised in this space, not necessarily today, tomorrow, or the next few days, but in the next couple of months, we would stand good chances of capturing an upcycle. We’re sitting at a down cycle of almost four or five years and in the last two years itself, our own NAVs have fallen by around 35-40 percent. The Index has fallen a lot more.
So we’re happy to take money when prices are falling. Because as prices fall, if the hypothesis that the underlying companies are good is intact, lower prices mean a relatively higher margin of safety or relatively lower risk, and we’re happy to get more money at this point in time.
Vinit Sambre, Kalpen has already explained beautifully about what the logic is, but as the fund manager, (why are you opting for) the current point of time? There could be further damage in the small-cap universe. We’re not out of the woods as far as the biggest scare for the world markets in the last decade goes.
Sambre: I think you’re right. This may not be the low point right now but I don’t think any investor was ever able to capture the low points in the market. Instead of really going ahead and predicting what will be the low point of the market and what will be the low point of the stock, I think what measure what measurement criteria which we sort of are using is, let’s say if the intrinsic value of the company on the basis of our long-term assessment of the business matrix (is at a certain level). If the current market price falls much below than our expectation of the intrinsic value, then I think there is room for an opportunity for the investors.
In the same breath, in 2017, when we had shut the fund, we had actually felt that the current market prices were reflecting a much higher point as compared to their intrinsic value. That was a point when we felt that it may not be in the best interest of the investors to keep pumping up and keep buying these stocks.
But now, there’s fear all around, people are afraid. This may not even be the low point. Probably when we hit the peak of the epidemic, that may be the low point. But what we want to do is that and that will be also a time where investors’ courage and sentiments will also not give him enough ammunition to go ahead and put money. So I think what we’re trying to indicate to the clients is that it’s not that from now onwards, things will start moving up as far as the small-cap is concerned. But the attractiveness of the category is relatively much better today.
If we were in receipt of flows into the fund now, I think the kind of companies that we can buy considering that the businesses have not got impacted on a long term basis, I think that opportunity is coming up. So I think that’s the whole logic.
Kalpen, there’s a very interesting statistic that I think Yash Upadhyaya from my team got out. For example, I think for your fund or for the small-cap space, the lowest ever one-year return has been negative 67 percent. But the highest ever return is northwards of 200 percent and the average lowest average CAGR or 10-year CAGR is about 11 percent. Now, what is it that comes out of this? Does it say that if you buy into quality small-caps as well, over a slightly longer period of time, there is money to be made, irrespective of the market scenario?
Parekh: These are valid statistics that we have released just today morning on social media—in the spirit that we always want our investors to visualise the risks upfront before they invest and not after they invest. So, we’re very keen at all points in time to show investors both sides of the coin. One side of the coin is what would have been your worst-case return. So, minus 60-67 percent is the return that the fund had gone through in the 2008 global financial crisis, the index had fallen; small-cap index had fallen 75 percent or something that night, and the fund dropped by 67 percent. This is just to make investors aware or recognise that equities have risk and small-caps also have risk.
But on the other hand, what we are also highlighting, is if you really give time to your investments over a long period of time, you are able to make significantly better returns than fixed income. But that long period has to be seven to ten years, not just three to five years, which is what typically many investors tend to look at. More importantly, we’ve always said this even on your show that good companies are good companies; not necessarily large-, mid- or small-sized. The hypothesis is that we are buying good companies, we’re putting together a portfolio of 40-50 companies around a very robust, well-tested investment framework which has been clean over the last 10 years. We have put out this framework also in the public domain in terms of the filters that we apply to select companies and equally important filters that we apply to eliminate companies. There’s a lot of emphasis on forensic analysis. We have a separate role called skeptical analyst in each team, whose job is to look for where can accidents happen, where can there be governance red flags.
So, we try to minimise permanent accidents. So the message to the investor here is over a long period of time, what can be your worst-case return? We are happy to show worst-case returns rather than show best-case returns because more often very few investors invest in a down cycle and get the best case returns. Best case returns end up only being in our fact sheets. We want investors account statements to get better returns and that tends to happen normally when investors invest in a down cycle. So, the whole idea of conveying this data point is to highlight risk but at the same time also highlight that if you stay put for a long period of time, even if you’ve invested on a wrong day, 10 years back, your worst return was 10 percent.
And do you reckon Kalpen that the risk-reward at the broader end of the spectrum is a lot more reasonable and favourable right now? Because you started investments in the small-cap fund itself I think some time back. We had a chat there, but the lump sums are now being opened up. So, you clearly believe that the risk-reward is completely in favour of starting to invest even in a lump sum fashion in the small-caps.
Parekh: Getting better.
I like the term “skeptical analyst”. I’ll talk about that in a moment for now. It’s not something that I’ve heard, generally, but Vinit, the other question is that the broader investment thesis has always been that go out and buy leaders because they tend to do well. Now my question is on a relative basis because you as a house you have a large-cap and mid-cap. Do you have that quant fund, which is investing into high companies and almost large-cap companies and almost everybody that I speak to in the market Vinit, and maybe you might have the thought too, that when the bounce comes back—once this dust settles down, large-caps will be the first off the block. So, on a relative basis, would you believe that because of the price damage, small-caps are still more attractive than large-caps or would the first port of call be large-caps and then some bit of money should also go into a small-cap fund? How do you kind of differentiate between the two?
Sambre: See, I would not really like to guess what type of capitalization for companies is going to be in the front runner when the things come back. Surely, the first port of call is a large-cap as we start seeing some semblance back in terms of the recovery. But I think is the businesses start performing well and if the visibility of the growth comes back, then I think those companies have to perform.
In the past, if you were to just track some of this lead-and-lag between the large-cap, mid-cap, and small-cap, I think the mid-caps and large-caps by and large typically have a very narrow lead-and-lag, the mid-caps tend to catch up faster. Small-caps are probably in the line, they are ranked the last and for the small-caps to really go up they need sustainability of economic growth and also the sustainable visibility of growth coming back. So, I agree with that. In terms of fundamental aspects, these small-caps would require much stronger fundamental and stronger economic growth and that too, the sustainability of that. So I think from that perspective, we have to think about our economy, we have been in a low cycle for a long time.
We were building up a type of scenario where we were looking for back end growth. Now, because of this Covid-19, the growth got pushed back some bit. Hopefully as and when we revert to our normal levels of growth, and there is a sustainable growth that comes back. I think, all type of companies, good companies, which work with a leadership type of profile, which works with cash flow in mind, which work with high capital efficiency factors and which probably, I can say that they have some unique advantage over the others; I think those companies over a period of time will tend to create value. This is what we have experienced in the case of small-caps. So I think as far as investors are concerned, for them to also very accurately time that we start off by allocating 100 percent to large-cap and then when the rally is red, immediately make a shift to the mid-cap and then when the mid-cap is red, let me switch back to the small-cap. I think that’s going to be a very Herculean task. So I think the better way is to have the allocation done at the juncture where on fields the valuations are in our favour and then it’s all about patience, probably small-cap may require slightly more patience that patience pays off in terms of the return matrix. So I think that’s what I would think so.
Relative to itself, Vinit, what’s the kind of opportunity you see? What kind of companies do you believe your fund would house? I heard Kalpen say a statistic of some 40 to 50 companies is that the investable universe from which you choose the company or will the fund house about 40-50 companies? Can you give us some details so it gives us an idea about what kind of companies are you as a fund manager looking to go out and choose?
Sambre: So see, the universe is wide and large. As a house, we track some 270-280-odd companies. This basically includes all the large-, mid- and small-cap companies. But for us, it is open, let’s say for some companies which by and large are looking good in a particular cycle and if you don’t have under coverage, we are provided that they meet all of our criteria and we can bring those into our universe as well.
So I think in a way universe is sort of open but as a house, we keep tracking, let’s say roughly 300 odd companies in that range. Now, the opportunities today, I may say that in your initial remarks, you mentioned that there is some analysis done which says the bottom hundred companies are trading at single-digit P/E. So, in a couple of sectors, today we’re seeing the stocks are actually hitting low double-digit to a high single-digit type of multiples.
In some cases, it’s a very low single-digit multiple which the companies have cracked down to. Within the auto ancillary, these may be within the textile pack, these may be somewhere in the chemical space, some pharmacy names selectively. The other factor which is also very relevant is- all this while the consumption-oriented companies were hitting a high point in terms of their valuation metrics. Now, the companies which used to trade at 40-45 or even higher multiples, we have seen them tracking down between 20 and 25 multiples.
Now, the earnings itself is something which earnings you want to take because this year may be a washout year, but I’m saying on a stable scenario basis if these companies were to perform and if I were to assume those earnings, then I think these companies have cracked down to decent multiples.
Now, the opportunity set is wide and large across the board. Good companies within the consumer basket are one area where we are looking for an opportunity. There are agri-based and agri-oriented companies where we are seeking opportunities. Further, there are a few financial names where the damage is not likely to be as high and where the quality of assets is within our given parameters. I think we’re looking at such names within our category.
Just a follow up though. There are a bunch of mid-sized companies which have been de-rated a lot more to some people’s minds. They have been de-rated a lot more because of the situation than what they should have and there are some in which there has been a bit of business stress and therefore the valuation of a pull-down is just so dramatically low that they are probably available at levels closer to the global financial crisis or otherwise. Do you reckon there could be a mixture of both? Or are you as a small-cap fund manager, first looking to buy good businesses and then the filter goes on to the valuations? How is it that you’re approaching this space right now?
Sambre: I think it’s a combination. You can’t keep them separate. So at a point in 2017, at a peak, you had good businesses but the valuations were not comforting at all. So, you were in some form or fashion discouraged to buy those. Today, what is happening is that good business and good valuations are sort of coming at one point in time which I think is a good opportunity per se.
Now we’ve been arguing about this for so long that at some point of time, people banking upon the small savings rate staying high, would keep on being there and not look at other options. Does this make the case for investing in equities (and maybe mutual funds because even debt mutual funds probably give much higher returns, but not in the small savings) at these valuations even more compelling, just because of the fall that we’ve seen now? And the likelihood of more taxes when if interest rates are on the way southwards?
Parekh: So, I tend to keep these two pockets separate because every investor has a safe bucket, which goes into small savings, provident fund, fixed deposits or debt funds. There’s a growth bucket, which is basically stocks and equities. I would appeal to a lot of investors who themselves buy direct stocks in the market especially in the small-cap universe, where the volatility is very large and over a full sight and more often we realise that no return is made or there is actually a loss of capital. Through a fund management platform, with the right processes and risk frameworks, what we are looking at is buying companies with high ROC’s, very low-leverage, owning for a four-year five-year minimum time horizon.
So, I would like to attract that pool of money into the small-cap fund. Now, of course, the alternative rate of interest for a positive set has come down with the PPF rates being brought down but that investor in my experience normally when he sees that- equities are falling by 20-30-40 percent, behaviourally, an investor who’s seeking the comfort of capital protection is unlikely to move to equity.
Vinit, what is this “skeptical analyst” function? Tell us about it?
Sambre: See the way we have sort of analysed the companies and especially within the small and mid-cap range of businesses, I think the risk of companies going down under or companies getting bust is much higher than the out-performers.
Essentially, we observed in the last three, four years, the issues relating to governance, capital misallocation, and the regulatory bottlenecks have had a significant amount of impact on many businesses and many companies. So I think from that perspective when we are having a significant amount of assets under management within the small and mid-cap category of stocks, we felt that it is prudent to have someone who really has an eye on some of these issues and red flags which we can come up with slightly ahead of time and allow ourselves to safeguard from investing or getting caught into such wrong investments.
So, I think from that perspective, this role was carved out and we have one person who is taking care of this type of research and his role principally goes beyond the regular research. The idea is to look at the various related party transactions, look at various connected companies, and look at various promoter activities, which are publicly available on in various data information vendors and all that. I think from that perspective, we can dive deeper into their financial metrics or accounting metrics and if we are able to get the red flags highlighted early on, then we could probably safeguard ourselves from wrong investments. So, I think that’s the whole summary of why we decided to go with this “skeptical analyst” approach.