The high volatility in markets over the years has shaped investor behaviour into a mix of caution and expectation. The primary interest of investors today lies in safeguarding their assets, while getting stable returns in the long term. It is quite rare to find Fund Houses who capture such interests before prioritising their own objectives. Peerless Funds Management Co. Ltd, a subsidiary of The Peerless General Finance and Investment Company Limited (PGFI), founded in Kolkata, aims at creating long term value for its investors by betting on safer options that minimise future loss of capital and generate stable returns at the same time.
We interacted with Amit Nigam, Head – Equities at Peerless, to discuss the philosophy behind the only equity scheme in Peerless’ bag of funds - Peerless Equity Fund. Previously, Nigam managed equity portfolios at BNP Paribas Investment Partners, BNP Paribas Mutual Fund and SBI Mutual Fund.
Our conversation began with Nigam discussing how we can identify whether a business is financially sound or not. At Peerless, the most important factors indicating the financial health of a business are the Returns on Capital Employed (ROCE) and Cash Flows from Operations (CFO) in case of manufacturing businesses. While for other sectors like Banks and NBFCs, Return on Equity (ROE) and Return on Assets (ROA) solve the same purpose.
Further, he explained the process of picking the most suitable stocks. The first step is to filter out relatively smaller businesses in terms of their market capitalisation. This implies that only those companies which have a market capitalization of more than ₹1000 crore proceed for further analysis. Nigam believes that at this stage, the company/management would have already gone through many hurdles along its growth path. Such companies would have a higher probability of having systems and processes in place while conducting its business. Also by virtue of size it would have better financial strength to face competition.
Once companies pass the market capitalisation test, Nigam evaluates the financial health by performing a quantitative analysis, using ratios like ROCE and CFO over the last 15 years. He believes that this is a long time line for the management to have witnessed the up and down cycles of the business. For manufacturing businesses, an ROCE of 20% or above is considered ideal. At such ROCE levels, he believes that not only both sources of capital providers – bankers and shareholders – are adequately compensated but also the surplus – returns in excess of the cost of capital (usually at around 15%) – allows the management to reinvest the surplus back into the business. This is now regarded as a self-sustaining business model.
Nigam also shared examples of businesses wherein a majority of sales tend to remain as accounts receivable for an extended period of time. This is considered as a negative indicator due to the poor nature of cash flows. As a result, the next important indicator for the Fund Management team at Peerless is Positive Cash Flows, as they guarantee stable returns moving forward and in turn help in maintaining the desired ROCE levels.
As Banks and NBFCs are usually highly leveraged, their cost of capital is comparatively lower (around 12%). Hence, the required level of RoE and RoA is 15% and 1% respectively.
To implement this process, Nigam has devised PSFS (Peerless Score of Financial Strength), a score attached to a particular company based on the returns/ cash flow generated over the last 15 years. For each of the 15 years, a company clearing the above explained threshold in that year would earn a score of 1 and likewise get scored for all 15 years. In this manner, a company can amass a maximum score of 30 (2 parameters each scoring 15/15). This would imply that a manufacturing company has had an RoCE exceeding 20% and has also been generating free cash flow for each of the 15 years, or a financial company has had an RoA greater than 1% and RoE greater than 15% in each of the 15 years.
Once all companies with a market capitalization greater than ₹ 1000 crore are scored on the basis of PSFS, they are ranked in a descending order. Companies that are part of the top 40th percentile are considered for further examination.
The next and final step is a Subjective/Qualitative method that determines whether the company can sustain the current ROCE/ROE/Cash Flow levels in the foreseeable future. This demands keeping a track of the business and the changing dynamics of the industry. Also what is extremely important is the character and conduct of the management, along with the Corporate Governance system followed by the company. Companies that score low on Corporate Governance fail to bring a sense of reliability in the long run and thus, are filtered out from the stock selection criteria.
Nigam strongly believes that it is better to be safe than sorry when one manages money on behalf of minority shareholders who in turn have invested their hard earned money with the mutual fund.
The discussion concluded with Nigam describing Peerless Equity Fund’s portfolio, which consists of 30-35 stocks and is diversified with no bias towards any particular sector or market capitalisation. He prefers to pick companies using a bottom-up approach, while determining their weight in the portfolio by using various techniques to gauge their valuation gap.
The change in the fund management team at Peerless Mutual Fund led us to have a conversation with Nigam to understand the philosophy and processes involved in selecting stocks. We believe that if the fund management team is able to meet investor expectations in line with their transparent processes, then it is only a matter of time before their equity fund starts climbing the AUM curve. However, we feel that the fund house needs to be more active on the equity side by launching further open-ended equity funds. A vibrant fund management team along with a well formulated investment philosophy should help in making Peerless Mutual Fund an active equity player.