The Hindu Business Line : Mid-caps will outperform large-caps by a margin of 30 per cent

As per our internal estimates, the overall market is trading 14.7 times forward earnings and mid-cap stocks are at 11.5 times forward. At these valuations, there is reasonable value... markets will peak out at 30 times forward (earnings) and that is a long way off.

MR SANDIP SABHARWAL, CHIEF INVESTMENT OFFICER, JM MUTUAL FUND.

Mr Sandip Sabharwal, who recently joined JM Mutual Fund as Chief Investment Officer and fund manager for its equity funds, has always stood out for his selection skills of mid-cap stocks. Therefore, his assertion that mid-cap stocks would outperform the large-cap pack by 30 per cent over the next two years, does not really come as a surprise. His views also turned out to be quite offbeat, though unwaveringly bullish, in this interview with Business Line, where he discusses the prognosis for the stock market, liquidity issues in mid-cap stocks and interest rates.

Excerpts from the interview:

With investors in a risk-averse mood, mid-caps haven't participated actively in the recent rally. Now that you are launching a mid-cap fund, do you see out-performance from these stocks, in the days ahead?

We wanted to launch a product that we were convinced would deliver good performance; we saw that opportunity in mid- and small-cap stocks. These stocks have gone into a substantial discount to the large-caps. Last April, when the markets peaked, mid-caps were at a 20 per cent premium to large-caps. Today they are at a 20 per cent discount.

Right now, investors are frustrated with the mid-cap stocks or funds they hold. So we feel this should be an inversion phase when mid-caps will begin to perform better. The mid-cap out-performance has started to build up in the downtrend and it will accelerate as the market recovers. Our view is that over the next two to two-and-a-half years, mid-caps will outperform large-caps by a margin of 30 per cent. That will create an opportunity for alpha generation.

There are strong logical basis for this view. First, we have seen two-year cycles for mid-cap/large-cap out-performance. You go to the bear market of 2001-02. Those two years, mid-cap earnings were not great, so large-caps outperformed. In 2003 and 2004, the markets recovered and mid-caps did much better. Last two years, mid-caps have again under-performed and we believe the time is ripe for the cycle to turn.

Another phenomena observed worldwide, although empirical evidence in India is not available, is that in an increasing interest-rate cycle large-cap stocks typically do better. When interest rates peak and then decline, mid-caps do better. Earlier, the expectation was US interest rates will start declining by end of this year. But now the expectation is it will happen faster. As the interest rate cycle peaks out, we feel the mid-caps will start to perform (the underperformance has been a global phenomenon). Today, there is so much risk aversion that everyone wants to be in large-cap stocks. But as we go forward, we will see more foreign investors investing in mid-caps and the cycle should turn. The valuations are too compelling today.

Most other fund managers now structure their mid-cap funds as close-ended products citing the liquidity issues associated with mid-cap stocks. You are launching an open-end fund. What is your view on these liquidity issues and how you are going to manage them?

From JM MF's perspective, it was important to make a statement to the market that we are confident about this product. I think liquidity is an issue in the short run. You make more money in (mid-cap) stocks only if they are illiquid. If a mid-cap or small-cap stock is too liquid, then either it is speculative or too many people are in on the story already.

Construction stocks were so illiquid at one time. Today, they are traded in the futures market. Property shares did not trade at volumes of more than 10 shares at one time. Now the market fancies them; those who bought these stocks in 2005 made money. Those who bought in 2006 did not make money. So as the story gets discovered and liquidity builds up, the potential return reduces.

Isn't liquidity in mid-cap stocks a function of overall liquidity in the market? If overall liquidity is scarce, can mid-cap stocks perform?

No, my view is that if there is value in something, it will move up. Who buys the stock, is not important. If a stock is highly undervalued, the promoter himself will buy it. If it is reasonably undervalued, some good fund manager will buy it. The market fancy for mid-cap stocks actually starts when the stock is reasonably valued or slightly overvalued.

From the market perspective, liquidity might be an issue in the short run — this next one or two months. But to pick out mid-cap stocks, you need this kind of scenario. I can buy any stock I want now, because no one wants to buy it. But in two months time, when mid-cap stocks are rallying, the impact cost will be too high. As per our internal estimates, the overall market is trading 14.7 times forward earnings and mid-cap stocks are at 11.5 times forward. At these valuations, there is reasonable value. As for all these fears on markets peaking out, I do not think the markets can peak out at 14 times forward earnings. Markets will peak out at 30 times forward (earnings) and that is a long way off.

What are you doing to improve the performance of JM's equity funds? Several of them have been in the bottom quartile in return rankings over the past one year.

Our first attempt was to re-align the portfolios according to their mandates. My philosophy has always been to have a concentrated portfolio — not more than 30 to 35 stocks. So the first step was to reduce the number of stocks, in accordance with the mandate of the scheme. So JM Equity has been positioned as an "opportunities" kind of fund which will be at least 60-65 per cent invested in large-caps and beyond that, will move between large-cap and mid-caps depending upon the view.

The Emerging Leaders Fund was launched in 2005. This fund went through a lot of problems because it raised a huge amount of money, but subsequently saw a shrinkage in corpus. We have taken accelerated expense write-offs in this fund and the portfolio has been re-aligned. That fund will now just have 20-22 high-growth stocks that we think can be a multiple of their current size over the next few years. It will be a very low-churn fund.

Then there are the five sector funds, which have their pros and cons. Sector funds are typically for niche investors and typically do not grow in size. We will have to re-evaluate our strategy on them on a later date. On the diversified category, we have two other funds. One is JM Basic fund, which was an erstwhile oil and gas fund. Now we have diversified the mandate to include basic industries, capital goods and we have gone to the unit-holders to get approval.

The re-structuring has worked well in the last two months. JM Hi-Fi fund was launched last year. In the last two months, housing, infrastructure, finance have all been battered and the entire portfolio has not done well. So we are restructuring that too. Restructuring a fund in such turbulent times takes a toll on the fund in the short run. There is a price mismatch and a time mismatch. We are telling investors to stay on over the next few quarters. We hope to move into the first quartile in terms of performance over this period. We compare ourselves to the entire universe of 180-190 funds.

Looking at the entire investment universe, would you share the view that the sector choices are shrinking — policy issues have made cement and sugar unattractive, infrastructure and IT stocks have been hit by Budget-related tax proposals, there are fears of rising interest rates hurting several sectors...

There are sectors such as FMCG or pharma which were once fancied, where valuations have declined, but people haven't been willing to buy. I think that capital goods and power equipment companies offer a lot of value after the recent fall. I think IT, across the small-, mid- and large-cap segments offers lot of value. I think the growth story on telecom doesn't change, even if there are short-term issues. As interest rate fears die down, we might see the auto sector picking up because volume growth is still there and margin pressures are down. I also think that there are niche plays that you can also find across sectors. Pharma is mostly a global generic play. In the US, the justice department is evaluating further action on authorised generics; if this is struck down, there could be opportunities for pharma companies with a global presence. I would agree with you that the investment universe is shrinking in the large-cap basket and that is why a lot of focus may shift to the SME segment.

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