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This strategy is creating many happy investors

KrishnaKumar, CIO - Equities, Sundaram Mutual

10th May 2017

In a nutshell

It's a strategy that many purists frowned upon a couple of years ago - but the proof of the pudding, as they say, is in the eating. Sundaram Mutual has, over the last 3 years, launched 13 funds within its Micro Cap closed ended range and is introducing another of this series this month. Closed ended product construct coupled with a very proactive dividend distribution philosophy means that even as investors remained invested through these 3 years, they have received their capital back as dividends for all funds that are more than 3 years old have crossed 100%. How's that for creating happy investors? Well, that was in the past - but are microcaps worth investing now, at these elevated valuation levels? Check out the data and insights that KrishnaKumar shares as he makes a cogent case for continuing to invest in this very promising space.

WF: What has been the returns and dividend track record of your MicroCap series of closed ended funds?

KrishnaKumar: We have launched 13 funds in this series over the last 3 years and are now launching the 14th of this series. To answer your question, I will take you through the performance of the first 10 - which have completed between 1 to 3 years. Of these, the first 4 are thematically similar - they focus on the MNC space within microcaps, and have completed 3 years. The 3 year CAGR of these funds on average is around 35%, and the last 1 year was around 21%.

Funds 5-10 played the cyclical recovery theme, and have on average, delivered 38% return in the last 1 year. Clearly, in the last 1 year, domestic cyclicals have done better than market, and these funds have accordingly benefitted. In contrast, microcap MNCs - which are broadly in the industrials, materials and consumer space, did very well in the early part of this bull market, before domestic cyclicals took over market leadership.

Our dividend distribution policy has been consistent for this range of closed ended funds through the last 3 years - we look at proactive dividend distribution when fund NAVs are in the 12-16 range. In the first 4 funds of this series which have completed 3 years, we have given over 100% dividends - which means the entire capital has been returned to investors by way of booked profits. In fund series 5, 6 and 7, dividends totalling between 20-30% have been distributed so far - and the focus will remain on regular dividend distribution when fund NAVs are in the 12-16 range.

We understand investors' desire to book profits because profits in the bank account are given far more importance compared with profits on paper, as many investors fret about whether profits on paper will evaporate in a market downturn. What this combination of closed ended funds coupled with a proactive dividend distribution policy ensures is that investors stay committed to their investments, with the comfort that we will proactively look for profit booking opportunities, at regular intervals.

WF: Are your dividends a reflection of rising valuations within the small and micro caps spaces, which is prompting you to actively book profits?

KrishnaKumar: Not really - as I mentioned, profit booking is an ongoing strategy in this series of funds. Out of the 100% dividends paid out in the first 4 funds of this series, only 15% has been paid out in CY17. Every year over the last 3 years, dividend paid out has been in the region of 20-25%. So, its really got nothing to do with current market valuation levels.

WF: You are launching a new fund within your MicroCap series at a time when valuation concerns in this space are quite high. What is the rationale for this product launch at this time?

KrishnaKumar: Yes, I understand there is a lot of talk around valuation bubble in small and mid caps, especially when one looks at segment indices. Indices have many underperforming companies which are still struggling to come out of the rough patch of recent years. If you simply remove all the negative EPS companies from these index PE multiples, and then consider average PE multiples of companies making profits, you will get a much clearer picture of the actual valuations in the set of companies we consider. Our focus has always remained bottom up and we look at this fund series as absolute return products.

Secondly, PE based on historical profits is perhaps not a good metric at a time when you are expecting a robust turnaround in earnings after a prolonged slump. If you take Bloomberg consensus earnings estimates for FY18 and FY19, and then look at valuations across large, mid and small cap indices, here is how it looks:


On a relative or absolute basis, you can see that the SmallCap index - which is the closest proxy for MicroCaps, is not looking stretched from a valuation perspective.

We have around 45 stocks in our MicroCap series of funds, all of which are bottom up picks based on high conviction in their growth prospects. If I look at the PE for this universe, it stands at 17.5X FY19 earnings forecast - which is a tad higher than benchmark valuation. However, earnings forecast for our universe of 45 stocks is very robust at 31% for FY18 followed by 28% for FY19. So, as you can see, the premium in terms of valuation is more than justified by higher growth prospects.

The domestic recovery story continues to offer many opportunities from a bottom up perspective in the micro caps space, and that is what we will focus on in the 14th edition of this series.

WF: What themes within the micro caps space look attractive to you and why?

KrishnaKumar: While the overarching theme will continue to be domestic economic recovery, GST implementation and demonetization have catalysed the move towards organised sector and the squeezing out of the unorganised sector. This is incrementally throwing up interesting opportunities across several sectors within the micro caps space, which will be a key focus area for us.

There are three specific themes we are very optimistic about within the broad domestic recovery play:

Infrastructure: Government spending and focus on roads, ports, metros, water supply, urban infrastructure and affordable housing offer many investment opportunities across asset owners and asset builders.

Rural value chain: Substantial increase in farm income is a key political priority for this Government in the run up to the 2019 elections. Budget allocations towards crop insurance and irrigation, and policy moves to enhance better prices for agri products for farmers are all steps in this direction. We see rural consumption picking up appreciably over the next 2 years as a consequence, with greater delta in the discretionary space. Consumer durables, automobiles, auto ancillaries, lifestyle products, entertainment - all of these segments which cater to the rural population can see strong growth.

Financial services: All of us are familiar with the under-penetration story and the rapidly changing profile of household savings, away from physical and towards financial assets. This represents huge opportunities for lenders as well as wealth managers of various kinds.

Apart from the domestic recovery story, there is also an encouraging trend in pick up of global growth, which augurs well for textile and engineering exports.

WF: What is your overall market call for FY17-18 and what do you see as the key drivers?

KrishnaKumar: I think the much awaited inflection point in earnings growth is finally here. The 3rd and 4th quarter earnings growth should be much better and the stage is now set for an 18-20% earnings growth over the next 3 years.

Job creation from higher construction activity, revamp of MNREGA program and higher farm incomes are all positive for spurring consumption. I don't think we should expect any significant pickup in corporate capex for the next 2 years - but earnings growth should be on track despite this.

Recent efforts towards NPL resolution should be positive for banks, which in turn will set the stage for the next credit cycle.

Domestic investor interest in equities continues to be strong, which will support equity markets over the medium term. This, coupled with sustained FII interest in the India story, should keep demand robust for Indian equities.

We therefore remain very positive on the medium term prospects for the Indian equity market and would advise investors to remain well invested in the India story through equity funds.

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