Background:

The role of regulators in any part of the world should be to pave way so that fair play is assured for all market participants. It is completely undesirable for the regulator to create situations where their selected stocks are chased or their prices move in one direction irrespective of factors that influence such movements, in normal course. The case in point is SEBI’s 2017 directive to MFs to rejig portfolios based on SEBI’s classification of what constitutes Large Cap, MidCap and Small Cap stocks. One will probably be at loss if he attempts to find out such inferences from any commentary on equity markets.

Fund managers at MF’s AMC are accountable to investors with their performance of investing pooled money in right stocks. If directions on where to invest come from people who are not in the forefront, with practically no responsibility, fund managers will have to choose between devil and deep sea. More so, when such instructions question the very foundation of investing principles being followed. SEBI may justify their stand saying that MFs have been resorting to bad practices of naming schemes as Large Cap while the actual investment is going into Mid Cap or Small Cap stocks. As a responsible regulator, inflicting damage to the whole MF industry directly and affecting the overall market indirectly, SEBI ought to have foreseen possible negative consequences. In these days where RBI also have MPC set up to decide on key issues of monetary policy, it is only fair to expect a powerful regulator like SEBI to seriously consider views from market participants.

SEBI classified stocks based on Market Capitalisation!

SEBI arranged all stocks based on their average market capitalization in preceding six months and then started calling top 100 as Large Cap and next 150 as Mid Cap. All other stocks are termed Small Cap. As a result of this approach, many a stocks can move up or down from their groups, not based on their operational performance, but based on market dynamics. Those who are on the border have a big incentive to push their prices up because many MFs will have your stock included in their eligible list. A small effort to push price up by a few ticks could help your stock become a sought after stock by MFs which hitherto fore have been forbidden from investing. While it is unfair to conclude that someone manipu-lated, there are always chances of attempts to influence prices which hurts investors more than protecting.

The impact of SEBI directive to MFs:

AUM in equities of MFs has grown from 5.90 lakhs crores in 2017 March to 8.93 Crores by 2020 March, despite a big correction in the month of March 2020. In value terms, corpus has grown up by 51% in this period. However, on analysing the MF holdings data between periods of 2017 March and 2020 March, we noticed that MFs have more than doubled their investment in the shares from SEBI list. Number of shares held in SEBI list went up by 120% from 2017 March levels.

Because of recent drop in prices, the value of MF holding in SEBI latest list of 250 has gone up by 67% only. In the same period, number of shares held by MFs in other companies outside SEBI list have gone up only by 19.84% in three years. Worse still, the value of such holdings was markedly down by negative 26%. If the stocks in SEBI list have performed exceedingly well in these periods, it would have been justified. To comment on this aspect one needs to study the operational performance in detail.

Operational performance of stocks:

We have carried an extensive analysis of data spanning from 2003 so as to include all phases of markets, be it bullish or bearish or sideways. SEBI’s idea to influence MFs investment philosophy has hurt almost all classes of investors very hard. SEBI’s top stocks also bore the brunt of attempts to delink operational performance from Fund Manager’s prime criteria and natural choice of stock selection. The facts are glaring to see how good and quality stocks performed before and after this missive from SEBI.

In order to gauge the market response to SEBI’s classification of stocks purely based on market capitalization, we divided all stocks in to two categories. One, that contains SEBI shortlisted stocks and Two, stocks that fell outside the list thus far. We then tracked operational performance of past 3 years and checked out how many of them, at the end of each quarter, improved sales by at least 5% over prior three years(or twelve quarters) and also EBIDTA by 2%. To be more clear, at the end of 2004 March quarter, we picked up data of all companies for the quarter beginning from 2001 June to 2004 March. We compared that data with data pertaining to quarters beginning from 2001 March to 2003 December quarters.

Stocks’ price performance post good operational results:

We covered the data from 2001 onwards and right till 2019 December quarter. Once stocks in respective quarters are identified, we checked how many of them have seen their prices move up by at least 20% in next two years. From the values that emerged, Market clearly disapproved SEBI’s approach, in the sense that profit making chances based on time tested principle of value buying suffered heavily post this event.

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SEBI’s intervention wasn’t welcomed by Market:

Before SEBI’s intervention, stocks steadily doing well in their operations have seen their prices move up steadily too. A overwhelming 86.24% of performers have seen appreciation of at least 20% in next two years. Average of possible peak growth witnessed by these stocks stood at an astonishing 122% in two years, though one’s ability to capture such highest growth points is rare. Stocks in SEBI’s list or outside did not have too much variance in performance, meaning people adopting informed investment decisions were rewarded well. Post SEBI’s intervention in MF approach to investments, Mutual Funds dumped all stocks outside SEBI’s list of 250 causing serious set back to the process of informed buying. Performance of companies seems decoupled from performance of the underlying stock prices. In fact, after this intervention, percentage of stocks appreciating by 20% from SEBI’s list dropped to less than half and stood at 43% from 88% earlier. Stocks outside too fell to 40% but from 72% earlier. Moves like this will put a question mark on valid approaches to right way of investing. Suddenly all fund managers known for their evaluation of balance sheets and operational performance, for past several years or decades, have been subjected to investor wrath, for no fault of theirs.

Markets remain resilient, despite unwarranted interventions in between:

From values given above, it is established that value buying has no merit in investments, whenever external factors attempt to vitiate the price discovery process. Today’s Large caps were midcap stocks some time back and probably even penny stocks if you go further back in time. It is the operational performance that ought to attract the investors instead of size of the company. If we brand only large companies as good and worthy of buying, interest in capital market will dry up sooner than later. Many entrepreneurs will lose interest to have their companies listed in market for the fear of being overlooked for many years with this flawed approach of MFs being directed to invest predominantly in stocks that enjoy largest market capitalization.

Fortunately, when regulators’ moves or external factors disturb the natural process of price discovery, market has its own way of addressing them to bring back value buying into the fore. Though MFs have no choice but to strictly adhere to SEBI’s arm twisting direction to load their portfolios with top 250 stocks, lately they have been coming out with Schemes meant to provide them freedom to chose the value stocks circumventing SEBI’s direction.

We have seen mushrooming of schemes that are classified as Market Cap or multicap so that they will have wider choice to pick from stocks that are valued too low. In the last 12 months, only 40% of fresh money subscribed to MFs was for schemes focusing on stocks listed by SEBI. That is to say, close to 60% of the money raised by MFs is free to be deployed in any stock that has proven merits. Hence, it is only a matter of time before such under valued star performers surge upwards at the first sight of normalcy in our economy.

What future holds for investors:

However, investors normally will have long learning curve and by the time they realise that impact of ill advised direction has lost its relevance, many stocks may have gained their fair price leaving very little upside. If another regulator comes up with some other strange direction, just because they enjoy unbridled power sans responsibility, the story repeats. Error in judgement is permissible but exercise of powers with no foresight or fear of consequences must be checked. Investors will be better off by analysing the developments in the capital markets for the past two/three years and realise that the impact of such intervention is nearing its end, if not ended already.

They must refocus on time tested and internationally valid common sensical approach of value investing to reap profits into the future, again.

Ideal practices at Regulator’s office :

Establishing an empowered regulator augurs well for smooth functioning of capital markets. But, vesting too many powers in persons with academic knowledge alone may cause avoidable mishaps for the whole capital market and there by affect the investor sentiment adversely. Involving market players and evaluation of their inputs in public view could probably help avoid such serious mistakes in future. It is in this context, one must explore the option of involving proven market participants, with high ethical conduct, in decision making process at the regulator’s discretion. A committee may be formed and views of all members, including dissent notes, be well documented and circulated for public view and feedback before announcing such radical measures. Finally, everyone should be prepared to be held accountable for their unilateral decisions. Authority sans responsibility is injurious for any markets.