Sundaram SMILE has put a big smile on investors' faces this year, after a disappointing 2013. KrishnaKumar takes us through what went into the performance turnaround and recent changes in portfolio strategy aimed at maintaining its winning momentum. He also shares his perspectives on the road ahead for mid and small caps and asserts that one should not underestimate the power of operating leverage on profitability - a factor that he sees will drive earnings upgrades for mid and small caps, and thus make valuations attractive even after the recent run-up.

What do percentiles and their colours signify?

Fund performance is typically measured against benchmark (alpha) and against competition. Performance versus competition is measured through percentile scores - ie, what percentage of funds in the same category did this fund beat in the particular period?

If a fund's rank in a year was 6/25 it means that it stood 6th among a total of 25 funds in that category, in that period. This means 5 funds did better than this fund. In percentile terms, it stood at the 80th percentile - which means 20% of funds did better than this fund, in that particular period. If, in the next year, its rank was 11/26, it means 10 other funds out of a universe of 26 did better than this fund - or 38% of funds did better than this one. Its percentile score is therefore 62% - which signifies it beat 62% of competition.

Most fund managers aim to be in the top quartile (75 percentile or higher) while second quartile is also an acceptable outcome (beating 50 to 75% of competition). What is generally not acceptable is to be in the 3rd or 4th quartiles (beating less than 50% of competition). Accordingly, we have given colour codes aligned with how fund houses see their own percentile scores. Green colour signifies top quartile (percentile score of 75 and above), yellow or amber signifies second quartile (percentile scores of 50 to 74) and red signifies 3rd and 4th quartile performance. A simple visual inspection of colour codes can thus give you an idea of how often this fund has been in the top half of the table and how often it slips to the bottom half. A great fund performance is one which has only greens and yellows and no reds - admittedly a tall ask!

WF : Your fund is the No.1 performer this calendar year in the midcaps segment, which is a huge focus area in the MF industry right now. To what would you attribute this commendable performance this year?

KrishnaKumar : The fund was clearly positioned to play the impending economic recovery with significant over weights in industrial, infra, construction auto, cement & financials. Stock selection is more bottom-up and we saw huge under valuation in many small cap stocks. We clearly played this valuation catch up that happened as investors re-balanced their portfolios to cheaper cyclicals when growth visibility improved for them.

WF : A look at the longer term performance analysis suggests that your fund does better than most (top decile performer) when markets are rising rapidly (2007, 2009 and 2014), does reasonably well (2nd quartile performer) in reasonably good market conditions, but performs much worse than competition (4th quartile) during bad market phases. Is this a fair comment? To what would you attribute this kind of a performance history?

KrishnaKumar : Clearly the years you have mentioned are years where market were at inflexion points, which points to the fact that we read the up cycles pretty well. During downturns which can be event triggered like Lehman or 2G scam, the fund by its mandate, being in small and midcaps, tends to get hurt from a significant shrinkage in liquidity and investor interest in the small end of the market. There is very little that one can do in these extreme conditions in a small cap fund.

WF : Some experts believe that midcaps have now caught up with largecaps in terms of valuations. From hereon, what is the central investment thesis for midcaps?

KrishnaKumar : I will not agree with that view as small and midcaps still are undervalued relative to large caps. Investors generally tend to underestimate the power of operating leverage on profitability. I expect earnings growth estimates of midcaps to be continuously revised upwards in the next 6-12 months which will spur further returns. Higher growth, valuation re-rating driven by investor interest is the way forward in this segment.

WF : Which sectors within midcaps appear most promising right now?

KrishnaKumar : As explained earlier, the cyclical sectors will benefit most from the economic recovery. Further policy initiatives of the new Government could revive the broken investment cycle and help improve the banking sector prospects. Exporters across sectors seem to have good tailwinds from currency & global demand.

We like financials, auto component, cement and capital goods sectors in the midcap space.

WF : What are the significant changes you have made in recent months in your portfolio strategy and positioning?

KrishnaKumar : Going down the cap curve to derive benefits of a valuation re-rating and sharper growth has been done. Further we have added significant bias to the positions in the sectors like financials, trucks, auto components, housing & textile exporters. Stocks like Andhra Bank, Indian Bank, GIC Housing, Mahindra CIE, Wabco, LGB, Ashok Leyland, Himmatsingka have been added.

WF : What are the key risks that investors should be aware of when investing now into the market?

KrishnaKumar : There could be short term risks like the Iraqi crisis, deficient monsoon etc which could affect the pace of recovery and dilute the new Government's measures to push up growth and manage inflation expectations. Any corrections however should be viewed as an opportunity to invest into the equity markets with a medium term perspective.

Share this article