`Mutual fund investors do not have as much exposure to mid-cap stocks as they ought to.'

Suresh Krishnamurthy

SEVERAL mid-cap funds have been launched over the past two years. Still, investors in mutual funds do not have as much exposure to mid-cap stocks as they ought believe fund managers at Cholamandalam Mutual Fund. This aspect has prompted them to launch Chola Multi-cap Fund say Mr Sashi Krishnan, Chief Executive Officer and Mr Tridib Pathak, Chief Investment Officer of Chola Mutual Fund.

An engineering and economics graduate, Mr Krishnan has worked earlier in Unit Trust of India and has been an observer of the markets for the past 18 years. Mr Pathak is a chartered accountant who started out as an analyst in the project finance division of IDBI. Both are bullish about the equity markets and feel only equities can help investors beat inflation. Excerpts from the interview.

Let us start with the premise behind Chola Multi-Cap that it is not possible to shift between large-cap and mid-cap in an existing diversified equity fund. Please explain. TP: When we took all the diversified equity funds and aggregated their holdings, we found that 74 per cent of the assets was invested in large-cap stocks, 24 per cent in mid-cap stocks and only 1 per cent in small-cap stocks. That is, almost all equity funds were diversified largely amongst large-cap stocks.

However, if you believe in the India growth story and if you believe the growth gap between India and the rest of the world will persist, then the underlying dynamism will ensure that opportunities arise across all market-cap sizes. It is therefore time to diversify beyond large-cap stocks alone.

What we have set up is fund that now has the mandate to invest beyond large-cap stocks within specified limits. The fund will invest about 40-45 per cent in large-cap stocks; about 40-45 per cent in mid-cap stocks, about 5-10 per cent in small-cap stocks and about 5-10 per cent will be the cash position. We think the multi-cap funds meet the existing need of a fund investor. Investors who seek diversification do not have it as of now.

SK: Our analysis of aggregated holdings indicates that 68 to 70 stocks account for almost the entire market cap held by funds. By design we are looking at various market-cap segments.

The theme suggests that there are waves in the market that alternatively favour large-cap and mid-cap stocks. The basic trend has however been that when markets rally, mid-caps gain more and when prices fall they fall more. How do you propose to handle these issues?

TP: The asset allocation that I indicated will be almost sacrosanct. We can have a swing of 10 to 15 per cent away from this asset allocation pattern in case we see opportunities. We will not be doing it every day or every week. If once in a while, however, we find that big opportunity coming, then we will change the asset allocation to take advantage of the conditions.

Also, if we find that mid-cap stocks have gone up sharply and there is a natural need to temper the exposures down, we will do that too. The focus will be on stock selection. We will be taking advantage of the market movement though would not be strive to do so every month or quarter.

You say you are going to put in only about 45 per cent in mid-cap stocks. Does this mean that you are wary of the valuation of mid-cap stocks?

TP: Not at all. We have a mid-cap and a large-cap fund. We did not have a truly diversified fund, which we believe the industry also does not have. That is where the asset allocation comes from. It has nothing to do with valuation; if you look at our mid-cap fund the PE ratio is less than 10.

SK: The range is 25 to 75 per cent for both large-caps and mid-caps. Under normal circumstances, we will have about 45 per cent each in mid-caps and large-caps. The gap of about 25 to 30 per cent will be used to make the swings away from or towards a particular category of stocks. The idea is to make these swings. At a point in time, we can have 60 per cent in large-caps and 20 per cent in mid-caps. It will depend on market movements.

What will these swings depend on?

SK: There will be triggers where the out-performance of mid-cap over large-cap will be tracked and this will help us decide when to get in and when to get out.

TP: Absolute out-performance will be one of the triggers. The triggers are only for swings of about 10 to 15 per cent, which is in not any case major. Tactical swings into or out of mid-cap will happen once in a while only if necessary conditions exist.

How would the portfolio look like in terms of diversification?

TP: We would have about 40 to 45 stocks in our portfolio. In mid-cap and small-cap segment, the exposure in any single stock would not be more than 4 to 5 per cent. We can afford to have an exposure of more than 5 per cent in a large-cap stock but not more than 8 per cent in any case.

For the overall market, have returns kept pace with earnings growth or has this rally eaten into future years' returns?

TP: Returns have lagged earnings growth. In January 2000, when the index was at 5,900 levels, the PE was about 25 times. Now at 6,400 levels the PE is about 12.5 times. I am talking about a one-year rolling forward PE. Even over a ten-year time frame they have lagged earnings growth.

Would earnings growth continue to drive returns or improved valuations also come to play?

TP: We do expect it. Inflows from abroad could continue if overseas investors are convinced that the growth gap India has will be sustained. More importantly, increasing participation by domestic investors can also lead to a re-rating. It is bound to happen as alternative asset classes are offering lower returns.

SK: The Indian households have to increase the allocation for equity. That is the only asset class which can help them head of inflation. The realisation is dawning on investors. It will happen.

The household savings data indicate a sharp rise in borrowings. So when they pay an EMI, the proportion of real estate owned keeps going up. Do investors prefer real estate to stocks to help them stay ahead of inflation?

SK: That is a fact. However, a sizeable part of the money going into real estate is not investment. The money that is going into real estate is not realizable because it is not going to be sold. Equities are going to be the only class that will deliver.

The point that Tridib keeps making is once this housing need is met and EMIs keeps becoming a smaller portion of the income, the allocation to equities will rise.

I am certain that this will happen over the next half a decade or so.

(This article was published in the Business Line print edition dated January 2, 2005)
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