The Mutual Fund Show: A Fund House Justifies Investing In Higher Valuation Stocks 

Aashish: Two or three things I want to clarify at the outset. First is that, whenever there is a discussion about high PE and quality, I think it sort of gets co-mingled. I don’t think it’s necessary that quality has to be high PE or that high PE has to be quality. I don’t think that correlation should be made causation. Second is, what is quality is not defined by anybody. We are a torchbearer. Generally speaking, the debate used to be between value and growth but for the last five to six years, we have focused a lot on communicating our philosophy and we have put in a lot of effort to communicate what is our style of investing. But I think that somewhere the word is being carried around but what is quality is neither defined nor well understood. So maybe through this discussion, Akash will throw some light on it.

Aashish: Yes, because right now it appears like, everything that went up in the last one year is quality or everything which is high P is quality or everything that is B2C consumer is quality. That’s a perception that one should clarify. The last point that I would like to share is that quality in itself; when you say quality, then the opposite end has to be non-quality or junk, right? So, the point is that, is quality an absolute end and then there is a wide chasm between quality and so-called junk or is it that there is black on one side and white on the other side and in between, there are varying shades of grey? So, it’s a continuum. It’s not like this is quality and that is not. So, these are few foods for thought.

Akash: There are two dimensions to it. First, will expensive stocks remain expensive? Before that, let us understand what is quality and what is expensive because again, valuation is a relative thing and every fund manager can have a different call. Valuation lies in the eyes of the beholder as you say. So, we need to understand valuation and quality from a different frame of mind or spectacles. So what I feel as quality for me, I think the entire street will think high return ratios, cash flows, no leverage, no pledge- these are the things that make quality, which is partly true because these are the parameters you can easily check and easily figure out. To us, it is not only about these return ratios or financial metrics. Quality denotes a much bigger embodiment or a bigger thing where you include various factors. So, we have had a lot of discussion on corporate governance in the past, but hardly do I find any discussion about the culture of the company, on the integrity of the management, on the leadership and the execution of various company managements, on the reliability of their guidance and the conduct they have in the business. So, there are many softer aspects which go into defining a quality which falls into these qualitative parameters and which is so subjective that every fund manager will have their own opinion. So, what happens is, when you evaluate both these parameters; quantitative and qualitative, the next step is to see whether the quality could be elongated or not. So in the second aspect we see that there are many companies; maybe tech companies are traded 20 times because the visibility in the changing technology environment is for 20 years but consumer staple companies when they are traded 40-50 times, we are certain that in a demography like India, the consumer or the consumption spend will remain because the population is growing. So, longevity of growth. The third is, how is the quality of growth itself? Whether these are cyclical businesses, structural or secular businesses and whether they are consistent, and they have stable earnings. When I see the quality of growth, I would also be looking if they are earning surprises. If there are earning surprises, the valuation automatically comes down. Lastly, I would say, historically, it has always been perceived that price is a measure of valuation and margin of safety is measured by price. If you pay a low price, it means you get some value and there is a lot of margin of safety. We believe that quality is also a big margin of safety. So, if you invest in quality stocks, that itself is a big margin of safety; whether it is on the downside or on the upside. So, these are I think different thoughts which we have, and which differentiates our perceptions of price and valuations.

Akash: I think a very good example is Hindustan Unilever and if I have to see on all of their qualitative parameters like, whether the culture is aligned to strategy or the competitive advantage of positioning it has or the modes; I think it has everything fundamentally which one company should have. Since the environment is obviously changing, we have to see if the modes are increasing or decreasing over a period of time. If you see between 2000 and 2010, when there was a price war with PNG and the competitive intensity increased, in fact it was a position or a situation of the modes were not increasing but once the competition eased, then again, having a great company with a great leadership, with a great culture and great expanding modes in a positive trajectory; I think that led to phenomenal earnings. When you play growth and quality together, even for structural stories, there could be points of time when the growth could be low due to external environment; not because of the internal environment but definitely for the external environment. But once the external environment eases off, or they take their own steps to counter it, the returns again, become phenomenal and then you again compensate for the lost period of return. Whether Unilever or Asian Paints or most of these companies, they have made spectacular returns. Even they had some few lean years, which happens in other non-quality stocks also, they definitely compound and make up for the lost return.

Aashish: Firstly, I don’t think any of our discussions are basically trying to insist that even when there is a growth period of a company which actually comes to a halt and it’s just not delivering, we are not saying that we should keep holding a 9 percent exposure and just be absolutely passive and complacent about it because all said and done, we are active managers. There may be time to time that we, ourselves have execution issues where we may slightly be behind the curve on a certain growth projection, sometimes we may be early in selling. I have examples where we have been blamed for selling late and we have been blamed for selling early as well. Since we are discussing from the portfolio and since we are discussing examples, none of this is my holding- I am talking for the Mutual Fund. One can say that, in certain auto names, we were late in selling but one can equally say that in certain names like in Bajaj Finance, we were early in selling. So, the point is that, right now we were discussing quality as a concept; it doesn’t mean that we are complacent, and we are just going to sit around. First is portfolio are, generally speaking, actively managed. Our churn ratios are very low, but it doesn’t mean that when something has run its course, we still need to just sit around. Second point is, in a portfolio of 20 companies, you will never have 20 companies time correcting. So, let us say that this discussion was not about quality, it was about cyclicals, it was about deep value. I don’t think there also, you will ever have a portfolio of 20 companies which are all at the wrong end of the cycle and which are all going through their mess. So, any portfolio of 20 companies will have 2-3 companies which are disappointing, which will have 10-15 companies which are average, you will have 2-3 companies which are blowing the day lights for the portfolio. So, clients, I think by and large three to five years is a good time horizon. Last 1-1.5 years has been very bad overall. But still our funds have a respectable three-year return and a very respectable five-year return. So, I don’t think that people who are investing for 3-5 years should worry. But if I am a customer, I would ensure I have style diversity. There is a lot of debate on what happens when you buy quality but not a lot of debate on what happens when you buy junk. So, I would ensure style diversity in the portfolio, that’s the limited point.

Akash: So, if you see the call which you are saying, essentially boils down to whether the pricing is right or not. The value what we pay is determined with respect to earnings what we get in the future— in the next one or two years. For us, time correction can happen in quality stocks- we are more worried if growth correction happens. For example, we are estimating 20 percent profit growth for any company and if it comes flat or negative, then that’s a big correction because your earnings also go down and your valuation multiples will go down. I would be a seller of the quality names only if I believe the growth also corrects. So, growth correction is a big issue for expensive stocks and if growth disappoints, these stocks will definitely falter. But for us, for the companies which you have mentioned, I would say the growth what we have seen in these companies- if you take the last three years, five years and even for the forward growths, what we look at for the next 3-5 years, it is going to be phenomenal. Most of these companies will deliver more than 20 percent PAT growth on a steady basis and even if the valuation multiples remain the same, the stock should compound as per the earnings growth. The problem would be only if the earnings growth doesn’t come which we don’t think will happen.

Akash: If I see the environment today, which is a growth starved environment and growth challenged environment. This is an environment where I think for the next six months to one year again, the polarisation will continue into the high growth stocks because the environment itself is low. Let us come to HDFC AMC or any insurance say, HDFC Life. So, these are the companies which have been recently listed in the last 1-1.5 years and historically, for our country, we have not had comparable valuation multiples for these companies or how do you value these companies. These stocks even in our funds have done very well. If I have to just see the longevity of growth, and I’ve been speaking about the rate of growth so far; that till the time the rate of growth rectifies, the businesses, they do well, we’ll find value in them. But in these companies, particularly the AMCs or the Insurance, if I have to see the longevity of growth, it is like the consumer staple names where unlike any other sector- whether it be IT or Energy or Autos or any other sector, the longevity of growth in any of these companies is not even 50 or 100 years, it could stretch beyond. So, we are earning, we are giving a multiple on the longevity of growth and on the rate of growth as well for these stocks. So that’s a different perspective which we think we bring to the table.

Aashish: One, Akash has clarified that it is a growth starved environment so there is practically no growth and growth is definitely not widespread. Second point is that, I want to clarify because there has been a lot of debate on quality, what you must have found interesting to note is that what you and Akash were debating just now, is actually barring one there were no consumer names there. He is actually talking more about thematics- which are newly listed ideas etc. Coming to your question, one is that we are in a growth-starved environment.

Aashish: The point that I was trying to make is that, the largest positions that you were discussing are all actually newly listed and in fact his portfolio itself doesn’t have what has been debated really. One is growth-starved and second point is that, right now any form of leverage- especially financial leverage is a bad word. Third is that, the economy itself needs to see where the economy is. For example, within quality, we need to move to capex cycle companies, right? We can move to stuff like equipment suppliers and we can definitely tilt portfolios. I don’t think that one has to be necessarily stuck in one side. These are ultimately actively managed portfolios and we ourselves have certain views of how things are actually playing out.

Akash: If you see, I would say instead of growth at a reasonable price or quality at a reasonable price, because globally if you see, the opposite of value is growth. So, either one of the two styles perform. If I see the last five years, growth style has performed by almost 50 percent premium to the value style. If I see the last 25 years and 45 or 50 years, both styles are given equal returns over a longer period of time. It depends on the timeframe. Normally speaking, if you see the corrections of 2000 or 2008, when you enter the peak of a bubble in the market cycle, when the market space whether globally and domestically which is 2000 or 2008, then the last leg of the rally if I say the peak happens in January, then the last three months of the rally ensuing six months or nine months. That is the time where the value or the growth at a reasonable price performs. So that is a period which is sharp. I want to clarify that when we look at consumer, we have to differentiate between staples and discretionary. So, there are some funds where we have bigger weightage staples but there are others where we have a bigger weightage discretionary. The franchises are different, the growth rates are different, the longevity is different, so we have to differentiate between the two.

Akash: If you see over the last 5-10-15-20 years for all these financials that you mentioned, people perceive it as a quality because they have given a CAGR earnings growth of 25 percent. Had they given a CAGR earnings growth of 5 percent, I would have said that, and no one would have believed it, that they are quality names. Second reason why people believe they are quality is because their risk management and asset quality is very good. In banks particularly, in financials, the biggest priority is to have your asset quality right. So, for me where normally growth is a big swing factor for selecting stocks but for banks, it is the risk management and asset quality which drives stock selection for us. And these banks are regarded as high quality because in the asset cycle, in the last 10 and 20 years, they have delivered and performed with minimal NPAs. So, these are the few things that the general market and the industry thinks is quality but again, if these two factors were missing, people would’ve thought it’s not quality. So, from a valuation perspective if I have to take a call, still I would first look at their asset quality, the NPAs and then again, how consistently they have grown. So, these are the more important parameters which justify why we hold these stocks.

Aashish: It is important to point out right now that these 2-3 private sector banks virtually have an uncontested landscape and time and again, people have been betting on PSU banks, right? First thinking that the asset worst is behind us, then thinking about recapitalisation, but now they are going for consolidation. So, I think this consolidation, and all is a long-drawn process. I don’t think it’s easy. It is going to really take time for them to get it together.  That’s what I keep thinking that there is a lot of debate on quality but there are not enough debates on the false starts. On one hand, you have the meter ticking in terms of performance. Please keep one thing in mind that you are perpetually waiting for something in the environment to change. You are either waiting for the economy to improve, you are waiting for the government to do something, you are waiting for the global steel cycle to turn around, you are waiting for theU.S. and China to end their trade war, you are waiting for some bank to announce QE or to cut rates. So, a lot of it is betting on macros and a lot of it is generally betting on stuff which is not in your control. Whereas, a good part of what we are talking quality incidentally also happens to be very inwardly or very inward-looking local businesses.

Akash: For our fund positioning, we believe in QG which is quality and growth put together. If these two metrics work but with the elongated period of time where the L comes. So, if these three factors are present we are happy to hold what we have unless valuations become too expensive in our view that it is like a case of sell where growth is also going to disappoint, and which will also lead to a valuation derating. Not only time correction but a valuation derating. If that happens, then I would say it is time to sell. But if I have to see for the foreseeable future, I still see that the growth will continue to remain at premium where the interest rates are very low. If you see global interest rates for the U.S., which is almost at a 300-year low. So, till the time interest rates are low, till the time growth is challenge, I would say that growth will continue to get a premium and this will end only when there is a bubble in the global equity asset cycle which I don’t think at this point we are heading over there.

Aashish: Since you are asking from an investor’s perspective, I think two or three things need to be kept in mind. Whether it is our equity fund or any equity fund, a humble request is always to judge at 3 to 5-year timeframes. Last year was such that, even growth-oriented companies had their own challenges. As Akash mentioned, there were 2-3 companies that were growth disappointed. So, that can happen, there can be execution issues, but the point is that, when we find ourselves at the wrong end of the cycle, then we need to say that okay, do we need to take corrective action? Or will we be able to ride this out? The fact is that, with autos for instance, we did not panic, and we rode it out and now we are looking smarter than what we were looking a year ago. So sometimes you have to take these calls but for an investor, 3-5 year is a good evaluation not to jump to conclusions based on what happens in six months, nine months or three months. That’s the first point. Second point is, again as an investor I would buy a fund fully understanding what the strategy is, and then I would judge them for tracking that strategy. At a portfolio level, I would ensure that I have style diversity. Just like in my portfolio, all 20 stocks cannot fire at all times, in an investor’s portfolio it’s a reality that if you own five funds, not all will fire at the same time. It’s important that you should have style diversity in your portfolios, and it is important that you buy a fund based on what it is preaching and practicing and not just based on last one-year return and those kinds of criteria. So, we will manage as per our style. Where we need to be active, we’ll be active, where we’ll need to hold on, we’ll hold on. The idea is not that we want to buy some stocks and sit on it. That’s not the point.

Aashish: That’s clearly a question of what we perceive as growth and are the quality parameters as how we perceive them being met.