»The Honest Truth by Ajit Dayal

7 reasons why Quantum's equity fund has "high cash"
30 AUGUST 2014

The Economic Times carried a nice-sized and flattering article on the fact that Quantum Long Term Equity Fund "hoards cash as valuation sparks concern".

The article highlighted the unique value approach to investing adopted by the Quantum Long Term Equity Fund, including the risks of taking such an unusually large level of 32% cash (the average cash holding of most funds is 8%, according to the ET article) which could result in "under-performance" compared to the benchmark indices. The article also pointed out that, in the past, this cash level has helped The Fund outperform its peers - and the indices - as money was deployed at lower levels.

While the past performance is definitely no indicator of future performance, investors would do well to better understand the reasons why Quantum Long Term Equity Fund holds cash. I should point out that I am on the Board of Quantum Asset Management Company Private Limited and a member of the Investment Committee so am intimately familiar with the "research and investment process". Having said that, nothing written here is a state secret and many of these facts are known and discussed at public forums including the Path to Profit series of seminars that Quantum MF has been conducting since 2009.

On a high of expected expectations
Before we move on to the 7 Reasons Why QLTEF has high cash, let's look at a snapshot of the current "market environment".

Since February 2014 (around the time when Rahul Gandhi directed the already sinking Congress ship into temporary oblivion with his famous interview with Arnab Goswami), the stock markets had been expecting a Modi win. These raging sentiments were met, stride for stride, by rising earnings estimates (Table 1) written by research analysts who work for brokers and whose salaries and commissions thrive on rising share markets. As stocks keep surging on "expected reforms", note how the cash levels of QLTEF keep rising. Obviously, the research team at QLTEF has a different view. Time will tell who was "right" and who was "wrong". But for now, the believers on the left column are facing off with the dis-believers on the right column!

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Table 1: The sell-side research raises estimated earnings, QLTEF sells and raises cash!
Reporting Period Earnings Estimate of S&P BSE Sensex for CY 2014 Earnings Estimate for CY 2015 S&P BSE Sensex Index Level % Change in S&P BSE Sensex in INR No of stocks in the portfolio, as stated in the fact sheets Level of Cash (after adding Net Receivables / deducting Payables)
14-Jan 1,345.7 1,576.3 20,513.9 -3.1% 27 15.7%
14-Feb 1,344.4 1,574.7 21,120.1 +3.0% 27 17.4%
14-Mar 1,571.2 1,817.90 22,386.3 +6.0% 27 17.2%
14-Apr 1,581.4 1,817.2 22,417.8 +0.1% 26 19.2%
14-May 1,576.0 1,831.4 24,217.3 +8.0% 23 32.3%
14-Jun 1,563.7 1,835.2 25,413.78 +4.9% 22 30.9%
14-Jul 1,553.4 1,860.2 25,894.97 +1.9% 20 32.3%
Source: Bloomberg, QLTEF fact sheets www.QuantumMF.com

The 7 Reasons
With that background, here are 7 reasons why the Quantum Long Term Equity Fund holds "high cash".

  1. QLTEF is a "value" investor"; they don't buy shares because buying shares is in fashion. A value investor assumes a certain macro-economic environment, contemplates how the management of various company will do in such an operating environment, and then estimates a "buy" price and a "sell" price for every stock that they research;

  2. They buy shares because they see "value"; when share prices reach "sell limits", they review their earnings estimates of the company, and - if there is no reason to "up" the estimates - they will sell shares, irrespective of what the "market thinks";

  3. When shares are sold outright or when positions are trimmed, cash levels rise

  4. This cash can either be deployed back in some existing stocks or in new stocks that may make it to the "buy limit";

  5. In a "bull market", chances are that it is difficult to deploy cash into new stocks or existing stocks that may be heading closer towards "sell limits" - things may look "expensive" for a "value buyer",

  6. As such, the rate of cash generation exceeds the rate of cash deployment (selling activity is more than buying activity),

  7. Therefore, levels of cash rise. It should be noted that "cash" does not mean that there are sacks of money lying under the mattresses of the Fund Managers - that is a domain of expertise best left to other elements of economic society! ☺; "cash" is actually "marketable instruments" that can be sold quickly and deployed back into stocks in case the opportunity arises.

As can be clearly seen from the above, cash is a residual of the investment process, it is not an objective. Neither Atul Kumar nor Nilesh Shetty - the fund management team of QLTEF - wake up every morning and say "the market is going up, let's sell and raise cash".
Nor do they say "the market is going down, let's buy".
Nope, they don't have the luxury of falling into such sentimental traps.

Think, don't feeeel...
"Think, don't feel" is a line from the cult movie, Enter the Dragon, starring Bruce Lee.
Sometimes feeling can be dangerous... and thinking does not always prove right!

Every action at QLTEF - good or bad - is guided by a deliberate research process that focuses on the long term and the resultant "buy" and "sell" limits which are based on:

  1. Long term macro views on the Indian economy,
  2. Assumptions on how a sector will do in such an environment,
  3. Assumptions on how a company will do in such an environment,
  4. Assumptions on what a "value" investor should pay for that expected long term growth in earnings of a specific company. ,
  5. Assumptions on whether managements who run these businesses are fair to their minority shareholders,
  6. Assumptions on whether the founder shareholders are people of integrity or people whose driving skill set is gaming the system.

Clearly, all these assumptions can change. Hence, they are reviewed, pinched, and tested constantly.

Holding cash in a rising market will be a painful process in the near term if markets keep rising. Holding cash in a falling market may help (Table 2).

Table 2: What "cash" can mean in different market situations.
QLTEF portfolio Market Up by +10% Market down by -10%
70% in equity 70% invested portfolio may go up by +10% for a +7% return 70% invested portfolio may go down by -10% for a -7% loss
30% in "cash" No impact, no appreciation No impact, no depreciation
Overall portfolio Up +7% Down -7%
Conclusion "under-performed" "out-performed"
Note: Illustrative example, there is absolutely NO guarantee that the markets or the QLTEF portfolio may behave in the way illustrated in the table.
Before you make any investments, read all offering material in detail, be sensible, be cautious, and don't be taken for a ride by sweet-talking wealth advisors, intoxicated friends, or smooth-writing (or talking) fund managers on glib TV channels. And, yes, please do not make any judgment based
on this article! Figure out what you want/need and then evaluate carefully.

For now, the assumptions made by the teams at QLTEF don't seem to merit buying stocks.
How wrong - or right - they are will be known over time.
But their process is their process - not open to compromise.
Their stupidity or their genius will be there for all to see over the next few years.

And, come to think of it, that is why they get paid a management fee: to have a view.
And succeed - or fail - by their decisions and their views.
If they are wrong, they will need to find new careers: something which they are good at.
If they are right, they will be safe in their views and their jobs - till the next challenging environment that is thrown at them by the market.

No amount of net worth can make a fund manager - or an AMC - a good or bad AMC.
Or a "serious"AMC.
Ultimately, it is the stated research and investment process - and the outcome - by which a fund house will succeed. Or fail.
For now, QLTEF has made its views known.
The outcome will be known in some time: maybe in 1 month or maybe in 2 years.