The Mutual Fund Show | Mid-Cap Investing: When And How
When should someone invest in a mid-cap fund? Should valuations matter? What should be kept in mind while choosing such a scheme?
Tushar Pradhan, chief investment officer at HSBC Asset Management Co., said investment in mid caps should not be a factor of whether the markets are trading at peaks or troughs. He suggested investors look at business opportunities while choosing funds in general.
“Any business that goes through a phase of growth, especially when it becomes a mid cap, the next phase of growth is when it will potentially travel all the way into becoming a large cap. But by the time it’s a large cap, I think, probably two-thirds of the journey is over,” Pradhan said on BloombergQuint’s weekly special series The Mutual Fund Show. “Not that large caps don’t make money, but the percentage returns from then on will be more in line with the broader indexes.”
He, therefore, advised “investing in the early signs” by identifying potential companies that may actually cross the threshold and become large caps and create wealth for investors.
Pradhan agreed that the valuations appear to be expensive compared with the history or averages. But what the market is reflecting is the potential of the business, he said. “It’s not reality as yet because the market value generally discounts the future potential of a business.”
The growth phase, he said, however, is underway and would create tremendous wealth over the medium term. “The faith has to be on sustaining the earnings growth trajectory, and the truly coming out of the Indian economy in terms of taking its place in becoming one of the most sustainable growth economies in the world,” Pradhan said. “If that is what you believe then the current valuation can be explained.”
Gurmeet Chadha, co-founder and chief executive officer of Complete Circle Consultants, advised to look beyond returns while shortlisting a mid-cap fund. He strongly suggested looking at factors such as consistency in performance across cycles, risk-reward ratios like the Sharpe ratio and standard deviation, quality and longevity of fund manager and team, and shortlist funds having a reasonable churn rate.
One of Chadha’s recommendations in the mid-cap category is the Kotak Emerging Equity Fund. That’s because the fund has delivered annualised returns of more than 21% in the last 10 years and over 18% in the last five years. The fund, he said, also has better liquidity and is “true-to-label”, in that it has an exposure of 75% in mid caps and 7% in small caps.
Watch the full show here:
Here are the edited excerpts from the interview:
Tushar, I want to start off with this tagline, ‘Invest in the early signs’. What's the juice out here? You guys believe that we are in the early throes of a multi-year mid-cap run?
TUSHAR PRADHAN: Well actually the early signs relate to the business opportunity. It's not necessarily about the market. So essentially what we've seen is that any business which goes through a phase of growth, especially when it becomes a mid cap, the next phase of growth is when it will potentially travel all the way into becoming a large cap but by the time it's a large-cap, I think, probably two-thirds of the journey is over, not that large caps don’t make money but as we all know the percentage returns from then on will be more in line with the broader indexes. When we look at the early signs, we're talking about identifying potential companies which may actually cross the threshold and become large caps. So that's really the universe that we will be focusing on. I think that's really what the tagline means, it's nothing to do with the market or whether it is early or late because market specifically, it will always be either up or down or somewhere in between. So, I think it has more to do with the stage of growth, the business that we're talking about and if you can lock on to an early stage, the journey can be very rewarding.
What's your thesis about where the broader end of the market seems to be currently? Starting 2018, the broadening of the market was decimated and people looking at the glass half full were saying that if you look at the broader end of the market it has merely retraced some of its lost glory, and some who are looking at the glass half empty were saying that the run-up has been so stupendous and so sudden and steep that it calls for a correction.
TUSHAR PRADHAN: I can see a lot of questions there but yes, the headlines do indicate that by any metric that we look at the valuations appear to be expensive compared to either history or averages. I think what we're missing out is when we look at the valuation parameter, we have to look at the price divided by the earnings per share. Now, what will be a little mindful of what has happened? First of all, we've been actually looking for this earnings growth for the last five, six or seven years—we are saying next year is going to be where the earnings growth is going to come from but in the interim, what we have actually been given, is a very tepid growth of earnings over this period of time and what has that actually made into is that after the Covid situation developed in 2020, the earnings not only did not go up as much as what we were expecting, but it actually collapsed. So essentially, what we're treating the valuation metric is two different orbits altogether. The valuations currently, what the markets are trying to tell you, reflects the potential of the businesses. It's not reality as yet, because the market value generally discounts the future potential of a business or a set of businesses or for this matter, the money. Now, what has happened is, we always need a crisis to kind of jumpstart—if you remember, there were many attempts in the past to jumpstart the economy, but they all failed because the demand was just very tepid. We were undergoing very average rates of return; GDP growth rate was not getting accelerated for various reasons. Now, this kind of jumpstart actually has come by way of the Covid situation that we just stopped. So like every engine when it stopped, it has to get a jumpstart. So, for that reason, all of the things which in the past that we were worried about—capex, demand, supply chains, all of those things that we were worried about, all now have started to get aligned. In a sense, this very forced, I would say putting down of demand for a year will have some impact and once this machine starts to roll on, then you will see some secondary impact as we go along. I think it's very difficult to dismiss this valuation on the headline, saying, look, we are expensive, what are you talking about? But I think if you start to see those two lines as we move about, then I think it starts to make some sense. The faith has to be on the sustaining of the earnings growth trajectory and the truly coming out of the Indian economy, as we call and we've been calling for some time, in terms of taking its place in becoming one of the most sustainable growth economies in the world and I think that is what if you believe and then the current valuation can clearly be explained. So, it depends on where you put your faith in.
...A lot of mid-sized companies are sector leaders, and they are coming out and announcing capex and talking about stupendous earnings growth. So, we believe the broader end of the spectrum is poised to give very good returns if you get the calls, right?
TUSHAR PRADHAN: I want to make a distinction that we don't want to say that we're timing it in any way so as to say, this is the right time to invest in mid caps, but we are talking about mid caps as a category and I think when we identify those companies which I mentioned earlier, when they catch that growth phase. Now, whatever the market does during that time, you can clearly see these companies emerge as market cap leaders because of the strength of their business model. It has nothing to do with the market in general, it has something to do with their intrinsic ability to grow very fast in any time. For example, I don't want to take names, but I'm sure we all remember that there were so many of these companies in the past three or four years where the market has remained fairly tepid but the kind of returns that we've seen in these businesses are upwards of three times, four times, five times in just a short period of between three and four years, and I think that is really where the focus of the mid-cap product needs to be and the focus of the investor who buys the product. It has nothing to do really with, to say as a whole are all mid caps expensive, that's really not looking at the story as we see it. If we can identify these potential businesses, then whatever the markets do the markets will do whatever—I mean, there have been times when earnings have been very robust, but a third-party event or something geopolitical causes the market to crash and suddenly people say oh, it is just so cheap, but nobody wants to buy it because of the geopolitical situation being so strong in your face that you are unwilling to invest. So, there is a gap as we perceive it between what the market is telling us and what the business is do. The businesses have to do what they have to do so. So that's why I wanted to point that distinction that mid caps have everything to do with identifying the early sign of a multiplier, of a business which potentially can become a large cap and then holding on to them for a period of time because it doesn't happen overnight. It may not happen in the next market rise either or for that matter you don't write them off in the next market fall either, it is something to do not with immediate gains, but it's something to do with the longer-term potential of these businesses.
...Not trying to say that this is the best time to enter into the markets or the mid-cap space from a timing or a level perspective, but from a business cycle perspective this might actually be as good a time as any. Is that the larger call? And therefore, if people invest and waited out for a slightly longer period of time, then the gains are more likely than not to happen?
TUSHAR PRADHAN: Absolutely right. I think you paraphrased it perfectly. The point is, when we put these mid caps together, people will always point that, that mid cap is trading at 50 times. That's not what essentially may be attractive to me right now, but there are mid caps which may or may not be at that valuation, but I see that potential going forward and when the market collapses, the 50 multiple with no story is going to collapse and within the market but my company that I have chosen and that actually satisfies the promise, that's first of all not going to fall as much as the 50 multiple gap but it is also going to sustain the earnings growth over the next two, three years and then when that rise happens again, who knows, it might take two or three years to get there. You've got a win. So that's really where the story lies.
Tushar, do you see a lot of themes where the probability of a multi-year growth cycle for that sector and good companies within that sector is possible or is it restricted to a select few?
TUSHAR PRADHAN: I think when we talk about the India story, and we've been talking about the India story for quite some time, but the India story has changed in nuance. The India story has not remained that one story, whether it was IT some years ago, whether it is now the specialty chemicals for the diversification of the supply chain story or whether it is e-commerce or whether it is aggregators or whether it is these financials I call them quasi-financials because they may be porters who actually democratise finance rather than actually lend. So, the lending businesses versus the intermediaries whether the asset managers, we're talking about various phases of the India story and as we develop as an Asian nation, as we develop as an economy, there will be so many more of these opportunities which today, maybe even not be visible. It may not be a part of my portfolio today because they don't exist, but can this potentially be something very different than what we were ever seeing in the past? Clearly yes, I mean the kind of range of opportunities that we see today, for example, are simply far more than just one or two sectors that currently we may like but very clearly some of these other businesses will develop into something much more. Whether it is electronic components... I mean there are so many things which far remain unexplored as even now, that has the potential for these businesses to grow.
Therefore, it's not the market timing but it is the business cycle timing that has led you to launch this fund, the HSBC Mid-Cap Fund. What are the characteristics? Why should people look to utilise this fund to make their investments?
TUSHAR PRADHAN: So, simply, one of the things that we've identified is the quality of business, which means that we first of all focus on what sort of businesses—forget about the valuation, that comes later but is this a business which we believe over the next three, four or five years is going to deliver on its promise, and then that's the research that we do in terms of understanding the business. The quality of earnings, are these businesses making the right sort of quality? So, I'm sure how the quality can be disseminated, and we understand that this is the pure asset turnover-led earnings, that we really look for. That is, higher RoE with a sustainable quantum of earnings because clearly the market cap is a function of how much we make. So that's the fourth cue and of course, the quality of management. So, I think once we have a fairly well-defined framework, then it's easier for us to identify these opportunities as well. If they tick all the four cues, that's a potential inclusion in the portfolio. So, what we are saying is, we have a broad spectrum, we are not focused on any sector. In fact, one of the things about the mid-cap index itself is it is a lot more diversified by percentage. So, it's not concentrated, as some of the larger-cap indexes are that they are concentrated in a few sectors, and they remain concentrated. So, the shift in the concentration happens but suddenly the focus again shifts very largely to one sector, but the mid-cap index actually is a far more diversified index which means it gives you so much more opportunity, much more of a broader spectrum to kind of picture bets in terms of where they are likely to be in the next five, six or seven years.
And I believe it is open for subscription as we speak?
TUSHAR PRADHAN: Yes, already. It opened on Sept. 6 and it will be open till Sept. 20.