Future returns from mid-caps will be less than before: Sanjay Bakshi




Well-known value investor Sanjay Bakshi, 50, is an adjunct professor at the Management Development Institute, Gurugram, where he teaches behavioural finance and business valuation. He is also a managing partner at boutique investing firm ValueQuest Capital LLP. As an investor for the last two decades, he has seen the market over several cycles. His investing style focuses on identifying companies with durable competitive advantages and staying with them for the long term, he tells Forbes India in an interview. Edited excerpts:

Q. Has the present outperformance of mid-cap stocks surprised you?
I am a student of financial history and anyone who has studied it shouldn’t be surprised. Situations like this are not uncommon at all. For new investors and for those who don’t read history, it would be a surprise because all this is new to them. 

Q. Could you point to similar instances in the past?
What I meant was that there is always some pocket of the stock market which is experiencing optimism and that sometimes becomes over-optimism. This is not physics, so there is nothing like the law of gravity which says exactly when a drop will happen and at what speed. There will always be pockets—it could be sectors or specific market capitalisation segments—that will enjoy periods of popularity which will be reflected in market valuations. In this particular instance, it’s mid-cap stocks, as a group, that are more popular than large-cap stocks. There are some great businesses in the mid-cap space but, as a group, mid-cap stocks are far more optimistically valued today than in the past 15 years.

Q. How would you compare the present mid-cap run to the one between 2004 and 2007?
I am making a larger point here. This is not about mid-caps in 2004, 2007 and now. This is the fact that there are always some areas that get popular. Usually, this happens for very good reasons. In this particular instance of mid-caps, the good reasons are higher growth rates in earnings for those businesses as a group, their higher returns on capital employed, their strong balance sheet qualities and their relatively low multiples a few years ago. In contrast, as a group, the large-cap businesses have delivered poor returns on capital, the decline in earnings, poorer balance sheets and much higher relative multiples a few years ago. So, it’s not surprising that mid-cap stocks have massively outperformed large-cap stocks.

But the market is like a pendulum. It goes to extremes. Good ideas tend to get overdone. This is what we are experiencing now as well.

Q. You’ve written in the past that exiting a stock simply because it has gone up is a mistake. Could you explain that thought process to investors?

We are operating in one of the world’s most rapidly growing economies and businesses are nowhere close to saturation. You only have to go to the US or Europe to see how businesses are struggling to grow. For us, a 5 percent or 6 percent growth is a slowdown. We have a lot of growth to see and our businesses have very long runways of future growth ahead.

Businesses that can deliver growth without stretching balance sheets and without taking in more capital (through the issuance of new equity shares) and where the quality of growth is excellent in terms of incremental returns on capital—they will increase per share value for stockholders over the long term. That potential growth in value is sometimes mispriced by markets even if the stock has appreciated a lot already. Under those circumstances, it would be a mistake to sell. You shouldn’t look at how much money you’ve made, but look at the potential value of the business 10 or 15 years down the road and then take a decision.

Q. While analysing a mid-cap company, how much emphasis would you place on things like the vision of the entrepreneur and the management quality?
A lot. That’s because, all other things being equal, as a group, smaller businesses are riskier than larger ones because they are a lot more vulnerable to economic shocks and so excellent, conservative management is a must.

Another factor is that large businesses are usually run by professional managers even when they are controlled by families, while smaller companies are run by owner-operators. This factor could either be a plus or a minus. The great compounders in the mid-cap space are owner-operator-driven where the person is ethical, focussed, has a growth mindset and is not a gambler. He can take calculated bets but he won’t bet the company on a single idea or borrow like crazy. They have what [author] Nassim Nicholas Taleb calls “soul in the game”. But there are also companies that are run by fly-by-night operators who don’t care about minority shareholders. One must avoid those. But, as a group, owner-operated businesses tend to deliver better long-term returns for stockholders, than professionally managed businesses. 

Q. As a mid-cap investor, how do you deal with shocks or sudden falls in the market?
I’d like to think of it in the context of ‘staying power’. If you have invested in a business that doesn’t have staying power because it is highly-leveraged or is a high-cost player in a cyclical industry, it may go bankrupt when the cycle turns. And one should also think of the investor’s own staying power: Are you investing your own money or other people’s money? Are you borrowing to invest? Do you really need the money in the near term? People invest money they would need in the next six months into the stock market and that is a huge mistake. That money doesn’t really have staying power.

If you and the companies you invest in both have staying power, you can ignore the market. The crashes should be used as an opportunity to buy if you have cash and should be ignored if you don’t.

Q. With a large number of mid-cap funds today, has the market for such stocks become more efficient?
Absolutely. Ten years ago many funds would not look at this space. The reason why mutual funds have launched mid-cap schemes is because they can raise money for them. People chase performance and it’s easier to raise money for a mid-cap fund today than for an infrastructure fund. As a result, past inefficiencies because of small size or obscurity have largely disappeared.

Q. Has it, therefore, become harder to find the bargains you could find 10 years ago?
Naturally. It is more likely that you will find bargains when you buy stocks at three times earnings than when you buy them at 20 times earnings.

Q. Given that the mid-cap index is pricing in a lot of future growth, would it be fair to say that future returns could be a lot less than those in the last three years?
I can say with certainty that compared to the past, the returns will be lesser for mid-cap stocks, as a group. There might be exceptions. Entry multiples are an important factor in future returns. Returns comprise dividends and capital gains. So you have to consider entry multiple, exit multiple, earnings growth and dividend. If you keep everything else as same and raise the entry multiple, the returns compress. It’s simple math.

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