The Mutual Fund Show: Equity Investing Strategy For Beginners

Sunil Subramaniam: First of all, it depends on the lifetime of your investment. I think it is very important for investors to understand for what time frame they are expected to remain in the equity markets.

As you mentioned at the beginning of the programme that you are talking about startup investor or somebody, who is new to the equity markets. For them, I would say stay away from the equity markets if you are looking to make a quick buck within one, two, or even three years.

So, first things first. Do you have a clear five-year investment horizon in your mind? If you do, then the market levels do not matter, because the market's absolute levels like 20,000 or 30,000 are meaningless numbers. They represent the cumulative addition of profits over the years of the companies in that index and they are shown at a particular level.

So, it doesn't matter, because when you enter, the stock market has the ability to give you returns on future earnings of these companies. So, what has happened in the past for them to reach these levels of share prices that the index reflects a particular number is all in the history. It is the future that the market delivers returns from. And, the two things that deliver in the future are: one is the future profit growth of the earnings in the index or the fund portfolio, and the second is that somebody is seeking to pay a price for future earnings.

Let me explain a little bit here. When you have a five-year horizon, in those five years, the companies in the index will deliver certain profits, which rightfully belong to you as the owner of those stocks, whether you buy it in the index or growth fund, number one. So you should make that return.

The second is, when you are going to sell your index portfolio, somebody has to buy it. The price that he is willing to pay for the next five-year output is what you are going to encash at the end of the five years.

The point is, if you just look at the past track record, even at the highest of the highs of the market, the lifetime highs—at various stages, markets have reached lifetime highs—if you stayed five years, two-thirds of the time, you will have a chance of getting inflation-beating returns. It is a probability game naturally. You can’t say it is guaranteed that you will get that. But, five years plus if you stay put, you are on a fairly comfortable wicket to get inflation-beating returns. So, as a startup investor in equities, please get that clarity in your mind.

There are some other things also that you should look at, that we will talk as the show progresses, but first thing is to have a five-year buttoned-down time frame—I will not look at my portfolio until five years are completed. I think that is a basic thumb rule starting point for any equity market investor.

Ruchi Sankhe: I overall agree that equity is a long-term investment. But you know, the market levels are very high today. And, it is a little bit uncomfortable for new investors. When they see a reduction in value of their funds over the next six to eight months, they get nervous and some of them can even withdraw their funds.

So be cognizant of that and the levels. While the macros and micros for India are not bad at all—and you can see the corporate earnings have been strong—global factors like high interest rates pulling down the equity markets, the U.S. dollar index being at the highest level are making the markets nervous. And that is going to have some impact on investors.

I would actually say that even though five years may be a time frame that you are looking to invest in, please be cautious and stagger your investments. That is how I would approach the rhetoric today with the investors and for existing investors as well. Some of the investors are looking at being underweight and then staggering it again.

So, I think it is quite prudent, because when the markets are at a high, after that for almost 12 months, you will see very muted returns. And, that is not the expectation that equity investors have, when they invest in this asset class.

So, I would tell those investors, who are starting out to be a little bit more cautious and try and stagger the investments rather than putting the entire amount that you have right now, because it may not be a smooth ride from here onwards.

Sunil Subramaniam: Absolutely. It is a big challenge as a fund manager, because when people give money in small-cap mutual funds, the restrictions are that 60% of that money has to go into small-cap stocks. And, when you are giving me money, we as an internal fund house have a 5% rule, that not more than 5% can be kept in cash.

So that means, of the money that comes in, 95% has to be deployed. And so, what is the solution? It is a challenge.

So, as a fund manager we look at two solutions. The first is that, buy only quality. So, how do we define quality here? Quality is consistent, sustainable EPS (earnings per share) or cash flow growth for that company over the next foreseeable future. So, the first thing is, I will not buy any company that doesn't give me that. Its share price may be rocking, analysts may be recommending it, but doesn't matter. There has got to be quality as first defined by sustainability.

Second, corporate governance of the ownership plan. Good quality corporate governance is a key.

The third thing is that that the company must be a market share gainer. The definition of quality is—it must be gaining market share, it must have the ability to replicate its portfolio across geographies, as a company it should be expanding.

If you tick all these boxes, most probably, this company is going to be a high value company, because there are 44 other mutual fund houses with small-cap schemes, which are all going to be thinking the same way.

The second aspect is, since I buy the stock with a five-year outlook, what is typically shown in the market is a trailing PE (price-to-earnings) ratio, which is last year's earnings, or a one-year forward PE ratio. And those stocks would reflect a certain high level of valuation when on one year forward PE.

However, as part of my research—that is where our own research becomes important—I will look at the company's earnings over a five-year period, attribute a profitability to a bear case scenario, a bull case scenario, a realistic scenario, and come at a weighted average EPS for the year FY23, FY24, FY25, FY26 and FY27. And, when I then look at it with the information in my hand, and if I feel from a five-year holding—which would effectively mean FY28—if that sounds valuable, I will buy that stock, preferentially, regardless of what the one-year forward PE is showing up. So that is where the benefit of research comes in.

And then, of course, finally, the biggest shastra for any mutual fund manager is diversification. Don't put all your eggs in just a few baskets. Spread your risk across equally so many good quality companies. And, like Ruchi said, given the fact that money flow into this sector is very variable, there could be chances that the portfolio could go down.

But because a lot of the flows coming into small caps are through SIPs—which is an excellent thing done by Indian advisors like Ruchi and all the mutual fund distribution companies—not only will I get money this month, but I will also be getting money every month.

So, if there are future corrections, I will be able to buy these same good quality stocks 5% cheaper, 10% cheaper, over the next 6-12 months. And that rupee cost averaging benefit will ultimately benefit the investor. So, I would say that the counter to that lies in these kind of processes.

Ruchi Sankhe: Actually, I have a little bit of a different opinion on this. While goal-based investing might work for certain people, it also depends on the corpus of investible surplus that you have. But, otherwise, I am actually a believer of asset allocation and portfolio which is sort of constructed for a longer period of time.

You are right. If the goal is very near term, then the kind of instruments that you will build in will be a lot more conservative, because you can’t handle the volatility then, because you know that you have got a near-term goal that you have to achieve. If it is a longer-term goal, then you can invest in aggressive or, growth-oriented kinds of assets.

But however, depending on the corpus, if it is a larger corpus, I always believe it makes sense to have portfolio allocation across different asset classes. So, you may want to capture different market caps in your asset allocation. You may want to capture different kinds of strategies within growth, value.

Having said that, so that could be but if the corpus is very small and it’s a near-term goal, then you may want to look at conservative kinds of assets or funds that you want to use to lead up to that goal.

So, I have a little bit of a different opinion—that it doesn't have to be just goal-based. Depending upon the corpus, you could actually have a portfolio allocation, which will effectively help you achieve those goals, but the construct or the way to lead the path to that it is a bit different than creating just a goal and then investments just to meet that goal.

Sunil Subramaniam: Some fund houses have stopped inflows into small-cap funds, because they feel that the valuations are very high. So, they have stopped accepting fresh inflows through lump sum investment.

You know, after 65% asset allocation in the small-cap fund, SEBI actually allows you 35% to buy even large caps. All funds have created the ability to have arbitrage—that is buying the market itself.

So, I think up to 50% of the portfolio, you can buy the market broadly and not necessarily choose. So, there are enough tools in the hands of the fund manager. You saved a portion of your investments into safer large caps, while the havaa—as they call it—is there in the small cap. And then, you can bring it back later, when there are corrections because large caps are easily liquid, easily tradeable, number one.

Second, you can buy hedges in the market up to 50% of the portfolio. So, these two tools serve the purpose.

The third I would repeat what I said before—that it is not that entirely every stock in the small cap is at a high. Only certain stocks are.

So, I am sure that if you take a long enough perspective at today's market, I do not feel that it is a market where you know, I should permit my fund managers to instead of take five—this is not a SEBI-prescribed rule, it is only our company-prescribed rule—allow five to 10.

But I don't want to do that, because I am of the view that with a five-year outlook today, given India's growth potential, there will be corrections in the future, there will be volatility, but I think, as Ruchi said, the fund manager will also stagger the money into the market that he gets and buy it with a longer-term outlook. Like I said, do look at FY28 or even a FY30 earnings of a company. If it is justified, buy that.

Sunil Subramaniam: The fund view on the market is, the markets have priced in next year's growth fully. The expected EPS growth of the next year—that is FY25—have been fully priced in by the market. Hence, at the current view, with a one-year outlook, you could be in for some disappointments, if certain companies in certain sectors do not deliver that expected view.

Why? Let me clarify this. Let us say the market is probably discounting a 21% earnings growth. Even if the economy and the sector has delivered 18%, the market could correct. Because, what price is the market at—21% earnings growth.

But at the same time, there is so much liquidity outside India waiting to enter India that, if instead of 21%, we show up 23% or 25% peak in earnings, the markets could touch newer highs.

So, we are at a very fine point, where even a small amount of liquidity could cause sharp volatility both ways. When we define risk in the market, we use standard deviation and standard deviation is a square root of a square, which means that negatives and positives get equal weightage. So, high standard deviation and high risk doesn't mean only downside risk, it also means upside potential.

Ruchi Sankhe: It will obviously depend on the risk profile of the investor—conservative, balanced, or aggressive. But with all those caveats, I mean, today, I think it would make more sense to be overweight on large caps, given the fact that over the last one year in fact, the small cap index has gone up by almost 37%. And Sunil is right that it is not that all stocks have gone up, but the index per se has. And mutual funds have a diversified way of investing in these segments.

So, it would be prudent to be a little bit underweight on small caps and mid caps at the moment, and be overweight on large caps.

I have noticed that over the last so many years, large-cap funds are finding it difficult to create alpha and passive investing has really taken in a firestorm over the last 5-6 years.

So, index funds make a lot of sense. In fact, when you are selecting an index fund, it also makes sense to see the tracking error. Lower the tracking error, better the fund performance and it will be closer to the index. So, on the passive side, the Nifty 50 and the Nifty Next 50 are too big indexes to invest in.

There are conservatively managed large-cap funds as well, which I like and one could include that in as far as the exposure. You may still want to not completely ignore the small-cap and mid-cap segments. So, you may still want some exposure there. But I would say that, it should be based on the investor's risk appetite. If it is an aggressive risk appetite, I would still do a little under allocation from this juncture, because most fund managers are expecting at least a short-term correction although not a long-term correction of 10% to 15% in these segments.

So having said that, I would be underweight on these segments and overweight on the large cap. I would put more into passive funds that invest in large caps like the Nifty 50 and Nifty Next 50. So those would be the two indices to take.

There are some very interesting flexi cap funds as well which give you an allocation to large caps and also some international exposure, which you may want to put in your portfolio but do it through the mutual fund route which, would be through a flexi cap.

So, there is one fund in this field that I like, which is the Parag Parikh Flex Cap Fund that I effectively really like because it gives you international diversification and gives you very value-based conservative portfolio on the large-cap side.

Also, like Sunil mentioned they also have been actively using arbitrage to create and dynamically manage the positions on the equity side. So, if they want to go underweight, they have very high arbitrage positions, which I think is a very good strategy and again, a concentrated portfolio.

So those would be a couple of choices. Go overweight on large caps. Use a certain amount, at least 20% to 25% through passive funds. Some inclusion on the hybrid funds may also make sense, because with the way the debt taxation has changed, you know, debt per se, debt funds have lost their sheen. People are taking exposure to hybrid funds like an equity savings fund or a balanced advantage fund and those should also be in the portfolio.

So obviously, the specific allocations will depend on the risk appetite, but those will be the segments I would touch to create a holistic portfolio for a starting out investor. And as I had said earlier, I wouldn't put all the money in immediately. I would take 6-8 months to really stagger in those investments and build the portfolio and construct it over a period of time.

Sunil Subramaniam: Two things are there. One is, a plain passive (fund) helps you to first of all, buy the market. If you feel the markets are going to do well, either you diversify over 3-4 fund managers to get the average of their performances, or you buy the market. Because, on an average, two fund managers will beat the benchmark, two will not. And like Ruchi said, in the large-cap space that is probably getting tougher, because the inflow of passive funds from overseas and from the provident funds in India is helping passives outperform.

It is like a virtuous cycle, because the money is coming into everything that is there.

The second way that passives play a part is, to do minor tweakings, which don’t need a huge fund management experience, like you mentioned, equal weighted funds.

So, what does that do. Like you take the Nifty 50. It takes 2% in every stock in the Nifty 50—it gives equal weightage to all the stocks. So, what it does? It gives you a median, because sometimes some stocks in the index run up and others don't and then in life you know there is always a catch up, so which means that you are always contrarian to some extent in an equal weighted fund. So, it is a particular way of playing.

The fees are very low, because there is no active fund management involved. It is just a passive allocation, but it gives you a different flavour because the bank index for example is 35% of the large cap. So, you are ending up buying banking even though you are buying passives. If you truly want to buy all segments of the market, an equal weight gives you equal allocation for literally everything that is there.

These are small tweaks. As time goes by, you will find other things like momentum index or a factor index. These are called smart beta products. I think SEBI will not allow the word smart, they are just differentiated beta products. Smart conveys that you will always be right, I think it is not. But these are flavours to give some space between active—where you charge 1% to 2% fees—and passive funds, where it is closer to 20-30 basis points.

We will probably charge you 30-40 basis points, but give you the tadka, as they call tadka in your dal.

Ruchi Sankhe: You are absolutely right. Actually, the market has completely changed after March. Today, post-tax, liquid funds are getting a lower return than even what inflation is. So, you are basically depleting the value of your money by keeping money in liquid funds. Unfortunately, that is the truth.

So what is happening is that there are alternatives. Obviously, arbitrage funds has been one of the favourites saying that that is something that if you are looking to invest or keep your money invested for at least 6 months or more, it makes sense because it gives you similar returns to a liquid fund but then exposes you to the equity taxation rather than a debt taxation, which kind of eats up the entire return.

And also, the equity savings schemes. Those also have a reasonable amount of exposure through arbitrage or you know and the liquid side, but again it exposes you to equity taxation. So those are options that investors have started looking at and are using to create even the contingency fund.

A certain amount we will always stay in short-term debt funds, because that is completely safe and has no equity component at all. I mean arbitrage funds, even while we do invest in arbitrage funds, we do not advise clients who have a very short-term view of 2-3 months to use that option. So, you will still have the requirement for liquid funds, but anything over 6 months, these are the avenues that are being used to create that contingency requirement for short-term call of money—arbitrage and equity savings, because at least post-tax, there are a lot more efficient than a liquid fund is.