'Volatility is a friend'

When you said 'emerging businesses', what kind of businesses were you interested in? Which ones would you avoid?
The name 'emerging businesses' has a legacy issue. The fund has been run as a concentrated-conviction multi-cap portfolio, which now comes under the focused-fund category of the new SEBI classification. Accordingly, the name has been changed to SBI Focused Equity Fund.

So that's the reason why you have a concentrated portfolio of 27 stocks?
Yes, it's by design. By the way, 27 is not concentrated. There is enough evidence out there that proves that diversification benefits peter down significantly beyond 20 stocks.

What has resulted in the outperformance by this fund in the last one year?
The top five performance contributors for the last one year were Divi's Labs, Gruh Finance, P&G Hygiene, Westlife Development and Elgi Equipments, in that order. These have been the key holdings for a long time. Divi's had the benefit of a base effect.

How do you pick stocks for this fund?
We are looking for three characteristics: a great business, a great management and a great price. Imagine the different types of philosophies that investment managers run. You have growth, value, momentum, top-down, bottom-up, contrarian, quant, arbitrage, activist, market timing, special situations, large cap, small cap and what not. By staying focused on just three characteristics, we automatically choose not to do a number of the above.

What defines a great business? For one, it needs to have some kind of competitive advantage. Two, it needs to or needs to be able to generate a reasonably high return on capital. Three, it has be scalable. To be able to generate high returns on capital and at the same time grow at a fast clip is like the best of both worlds, like having the cake and eating it, too. Four, low capital intensity. Five, high cash conversion. Six, pricing power. Seven, longevity, etc.

Managements can be cross-referenced for integrity, capability and vision through their track record. Look for transparency, accountability and clarity of thought. A good price is something that gives you a margin of safety. That is not only in terms of P/E and P/B ratios but also in terms of the stability of the business model and the earlier factors put together.

We think of these not in black and white but in different shades of grey. You will never get the ideal condition. It's about weighing the different variables for their intensity or closeness to where you want them to be and choosing the best combination.

When do you sell a stock?
One, when our investment thesis goes for a toss. Two, when we have better stocks to buy, given we follow a conscious concentrated strategy. And, three, when it is way beyond our target price.

How do you contain volatility?
We don't! Volatility is a friend; we try to use it to our advantage.

How are mid and small caps placed post the recent correction?
It is always a good time to be in mid and small caps.

Large caps are defined as the top 100 stocks in terms of market cap. Everything else then becomes mid and small caps. That's some 5,000 odd companies, of which around 3,000 are traded. If you want to build a 25-30-stock portfolio, what are the chances you will pick from here! On top of that, isn't this the only space where you can expect some research arbitrage - that from just being there without having to be smarter than the rest of the market?

There is also an average fallacy inherent in this question. Mid and small caps are not a homogeneous group with analogous properties. There are good mid/small caps and there are bad mid/small caps - maybe more bad than good. But, then again, there are more good mid/small caps than good large caps. How many do you need, anyways? The one big risk is the lack of liquidity.