The Mutual Fund Show: Can Mid-Cap Fund Investors Hope For Reversal Of Fortunes? 
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The Mutual Fund Show: Can Mid-Cap Fund Investors Hope For Reversal Of Fortunes? 

Investors in mid-cap mutual funds have suffered losses over the last year and half on factors like slowing economic growth, foreign fund outflows and U.S.-China trade war. Yet, there may be hope.

The funds have, overall, returned negative gains of 11 percent during the period compared with the category’s best performer’s 4 percent decline, according to Morningstar.

However, Sunil Subramaniam, managing director and chief executive officer of Sundaram Mutual, said people wanting to invest in mid-sized companies via mutual funds must understand how the broader markets behaved.

“The period starting January 2016 to December 2017 saw the midcap universe outperform its larger peers on the back of sound fundamentals and an influx of funds from foreign and domestic institutional investors,” Subramaniam said in this week’s episode of The Mutual Fund Show. “That drove up valuations and midcap (stocks) began to trade at a premium to the large caps.”

But foreign outflows and recategorisation of funds put pressure on the broader markets, he said, adding while earnings expectations have moderated so have valuations—which are at levels from where the index has historically rebounded.

Watch the full show here:

Here are edited excerpts from the interview

We have been hearing this for such a long time that buy midcaps and small caps. At some point of time they will do well. But so far, they haven’t. Why should the investors think of doing that right now?

The key reason investors are not doing that and recently there has been a trend change is because they have been burnt by the past underperformance. What’s happened is that and this is what we found from talking to our range of advisors as well as the investors is that they feel that the general mode around the economy became weak. It has been so negative; they feel that the mid and the small caps are getting hurt by the economic slowdown and hence they are wary about putting their money in. The reality is that the correction, which has happened was because there was an irrational rise in 2016 and 2017 in the price of midcaps. Taking away better exuberance brought the crash. But fundamentally, mid and small companies have in fact delivered more earnings growth performance than the large caps. So, nothing in future; even this quarters based that out. I think it’s a matter of time before that mean reversion occurs and the market will come back and respect the earnings growth and the money will flow in. It is important that people understand this aspect of it and then stay invested in it. I am not saying there cannot be a correction. Most investors through a SIP route, they stay invested. These are probably the best months and investments in these months will probably give them like, the best returns in the long run.

Is there something from history that can tell us about why this phenomenon happened in the first place and learnings from there which can be applied to investing right now?

Absolutely. Let me take you all back to January 2016. In the valuation story and the recent story, January 2016 was a year when all the indices were at a low. At that time what happened was that, there was Jan Dhan Yojana which Prime Minister Narendra Modi had started so banks started getting a lot of flows from the black economy to the white economy. A few months later, demonetisation was announced. Demonetisation led to much more of organising the economy in the unorganised sector. So, the mutual fund industry, suddenly in those two years, got something like Rs 1,65,000 crore of inflows which was just about Rs 70,000 crore earlier. At the same time, the world was going through a slowdown in 2016-17. So, all emerging markets including India got a huge lump of money from FIIs (foreign institutional investors). So those two years, about Rs 2.5 lakh crore of money came into buying stocks. At that time, large cap earnings were very spotty.

You can see a quarter-on-quarter earnings growth in two years, it was about one percent, two percent, one quarter was even negative. But what happened was, all the money from FIIs naturally went to the large caps because their mandate is not to go beyond the top 100/150 stocks in the country. The large cap with earnings not growing, their evaluations started going up and domestic fund managers who were sitting on the huge inflows suddenly, thanks to demonetisation were a little bit panicky about going and buying those large caps whose earnings were not visible and the prices were rising. So, the PE ratios were shooting. So, they quickly adjusted and saw in the economy, if you see the cash flows of BSE 500 companies, it was actually going up very sharply upon the back of the fact that the Modi government was spending heavily on the infrastructure from the period of 2014 onwards. And that spillover was not only seen in terms of demand but also in terms of order books for mid and small cap companies and so their earnings were growing at a rapid pace. So, a fresh allocation of that Rs 1,60,000 crore, I would suspect that 60 to 70 percent went into mid and small cap stocks. In that 2016-2017 two-year period, you saw that the forward PE of the mid-cap index went to 24 whereas that of the Nifty was around 18. Clearly, there was a technical factor supporting the fundamental factor. People believed that this mid-cap rise was there, the earnings were there for time to come. End of 2015, the bubble suddenly broke.

What happened there? Two things. One, in that year you saw both Europe and America come back to GDP-positive growth. Naturally there was a reversal of FII flows from the emerging markets back into the advanced countries and India was no exception. So suddenly FII started pulling out money from the Indian large cap. So, large cap valuations became more reasonable and at the same time, domestic funds continued to get more money. So, what was earlier diverted so to speak from the large cap to a mid-cap corrected itself. But more importantly perhaps, its important at the same time that SEBI came out and said that All Mutual Funds need to get rationalized which in effect meant that a large cap fund had to buy 80 percent in large cap. So, what about already they had brought 30 to 40 percent midcaps, they were forced to sell it. And for mid and small caps one of the key elements is liquidity. If everybody is selling and nobody is buying. So unrelated to their economic performance their share prices started falling. And because the free float is less, the liquidity is less, the crash happened in terms of the valuation.

So, from a period in December 2017, where the mid caps were trading at a huge premium to the Nifty, suddenly came down today to where they are at a 20 percent discount to the Nifty. From a 35 percent premium to the Nifty, just the PE ratio, so, you were at a 55 percent valuation correction. So that’s why I said, the fundamentals were strong but the technicals became weak. And even if you take the one-year earnings and in these earnings interestingly; most people look at the index, and you look at it but we have chosen not to do that. What we have done is, we have taken the entire SEBI defined large cap space of top 100 stocks and the SEBI defined mid cap. Why do I say this? Because the mid cap index, contains 25 percent large caps. So, its not a pure mid cap. Second, the mid-cap index has only 75 percent mid cap stocks whereas the mid cap universe has 150. Of course, the most people don’t invest in any index, they are not interested in index funds. They would invest in mutual funds. The fund managers have a full 150 and believe it or not, you’re going to fall off the table if I tell you this, is that the large caps, there were 14 percent earning growth in April 2018-19, and mid-caps there were 49 percent. And not only that, large caps have been propped up by the banks. Take away the banks, the large cap money has come down to 7 while the mid-caps were still 20 percent.

What my point is, mid cap companies—their economic health was strong right through this period, but it was the technical correction which led to this huge fall. So that’s what explains this fall and is not that something was fundamentally wrong with mid cap stocks. Now obviously, this has already happened. So, look at the way forward. Obviously, a up rerating took the midcaps up and a PE down rerating took the midcaps down. So, when will the next uprating happen?

People would think of that, people ask that question, right?

Yes, absolutely. We’ve just finished a quarter so let’s look in this quarter. Even if in this quarter which you take, yes there is negative earnings growth across in multiple sectors. But if you look at the midcaps against the large caps, again, the mid-cap companies’ earnings growth is larger than the large-cap companies’ earnings growth and this is if you take away the banking sector. The mid cap companies are much better. So, the economic performance of the mid cap companies is still better than the large cap. Then what needs to change for the mid cap evaluations to get re-rated? What needs to change is, first, what is significant, and which has happened thanks to the SEBI categorization.

Earlier, a fund manager had a lot of liberty to buy what he wanted. Today, no. In a large cap fund, he can only buy 20 percent midcaps. Right? But if you now look at the industry’s composition, only a quarter of the industry is in the large cap space. Suddenly the industry is diversified so there is enough of liquidity available to buy. Necessity for a technical rally is number one. The second thing is, as the earnings cap widens, today we are rated 20 percent discount of mid-caps to large caps. The market is predicting for the next calendar year, 18 percent for large cap, 16 percent for midcap. But you take it one year later, the gap widens sharply. It’s a 14 versus 10. What I am trying to say is, when a PE rating happening is when there is a surprise. So, when actual earnings come below expected earnings, PEs tends to correct themselves downward. When actual earnings come better than expected earnings, PEs rerates upwards. So, if a 10 percent earnings growth expected next year, it is a matter of time before the markets recognises this and there is enough liquidity in the market to go and buy it. So, what the other triggers? Obviously, we need government spending to come back, there are other factors in the economy. But to me then, given the irrationality of the price rise and the irrationalities of fall, today is the best time—if your long-term focus is there—is to buy in this irrational period. Technically you should have been selling in that irrational period, today you should’ve been buying in that period. So, I am just saying that, today, if you look at the fundamental perspective, it is a very good time to buy. Yes, granted that the economy is on the slowdown, but the market will recognise the reality and change the PE ratios accordingly. The market is the best judge.

At this point of time, I would actually recommend that if you got a three- to five-year outlook, you’ll increase the allocation to small cap and midcap. Yes, do it as an SIP (systematic investment plan) or an STP (systematic transfer plan) because all of us having human emotions not just having a long-term vision. So, if you spend your investments in the next six-nine-twelve months and allocate to smallcap and midcaps as the going goes, the ultimate winner will be that portfolio that contains that concentration. So that’s the point I wanted to make to your viewers that don’t get carried away by the past performance of the mid and small cap funds that you are investing in, the fact of the matter is that the fundamentals are not weak.

They carry the weakness that the economic weakness carries but otherwise, in a relative perspective, they are actually stronger than large caps. Look at it from a world economy perspective. World is in a recession, you’re going to see more money flow into emerging markets. It is not true at this point of time as there is a flight of gold at this point in time but over a period of next three to four months, you’ll see that set right and you’ll see India even with its 5 percent kind of a growth, will still be a magnet for foreign capital but that money is all going to come into the foreign capital but that money is all going to come into the large caps. Large caps are going to get expensive whereas midcaps are going to remain relatively with good fundamentals but also cheaper to buy. So I would say it is smart money which goes into the mid and small cap. Yes, to manage the volatility, do it through an investor management over a period of time but that’s the thing that is ultimately going to help you to plan your retirement or whatever you are investing towards.

Do you reckon that the current valuation differentials between the Nifty and Midcap index also provides the room? The reason I asked this is because when I look at the Nifty versus the MSCI-EM pack, the Nifty itself doesn’t seem that it’s closer to the 10-year average it seems at about some percentage points away from there. So, there is every possibility that from a long term 10-year average perspective, the benchmark Nifty might still have some room to go lower. What happens in that scenario? Would you think the midcaps would relatively outperform or do you think the absolute terms as well, because of the valuations that we are at, we can outperform?

I think the midcaps will outperform, but two things. The same year average, midcaps are proudly trading at a discount. So there is always value in that, one. Second is that, from a perspective of buying something, one is the long-term average, second is the comparative average and the third is that, what do you think is going to happen for the next six months. Yes, you see auto inflows has a slowdown, the whole consumption is at a slowdown, people are not buying. But what is that one certainty is that in the next six months, is that the government is going to spend on infrastructure. They may spend less than they intended to because of their fiscal situation is tight but not because they don’t want to spend. The direct beneficiary of any government infrastructure spend is your capital good suppliers, your cement, your building materials, your EPC contractors—all of which are evident in the small cap space. So, I see that the consumption might take time to come back as the NBFC crisis resolves, inflations tends to slightly rise and then confidence comes back. I see that the government spending is one thing and is sure to happen, be it in a smaller package or with the budget, the government is going to get a fresh room for the next year to do capital allocation. So, I see that there is a certainty lying to an orderbook in the government spending. Because the government has been doing and is trying to spend and stimulate demand, stimulate NBFCs, stimulate banks. The final card with the government is to go and do what the Keynesian economist said. Right? Is to be the capital multiplier by actually going and spending and that’s the ultimate step which the government has to do and will do, and it is a matter of when and not if.

So, I think with that certainty, you are definitely then going to see the orderbooks come through and flow through to these suppliers. It may be hard to find one company or two companies but you go into the midcap fund, the fund manager would be allocating to this, what we call broadly as a cyclical segment. So, I think that, to answer your question right in terms of the long-term average the point is that, we are now very close to a reversal in terms of the gap being narrowed between the mid cap and the large cap on valuations.

What funds do you have within your stable which are in the mid cap and small cap? I believe you have an NFO (new fund offer) launched between the midcap and small cap fund?

The NFO was launched as a multicap fund. Similarly, to large mid and small. So, we do we something called as the Sundaram midcap fund which is a pure midcap fund. We have something called as the Sundaram small cap fund. So, the small cap fund has half the weightage of the mid cap funds. The key point of both these funds is a very ethically managed fund. So, for example, my mid cap fund has not even 2 percent large caps in it and my small cap funds have absolutely no large caps. So, to manage it ethically, what we might do in an ethical kind of management is when the fall happens, it will fall more. When the rise happens, it will rise more. But we believe that’s the way we would like to press in these funds because the temptation over the last few months would’ve been there to blend in large caps to cushion the performance. But we have stuck to our dignity and we have kept our focus very clear and the faith is that, the midcaps are a thing and are still getting significant SIP flows which enable us to keep buying stocks through them.

At this point of time, if you were to start an SIP or an STP, you would start it in the mid cap, small cap multi cap category?

Yes, absolutely. What is the large cap space? The large cap space is banking plus consumption plus IT (information technology). If you see category-wise, IT is dependent on a world where your rupee depreciation may see you some bounce back, but the world is not in a growth mode. Your banking system, the private sector banks are trying to fill the space of the NBFCs, but their valuations are already fairly reasonable. If within the pack, you take out the banks the valuations are quite high. And the third factor is consumption which as you know, right? The festival season might see a pickup in consumption, but it is not necessarily a good reason for consumption stocks because it is going to come at a cost of a drop in the selling price. So, to me, the large cap earnings are going to be a little bit challenged in living up to the valuations but midcaps are the ones. I’m not saying in the next month it will go up, but this is a very good time to start an allocation or to increase your SIP amount in the next six to nine months. What I will say ultimately, in the long run, that is what is ultimately going to deliver your wealth creation.

Somebody asked me a very peculiar question. They said, if you can have a five-year view, ten-year or twenty-year view, where should I put my money. The answer will shock you. I said, five-year money you put in the small cap, the ten-year money you put in multicap and the 20-year money you put in midcap. The reason being that midcaps have an exposure to all areas of the economy. So, in twenty years, the mid cap funds have enough diversification to deliver that value. In ten years, you see a bad economic cycle, a good economic cycle and you need that flexibility. But in the next five years, given the correction that has happened, the small cap is the one which is going to deliver the best kind of a multi bagger outlook. Normally people say, small cap the longer, mid cap the.. no. Finally I would like to add, why these mid and small caps I am pushing. Because in an economic cycle, it is virtuous cycle versus vicious cycle; there are five key elements. The cycle goes this way -you start with a low inflation, goes to the transmitted interest rates on a loan which then leads to demand because low interest rates get demand which then feeds into capacity utilization rising and as capacity rises, you get the investment cycle coming in to create fresh capacity and then that supply comes in and creates a lower inflation. This is the cycle.

Now, in a bad cycle it’s exactly the reverse. High inflation, higher interest rates, lower demand. Where are we now? We are in a lower demand backed by neither higher inflation or higher interest rates. The problem has been what? The problem has been that the price hasn’t risen enough for the private sector to make an investment, one. Two, the government which was spending on the infrastructure has suddenly taken the ball off when the election came and that led to a drop in demand because they were creating jobs in rural India and they were generating business for small-cap and mid-cap companies. That’s what has blocked the cycle at its halfway stage because your inflation scenario is going to continue to be low because oil prices as long as the U.S. election is going to come, shale gas will continue to be pumped so oil is going to continue to be soft. Interest rates, the extent of 250 basis points which the RBI has cut REPO since 2014, hardly anything has been passed on.

Now with the latest thing with the government pumping in the capital, and merging the banks, you will see that actually the competition with which banks will lend. The transmission of lending rates will increase, and you will see leaving this summer aside, you will see consumption bounce back and capacity rise. But well before that you will see the government come again on infrastructure. So, the cycle is on a halfway stage, now what is needed? The 76 percent capacity has to go to 78 percent or 79 percent. The peak has to go to 83 percent. It is not like I need 90 percent capacity, it can never go. You will see in another 12 months the private sector capex cycle will start. They say—we should invest when people ask why and not why not. I think we are in a very sweet spot despite the near-term roadblocks, the speed breakers and the potholes. If you just cross this period, the highway is pretty smooth.

Okay, my final question. If you’re not so averse to risks, would you even consider thematic funds? in the current scenario?

In thematic funds, there are three or four kinds of thematic funds, right? There is banking sector funds, there is infra and there are pharma and very high technical IT fund. So, on banking sector funds, I think that the bank is a mixed play. The private sector banks are valued high, but decent earnings growth is there. But public sector banks because of the merger are probably going to take a year of restructuring. Because you have employees to deal with, branches to shut down, it will take time. For a long-term it’s an excellent move for the economy, but the government has swallowed all of it at one go. Infra funds I would say are a good bet, but you have to be prepared for the rough ride. Because in infra funds, you have the capital fund suppliers, you also have the ultimate infra project kind of a thing where again it is going to be a challenge.

So, I would say, stay away from sectoral funds because they are directly high risk, high reward. Rather you go to a diversified small cap fund which may be 30-40 percent towards infrastructure but at least the fund may have the flexibility to stagger, to delay to re-allocate. So I would say, it is not the right time to ride your horse, give it to a diversified space but like I said, its time to start increasing your allocation in small caps and mid-caps space in this point in time or be it a staggered manner.

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