Look at SEBI’s notification. I will not call it as a directive, but it is more like an alert that smallcap fund managers need to be careful, they need to have a mechanism in place, how will they deal with risk. How would you read into that notification or that alert from SEBI?
Feroze Azeez: Yes, that was written to AMFI and AMFI in turn wrote a letter to several asset management companies being a distributor, we got a hand on it. I see that as a great caution, point one, but I would not see that in isolation. Like yesterday, NSE released its rejig of all its indices. I may be wrong, but they have moved from market cap mechanism to free float mechanism. So, point one is SEBI is not doing one thing in isolation.

They have also written to exchanges, I would guess, because if there is a certain method of index creation, indices creation has withstood the test of time and then suddenly move from total market cap to free float market cap, that is a great move in conjunction with SEBI’s letter to asset management companies through AMFI that is point one.

Point two, now they have made 34 changes instead of their limit of 25 changes yesterday night. So, there has been a lot of rally because there is liquidity chasing of fewer stocks with lower free float. So, I think that is how I would see it. But the letter of AMFI to asset management companies reads, the second point seems a little more worrying for me, which says that people should not have a first mover advantage for an exit.

I do not know how AMCs would react to that. But I think if individual investors bought a scheme with a fair understanding of how easy he can get out, if you restrict that person’s exit by changing the rule midway in the game might have a larger collateral damage in terms of sentiment.

But how will it work? I mean, to put it very simply, if you have to redeem a unit, you have to take an application, get it endorsed and that day’s NAV is applicable. Similarly, you can go online and redeem your unit before the cutoff time and you will get that day’s NAV. So, in totality, how will this process be implemented?
Feroze Azeez: Yes, of course, like you rightly said, when business is as usual, I could access my money with whatever the corresponding exit loads exist but there have been instances of restricting flows in the past. There are provisions like, if I remember right, in 2008, FMPs used to be liquidatable, but there was a directive where FMPs which were bought from a perspective of an exit possibility, were locked-in as well. We also saw some cases during adverse situations, a fund has the provision to put a stop to redemptions. I do not think it will get there but it is each asset management company’s reaction to that second point. I think exit load changes could be there with a six-month window for a person to act because that is also a provision if you make any changes to the KIM, you have to give a person six-month window or one-month window to exit if he does not like the new rule.As a percentage of the total AUM which you are advising, how much is in smallcap, how much is in midcap and are you consciously looking at advising your clients that, look, the risk-reward ratio is not there in small and midcap stocks?
Feroze Azeez: The definitions of smallcap as a word may have not changed, but mathematically they have changed. To answer your pointed question, we have gone long on smallcaps from 5-7% as implied exposure in our model portfolio to almost about 27%. We want to book profits anywhere in the next one-two months from one or two schemes of smallcap because that has generated about 55-60% absolute return and about 30% alpha over Nifty for this year, so we may reduce in the month of March, point one, but not from a huge fear perspective.

I think it is always good practice if you go right too soon you should take some money off the table, that could be the sentiment. But having said that, I think the smallcap index has gone through some changes. The largest weight of the smallcap index yesterday has moved to midcap which is Suzlon Energy. If you look at the index of 250 stocks and look at its earnings, the earning estimate for the 250 stocks weighted average, according to us, is Rs 670. The price is about Rs 14,800 odd. So, we are looking at an index level of only 22 PE and Nifty is at 21 PE.

The devil again lies in the details. There are stocks with 10 PE in the index. There are stocks with 100-150 PE in the index. So, I think that the name of the game is going to be far more detailed and every fund manager has the provision to have 34%, 35% outside the smallcap universe which is defined differently than the index. So, there is going to be an evolution. That is the process of a market becoming more mature.

Do you think that in large part these restrictions are being imposed because large mutual fund ownership in low free float stocks can create liquidity issues and largely SEBI wants to determine how much illiquidity is there in the market?
Feroze Azeez: Yes, when we did a study in terms of impact of liquidity on different stocks, free float is a very strongly correlated variable. If there is a lower free float, the same amount of money results in a larger rise. If you look at the delivery as a percentage of market cap and then compare with the free float stocks, that is a very good ratio to see whether free float is something which moves prices up. If the free float is just 10% and money is chasing it, on a given particular day there are sellers who are not going to come out of the 10% smaller universe out of the 100% ownership.

So free float is a very important variable and we have checked the correlation between free float and the liquidity chasing up or down the prices of a stock and I am very excited that yesterday, of course, a preliminary judgment of mine – move from total market cap to free float – which is the most sensible way of doing it and that is how I think the foreigners do it . MSCI index of the smallcap has 467 stocks, if I am not wrong, give or take, that is an arbitrary number 467, so I was very intrigued to understand their methodology, because all our indices have a round number 50, 150, 250. But Morgan Stanley had 467. So, they go by free float and not by the number of stocks which they want to have in an index.

Looking at a notification or perhaps alert, I am using the words consciously because it is not a directive. We must make it clear for our viewers. It is not an order. It is an alert and it is a notification which went to AMFI, AMFI wrote it to AMCs, AMCs and distributors have it. Do you see a conscious change in sentiment that if you are an investor in smallcap stocks or a unit holder of small and midcap funds, could there be panic on the news? Could there be a change in mood and orientation towards small and midcap stocks?
Feroze Azeez: Not so much. Of course, it dents marginally for a few days. But I do not think it can materially change because SEBI is looking out for the investor. At the end of it, if somebody read the essence of it, they do not want volatility for the investor and that is what the investor wants himself. So, I do not think there is a reason to panic and I do not think people read too much into it, because there are other news which come subsequently which distract them from it. I think it is a great move from SEBI that you have always as a regulator be a little more cautious because the mutual fund investor is not prepared for underperformance.

But having said that, I am sure SEBI recognises the fact that there was four-five years of underperformance in smallcaps and that was the catch up which some smallcap indices were doing. If you look at a large Nifty stock at 80 PE which has a potential to grow at 8-10-12% but another 50 PE stock in the smallcap index which has the potential of growing at 20-25%, I would still, in the life of holding that stock for four years at a purchase price I might have a PE in single digit and that can grow at 25-30.

So, there is potential for several businesses and I really hope this directive improves the research from the institutional research desk. We are a very under-researched capital market. We might have the largest number of listed stocks, but institutional brokers do not cover as many stocks as a country like India merits.