Part I: How fund managers pick stocks for YOU

In the second part of an interview with Value Research, S Nagnath, President and Chief Investment Officer, DSP Merrill Lynch Mutual Fund, explains why he is bullish on the real estate sector and defines his rationale behind the company starting a Micro-cap fund close on the heels of starting a mid- and small-cap fund.

He believes that India is in the early stages of a real estate boom if one compares the situation in India with that of China. Here are the excerpts: 

What are your views on the real estate as a sector?

My view on real estate is like the pharma sector, you cannot take a general view. You have to look at it company by company. 

The sector began to boom in 2005 so it is almost two-and-a-half years by now. But we are still in the early stages of a real estate boom specially if you look at what has been happening in the real estate sector in China, Asia or even the Middle East and the UK. I think given the level of high demand and low supply, there is lot more room for the sector to grow. If I take a medium- to long-term view, I am very bullish on it.  

Although, one has to be very careful on how you pick stocks. You can have a positive view on the sector but when it comes to stocks, you have to ask some hard questions in terms of business approach and land bank valuation. 

Towards the end of last year, you launched a mid- and small-cap fund. Why a micro fund now in less than a year?

The market capitalisation spectrum comprises of large-, mid-, small- and micro-cap stocks. In our Top 100 Equity fund, we target the large-caps which are the top 100 companies in terms of market capitalisation. The companies in the 100 to 200 range represent the mid-cap segment. Those in the 200 to 300 range represent the small-cap segment. We define Micro-caps as a segment representing the 300^th company downwards in terms of market cap, which is where the micro cap fund will focus. 

Why was it targeted as a small, close-ended fund?

This micro-cap segment has the potential to deliver good returns if you do the right stock picking. But these companies are small in size and will be illiquid at various points in time. If we approach it from the context of a large fund, then taking a meaningful position is difficult since liquidity would be an issue. So we felt the best way to approach it is by going through a three-year close-ended structure with a cap of around Rs 500 crore.  

What do you look for in a micro-cap?

The key pointers that one needs to look at are, is the business in a high growth area? Is the company well positioned to ride that wave of growth? Can it scale up this growth to its advantage in the years ahead so it transforms itself from a micro-cap to a mid-cap and eventually a large-cap? These are the issues we address. 

The kind of business model we are looking at is one where as the business scales up, the company continues to maintain significant market share in the concerned industry or segment and the return parameters continue to remain fairly robust. This will lead not to an arithmetical but an exponential increase in market capitalisation.  

Isn't micro-investing fraught with risks?

There are always risks. Some companies may not scale up to the level we are anticipating. But over time, if you have more winners and less of those that do not perform as per expectations, you still come out on top.  

Look at private equity investing. If you invest in 10 to 20 companies and you get three or four that are multi, multi-baggers and the rest do not perform, you still end up with a reasonably good return on a CAGR (compounded annual growth rate) basis. I think a similar approach would typify the risk in this market space.  

So you would not say that this fund is more risky than your other funds?

Risk in itself does not portray where you stand. You must look at risk in the context of return.  

If you are looking at large-cap stocks today, the story is well told and everyone knows these companies. So at this level, our earnings expectation is that they will probably grow at 15 per cent CAGR over the next 5 to 10 years. And even if there is no significant PE rating, the market return will probably approximate 15 per cent.  

In fact, over the 20-year period from 1985 to 2005, market returns were around 15.5 per cent CAGR. Corporate earnings were also in that range. As you move down the capitalisation chain, the return expectation rises. 

The key lies in choosing good stocks that will do well. It is not that every stock will be a multi bagger. But by and large, given the degree of experience we have in analysing companies and sectors over the years, we are likely to make some very good choices. And in this context, the return profile is likely to be better than that of large- and mid-cap companies.  

Of course, there will be a certain degree of volatility to account for the illiquidity and so on and so forth. But remember, over long periods of time, the element of volatility smoothens out.  

So when we define risk, we talk about it in the context of expected return. And, we talk about risk and volatility of return in the context of the time period of investment.  

So if you take a short-term time frame of a few months, there will be liquidity issues and price volatility. But if you take a 5 or 10 year time frame, the volatility will not be substantially different from other larger market cap stocks.