WF: What are the most important filters you use to make your initial short list of stocks from the large universe of mid and small cap stocks?
Anand Radhakrishnan: There are various quantitative parameters, the first one being the size factor itself. We tend to gravitate towards some reasonable size in terms of sales, operating profits and net profits. Then there are profitability related filters which includes return on equity, RoCE and so on.
The most important filter to us is more qualitative where we look at quality of the business and see whether this business can grow materially over the next 5, 10, 15 years. We try to assess whether that company is sufficiently differentiated from its peers if it is in a competitive business or has got no peers as it is operating in a niche which others would find it tough to attack, and so on.
While quantitative filters are easy, qualitative is much tougher. Our ability to visualize the size of the opportunity, our conviction in visibility of growth, our assessment of competitive advantages of the company and the sustainability of such competitive advantages, our sense of the management's ability to respond to dynamically evolving business conditions - all of these help build conviction in a stock, beyond what the quantitative parameters tell us.
WF: How useful is sell side research in identifying new ideas in the mid and small caps spaces? How much reliance can you place on sell side research?
Anand Radhakrishnan: Sell side research has certain constraints. Brokerages usually initiate research into stocks where they see transaction opportunities. They would look at market making or broking business or investment banking business as the way in which they justify the efforts put into research. This limits the scope of their research.
Our perspective is different. We look primarily at the quality of the business, and are not concerned about transaction opportunities for intermediaries in the stock. If we like a business, if we are convinced about the long term prospects, we are happy to be patient investors for the time that it takes for liquidity to develop in the stock, as the story evolves.
Sell side research helps us vet our own investment thesis and is a cross check for us to ensure that we have looked at all angles of a business. But we do recognize that the perspectives of sell side and buy side research are different, and we keep that in mind when considering sell side research.
WF: It is said that quality of management is one of the most important determinants when considering a mid or small cap stock. Given that this is rather subjective, how do you assess management quality?
Anand Radhakrishnan: There are many dimensions to an assessment of management quality, the most important being that it is not a binary assessment - its not a simple good vs bad - there are many shades in-between, which requires a deeper judgement call.
We try to assess whether the management is excited about the business and are growth hungry. Some of them are just happy to run it the way it is, without much growth ambitions - which may be absolutely fine for them, but not for us as investors.
Once you have identified a management which is excited about their business and is growth hungry, you also need to assess whether they would be able to grow without significantly diluting the equity. If growth ambitions are so high that they would constantly dilute you out, that's not good for an investor. If growth ambitions are moderate enough to enable them to grow within their means, or in a marginally dilutive manner, that's better for us as investors.
Third aspect we try to assess is the willingness of the promoters to genuinely share with minority shareholders. We need to judge the ethos and the philosophy of the promoters. Some are listed but continue to be run as if they were privately owned. In such cases, the interests of minority shareholders will always be subservient to those of the promoters. That's not a type of company we want to own.
Fourth aspect is transparency of the management in terms of how proactive they are in maintaining communication with minority shareholders and their willingness to be frank and forthright on business issues, as there always will be dynamics that impact business plans and call for course corrections.
Fifth is financial practices and policies of the company and how reasonable these appear to be. You don't for example want to back a promoter who is willing to bet the house on a single idea. A mature and sensible financial policy inspires confidence.
WF: Liquidity is one of the biggest concerns in many mid and small cap stocks. How do you manage this risk in your mid and small cap portfolios?
Anand Radhakrishnan: Yes, liquidity is a challenge, especially when things start going wrong - either for the market as a whole or for a stock in particular. There are two ways to tackle this. One is to diversify adequately to ensure that you don't create large positions or concentrated positions either in a stock or a sector. For example, while our large cap funds typically have 30-35 stocks, in our mid and small cap funds, we usually build portfolios with 50-55 stocks.
But to my mind, the best defense against illiquidity is quality. If you own a good quality stock, either it is among the first to bounce back on liquidity parameters after the market has seen through a troubled phase, or even in the midst of a challenging market phase, you are likely to find a buyer at a price. Now the price may not be to your liking - but you can find buyers at a price, whereas if quality is suspect, you don't find buyers at any price, when markets go through tough phases. So, maintaining a high quality portfolio is imperative in the mid and small caps spaces.
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