Diligence more than liquidity shall drive re-rating of small and mid-caps.

A series of developments over last two weeks starting with SEBI prescribing exposure limits for mutual fund schemes to the recent furore over a mid-cap OFS got me thinking about how the retail investors can stay protected from the volatility thats inherent to this universe and yet benefit in long term.

Active investing outside of the leading 50 companies which make up the index requires significant efforts and diligence. It is not everybody’s cup of tea and thus its best to invest through decent sized mutual funds schemes which can offer compounding over a long period – rate of compounding though is individual’s choice based on risk appetite and this has given rise to myriad schemes across different capitalisation and sectoral themes. What has been observed over time though is that most of these mutual fund schemes also tend to have outsized allocation to top names – partly due to limited investible opportunity they see in such universe amongst many other genuine operational and structural challenges. This has led SEBI to nudge AMCs to review and restructure their schemes to adhere to the prescribed asset allocation norms and rightly so I believe.

However, there is a segment amongst us who is just waiting for any news to pounce on the opportunity – there were sudden euphoria around how the small and mid-cap stocks will get re-rated as more liquidity starts flowing into these segments. Lets be sure that it was not something that SEBI intended as subsequently clarified and nor would smarter asset managers follow blindly – thus its important to show allegiance to long term performance and actions of fund managers. Infact, it is this approach of cloning-sans-questioning for quick gains that perpetrates extreme volatility in small and mid-cap stocks. This leads me to cover the second news which caught my attention today.

This is about a mid-cap entity GMM Pfaudler whose market cap doubled over last six months – possibly much to the surprise of the promoters themselves who are satisfied with partial stake sale at half the peak valuation only. There is buzz on the street about management not confident of future of the company, allegations of distrust in their actions, and the stock not worth the rich valuations it traded at recently etc. While I do have concerns about management’s approach but on the aspect of rich valuations – that’s something which investors themselves doled out and should have asked before investing at a PE of 120+ .

The genesis of these problems typically lie in following herd mentality for quick gains. If we look at the shareholding pattern, it has largely remained unchanged except for some purchases by DII and FIIs which possibly triggered the rage amongst investors to amass a fortune before they run out of luck!

Shareholding Pattern – GMM Pfaudler
%Jun 2018Sep 2018Dec 2018Mar 2019Jun 2019Sep 2019Dec 2019Mar 2020Jun 2020
Promoters 75.0075.0075.0075.0075.0075.0075.0075.0075.00
FIIs 0.380.330.330.330.370.320.340.270.87
Public 23.5523.5623.5723.6123.2122.9122.7922.6122.03

Though this seems like a well managed company with long track of profitable growth, strong market share, sectoral headwinds, no debt et al but there is a price cap beyond which an investment does not make sense, more so for the quick returns. Even in case of GMM, given the established track-record and industry tailwinds, the valuation should catch-up with fundamentals over medium term but in the interim it exposes to execution risk and no upside. Cloning, following smart money or herd mentality – whatever name you call it – requires self diligence else its just another form of gambling!

Infact the classic example of herd mentality that I witnessed in this case was of benchmarking the competitors valuation to this fail-proof valuation of GMM. HLE Glascoat, a smaller competitor of GMM, trading at 800/ share (PE of 25-30x) till mid June 2020 started to follow the same tracjectory as GMM – articles and media clamour about how can the two entities in similar business be so different in valuation and people who missed the GMM bandwagon earlier jumped onto HLE pumping its price up as well. Now as GMM has started to crack, HLE is taking a similar course hitting the lower circuit. Had it not been for the unwarranted exuberence earlier, HLE price should not fall due to a company specific event of a competitor!

As regards to the actions of the management of GMM with respect to its OFS and the transaction with parent company – I believe management would have followed requirements in terms of disclosure and diligence but where probably it lacked was in terms of transparency. The management guided about its intent to buy the stake in holding company, restructuring of the group at global level and how GMM would fund this acquisition in August 2020, but it fell short of being transparent about the exit of ultimate promoter from GMM and the upcoming OFS. All this was part of one single transaction and ought to have handled that way though pricing of the OFS is not something that they can control but is essentially market dictated – who would like to leave money on the table for the other. Though the allegation about transactions in SLB market is a matter of concern that regulator should look into.

This is yet another anecdote where the irrational exuberance has not only caused losses to investors but led to mistrust in management which so far seemed to be delivering well and going against the SEBI’s ambition of making small and mid-cap universe more investible.

#questioningovercloning #investinglessons #riskv/sreturn

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