The Hindu Business Line : There are interesting investment opportunities across several sectors

It is very clear that the Indian economy and the stock market will be driven by three main themes over the next 5-10 years: Outsourcing, domestic consumption and infrastructure. — MR S. NAGANATH, CIO, DSP ML MUTUAL FUND

It has been over two years since DSP Merrill Lynch Fund Managers came out with a new open-ended equity growth scheme. Last week saw the launch of DSP Merrill Lynch Small and Mid Cap Fund, an open-ended equity growth scheme with a portfolio constructed primarily of stocks from small- and mid-cap space. Business Line caught up with Mr S. Naganath, President and Chief Investment Officer, DSP ML Mutual Fund Managers, to get his thoughts on the new product and his views on the markets.

Excerpts from the interview:

What would be the allocation pattern for your small- and mid-cap funds?

Bottom-up stock selection process is what we are going to adopt. We think it is the appropriate way to select stocks in the mid-cap and small-cap sectors. An allocation of about 20-25 per cent in large-caps and mid-caps will provide for liquidity, as it is an open-ended fund; about 75-80 per cent will be a mix of mid-caps and small-caps and within that, one-third in small-caps and two-thirds in mid-caps. And as it will be a bottom-up stock selection approach, it may lend itself to some amount of sector bias; we are not going from a sector down to a stock-driven approach. It may be thematic, it may be stock-specific. Essentially a fund like this will focus more on the companies we buy.

How do you propose to address the liquidity risk associated with mid-cap and small-cap stocks?

We will keep 20-25 per cent in a mix of cash and large-cap stocks to provide for liquidity. And over time if we find that there isn't much of requirement to maintain that high level of liquid assets, we may even reduce the 20-25 per cent to 15 per cent. But it must be appreciated that we are providing investors with an opportunity to participate in what we think is a high-growth opportunity in the small-cap-mid-cap space with the added benefit of liquidity. If you look at some of the other funds which have come out in this sector, they have all been close-ended funds. Here, if you desire that the investment horizon is not three or five years but one or two years, you have the opportunity to take the money out at any time. Liquidity management is something that we will have to handle and are confident of handling.

Which sectors are you bullish on, particularly in the mid- and small-cap space?

As I said, it is more thematic or company-specific. Broadly speaking, we think there are many interesting investment opportunities across many sectors — infrastructure, auto and auto-ancillaries, power and power-equipment, pharmaceuticals, logistics, media and entertainment. But then it again boils down to individual companies that we feel have the quality of management, and a very robust business strategy that will enable them move from small-cap to mid-cap status and from mid-cap to large-cap.

Do you think the valuations enjoyed by small-cap and mid-cap stocks over the last bull rally are sustainable or do these stocks have potential on the upside to justify such premium valuations?

We think there are enormous opportunities in many companies. Again one should not look at it on a generic basis. There could be, say, 300 small-cap ideas . If we pick 30 of them, what we are interested in is the growth prospects of these 30 companies. As a group, 300 companies in the index may not reflect much movement, but within that if you pick a few good companies that are capable of providing manifold returns, that is what will make the difference to the portfolio returns. Looking at the relative movement of the index may not necessarily communicate to you the full potential of a good company within a group that can do extremely well. And I think our job will be to identify as much as we can, the good companies in the small-cap and mid-cap space.

We have also seen numerous instances where valuations of mid-cap and small-cap stocks have been out of sync with fundamentals. How do you see this equation to shape up over the next year or so?

May be some companies in the mid-cap and small-cap space were overvalued but one could equally argue that during the decline in May and June, some of these companies did shed quite a bit in terms of price. And many of them are actually trading at very attractive PE multiples. And because they haven't participated as much in the recent rally, obviously there is an interesting opportunity to look at them closely. There clearly is an opportunity between the inherent growth potential and the current valuations at which they are available.

Of late we have seen a host of mid- and small-size companies going for acquisitions as part of their growth strategy. Is this a healthy trend? Do you see any risks associated with such a strategy?

One cannot make a general comment here. We have to evaluate each situation separately and see whether companies are capable of digesting such acquisitions, have they funded it through a right capital structure, etc. It all depends on the individual company's objectives, long-term business strategy, ability to incorporate the acquisition successfully and expand business.

With the Fed pressing the pause button twice, what is your view on the interest rate cycle in the domestic market?

We think that in the US, the rates will be on hold pretty much for the rest of the year. And if anything, they may be looking to cut rates in the first or second quarter of next year depending on how sharp the economic slowdown there is. In that context we think that in India also, the rates will be more or less range-bound. At best may be half-a-per-cent hardening from here but not more than that.

Liquidity has been a major force driving the recent bull rally. Do you see any pressure/reversal on this front over the medium term?

No, We don't. I think with oil now back to $60 per barrel, interest rates more or less stable, corporate earnings expected to be quite good this quarter as well, overall we think earnings growth for the year would be about 23-25 per cent for large-caps; the environment for equities continues to look good. Foreign flows are also robust.

What in your view are the key variables that are likely to dictate the next leg of stock market rally?

It is very clear that the Indian economy and the stock market will be driven by three main themes over the next 5-10 years: Outsourcing, domestic consumption and infrastructure. So they will continue to remain enduring themes for the medium and long terms.

When it comes to emerging markets, the most widely talked about is `Chindia' (China+India) being the next super-economies. How does India compare with China when it comes to valuations as of now?

Well, I think certainly Asia seems to be the place where a lot of people want to expand exposure in terms of equities. Within that there is great recognition of the demographics of India and China — the large consumer markets and the ability to deliver sustained growth rates. I think in that context, it really doesn't matter what the comparative valuations are. So everybody wants to have some exposure to India and China as an integral part of their portfolio.

The retail euphoria doesn't seem to die down. Companies across the board are on an overdrive to expand the retail chain. There is a fear that overcapacity at some point may dampen the industry's prospects. Your views on that.

Unlike in the other developed countries, Indians have traditionally been high savers. And while we consume, we have not leveraged household portfolios as much as it is in some other developed countries. So in that sense, we are still in the early days of domestic consumption boom. Consumption is always born out of confidence about the future. As the economy grows, more jobs are created, salaries rise and you are confident about the future, so you will consume more.

Second, there is a distinction that has to be made between what is called regular or maintenance consumption and aspirational consumption. And I think today, once you have that sense of confidence in your future, then you will certainly have maintenance consumption but, more undoubtedly, aspirational consumption. Hence, it is too early to say that there will be saturation. Even if you look at percentages, household debt on account of consumption as a percentage of GDP is a very small number compared to many countries in Europe, America and even Asia.

You did mention about outsourcing as one of the enduring themes. Assuming a sharp slowdown in, among other economies, the US, how do you see the outsourcing theme to play out?

We think that outsourcing will actually increase, as companies will seek to cut costs. And, therefore, we are bullish on the outsourcing story. May be to the extent we have some commodity exports, we might slow down a bit. But by and large as an economy, we are more insulated to the possibility of a US slowdown than some of the export-led economies in Asia.

DSP-ML also proposes to launch a World Gold Fund. Could you throw some light on the product features?

We have filed the document for the Gold Fund, which will be leading into an International Gold Fund run by Merrill Lynch. This fund will invest in gold mining companies. It will not be buying physical gold. Under this fund, the focus will be principally on gold. There could be little bit of investments in other metals as well, that is, in companies which are into mining operations. We are awaiting approval. As and when we get it we will announce further plans.

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