How Fund Managers Pick the Leaders of Tomorrow?

If you have been investing in mutual funds, you value the experience of fund managers at the respective AMCs. However, how do you think they predict which stocks are likely to perform well? How do they actually pick the market leaders of tomorrow?

At early stages, it’s pretty challenging to identify stocks that are likely to deliver impressive returns. When you look at today’s blue-chip stocks, most were small once. Often, investors ignored them, thinking that they lacked big potential.

However, the role of fund managers is to identify these stocks with hidden upside. They work with a forward-looking approach and choose stocks that can eventually drive your portfolio upwards. In this blog, we have discussed how fund managers pick stocks to establish resilient strategies.

The Key Philosophy Behind Fund Manager Decisions

Successful fund managers establish a clear investment philosophy at the outset. Some professionals prioritise steady compounding. Others focus on growth at a reasonable price. However, the goal of most fund managers is to generate long-term wealth without being distracted by short-term movements in the market.

Fund managers determine the kind of businesses they want to own and the extent of risk they are ready to take. Also, the professionals decide the duration for which they want to stay invested. With this clarity, the fund performs consistently across different market cycles.

Identifying Business Quality Before Market Recognition

Fund managers perform deep fundamental research to find future leaders. They channelise significant time in understanding the:

·       Business model of a company

·       Key drivers of revenue

·       Competitive edge

They scrutinise companies for sustainable growth and margin protection. Fund managers prefer businesses capable of adapting to changing market conditions. It’s here that management quality plays a crucial role. Companies with transparent governance and strategic capital allocation are likely to perform well and scale higher in the long term. Fund managers focus on these priorities early and invest in companies before the broader market can identify their growth potential.

Large Caps vs Emerging Leaders – Different Selection Approaches

The approach used by fund managers to choose market leaders differs across different market segments. In large cap mutual funds, fund managers choose established companies having:

·       Predictable earnings

·       Strong balance sheets

·   Leadership positions

These businesses may not show explosive growth, but they provide stability and consistency over time. On the contrary, the approach used by fund managers in the best mid cap mutual funds is quite different. They look for companies that are:

·       Expanding their market share

·       Entering new segments

·       Benefiting from structural trends

With higher growth potential comes more volatility. The challenge is to identify the mid-sized companies that can eventually grow into industry leaders.

Valuation Discipline and Timing the Entry

Fund managers also prioritise timing their market entry. The reason is, even the best business can turn into a poor investment if bought at the wrong price. That’s the reason valuation discipline is a crucial aspect which fund managers must prioritise.

Experienced managers do not predict the tops or bottoms of the market. Instead, they assess whether the current price of a company justifies its earning potential in the future. If valuations are stretched, managers may wait and gradually accumulate. Alternatively, they can reduce the exposure. This approach is effective in managing downside risk, improving the potential for returns in the long term.

Conclusion

Choosing individual stocks is only a part of the selection process. Fund managers also have to evaluate how each of these stocks fits into the overall portfolio. The exposure is eventually spread across different themes and sectors. This goes a long way in reducing the risk of concentration.

Experienced fund managers also manage position sizing. As a result, no single stock can disproportionately impact the performance of the portfolio. With this approach, the long-term outcomes remain intact even if a few assumptions don’t work out as expected.