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The Mutual Fund Show: Aditya Birla AMC’s Patil Sees Multi- And Small-Cap Funds Faring Better 

Multi-cap funds may perform better in the future due to their well-diversified strategy of allocation, according to Mahesh Patil.



An employee of The Royal Mint Ltd. holds open a bag of new 12 sided 1 pound coins. (Photographer: Luke MacGregor/Bloomberg)
An employee of The Royal Mint Ltd. holds open a bag of new 12 sided 1 pound coins. (Photographer: Luke MacGregor/Bloomberg)

Multi-cap funds would perform better in the near future due to their well-diversified strategy of allocation, according to Mahesh Patil.

The co-chief investment officer of Aditya Birla Sun Life Asset Management Company is also optimistic about small-cap funds, given their discount to averages. He expects rerating in the mid and small caps, with returns beating earnings growth. Large-cap funds can at best match earnings growth due to greater probability of downside and a “relatively played out theme”, he said in BloombergQuint’s weekly series The Mutual Fund Show.

Patil expects debt issues to settle in the next three months as markets have more or less factored in those risks. “Market fears the unknown, but debt issues by troubled corporates are already known.”

And he expects balanced funds that to fare better for investors in the long term on a risk-adjusted basis.

Watch the full conversation here:

Edited excerpts of the conversation:

When people are least preparing for a mood change in the market or for mutual fund investors who like to time the market, it’s a futile effort...

That’s true and we have seen that time and again when things look to be more pessimistic. The news flow on domestic and global fronts has been pretty weak, and markets tend to surprise you on the other side. So, it is very difficult to predict the market and where it will go. There have been concerns and apprehensions. Things aren’t as great as they were at the beginning of the year.

There are little choices also globally. There is concern in every asset class. Domestically, in the debt side we had issues in the last six months. You need to make the right allocation, maintain discipline and let the asset class play out over a period of time.

You mentioned that there where issues on debt side in past six months. Do you reckon those issues are behind us?

The issues on debt side are known and the market is all about the unknown. That’s where there is apprehension. Once you know where the problems are and to some extent the size of the problem then market tends to discount it and factor in. To the large extent, the problem in debt side wherever there is stress and there are certain issues in the NBFC side or on corporates is largely known to market. It will take its own time to settle down in the next three months. The larger damage is already there. We don’t see that as a systemic problem because then it becomes contagion problem. I don’t think it is likely to go in that direction. It will still remain contained to a few corporates where there is an issue. From equity market perspective to a large extent, it is factored in at this point of time.

What will you recommend in terms of asset allocation right now?

In equity, the divergence in the last year-and-a-half has been huge. Even in large cap, if you remove the top four-five names, there’s a big divergence. Risk reward looks better in the small and midcap space, but the risk also remains higher. It’s not like we’re in a secular path where there are no concerns looking forward. It’ll be better to do the right allocation across the large cap, multi cap, mid and small caps. Every particular category has its own advantage at this point of time. The large cap provides more stability and more certainty. The returns there would be more modest. The mid cap and small cap space are looking slightly attractive compared to their historical averages. Potential returns over next two-three years could be higher but the volatility should also be on the higher side.

A larger allocation should be done to a multi-cap fund because it gives the right balance of large cap and mid cap. Mid and small cap should also continue to be as an allocation at 20 percent of the allocation. The risk rewards there are looking favorable and the divergence has reached to a level now. In fact, we were looking at PE multiples and the relative performance of large cap vis-à-vis midcap. It has gone back to levels of what it was in 2013 when we saw a big underperformance in mid and small cap space, and we know what happened after that.

The valuation multiple at the midcap end of market is more predictable and lot closer to mean. Do you think the space gives you a buying opportunity?

At these levels, it suggests valuations are not too expensive. We have seen them undershoot on downside, too. The valuations have gone even below that level. It doesn’t mean that at these levels there is no downside and there is valuation protection. It suggests to us that the risk-reward ratio is favorable. The earnings outlook is improving then there is a fairly good chance of decent returns on the mid and small cap space. If earnings outlook tends to improve and if the growth starts, the growth hasn’t been great in a couple of years, then the multiple also tend to rerate. You have a potential here where there is scope for PE multiples to possibly rerate if the earnings growth comes good and the earnings growth will itself drive the returns. So, there is a potential of returns to be higher than the earnings growth which isn’t the case in Nifty. The PE multiple is already higher. The returns in that space can be at best equal to earnings growth or tad lower because there could be some mean reversion of earnings over a course of time.

What are your thoughts on passive investing?

There’s space for every type of category, whether it is quant funds or ETFs and the actively managed funds. Investors coming into this category need to understand that there are certain positives and negatives in each category.

In a quant fund, while it is based on trying to backtesting a model over the last 10-15 years, but we have seen periods where the models don’t work. What has happened in the past might not necessarily work in the future. There are many instances in the past where quant funds have done successfully for a period of time and suddenly in a particular scenario they tend to fail.

As long as people understand the pitfalls of investing and risks in each of these strategies, I think there’s space for everything in this market. When there has been some challenge in terms of beating the benchmark generating alpha which will come down over a period of time. Don’t go by what has happened in last 1.5 years as it is an aberration but arguably the alpha over the next three-five years would be lower than what it was in the last five years or so.

In that space, there will be opportunities for funds which is trying to beat the benchmark and there is some kind of quant strategy.

In a market like India, where there is still information asymmetry, there’s still scope for a lot of well-chosen midcap and small cap ideas and so active fund management will still score over passive fund management at least in near or medium term. Is that a valid argument?

Yes, I would think so. At least in the next five years and so there will be enough opportunities. The Indian market is still good though it hasn’t worked in the last one year or so. But there are enough good mid-sized companies which are in good growth potential. In India unlike in some other markets where the index tends to be much more concentrated, there are many sectors we could not only do stock selection but sector rotation where we generate alpha. The alpha generation is lower than what it was in the last decade but there will be enough room for active fund managers to generate decent alpha over the benchmark. There will be space for exchange traded funds, too. Somebody who wants to time the market or get into the market with a short-term view and just play the beta strategy to get the market upside then they might still look at the ETFs. We have seen the proportion of ETFs tends to increase as a percentage of the total inflows. That trend will continue but for a long-term investor, it is still active funds which can give you slightly better than passive funds.

What are your thoughts on balanced funds versus pure equity funds in current scenario?

There is some merit in balanced funds, which has two categories. There’s an aggressive hybrid category where the variation of the equity allocation is between 65 to 80 percent. That kind of leeway is to be able to do the right allocation. In the longer term, we see that asset allocation tends to workout well. When markets are going up, you normally tend to take the gains and put it into the debt side automatically because of the automatic cap and in the down market, you tend to move which is the classic way to allocate money.

On risk-adjusted basis if you look at the longer term, it tends to score better for a normal investor. In absolute returns, it might not match the pure equity returns. But for investors who are normally risk averse, I think it’s still a good option. Though we have seen that the balanced category has not seen much of it come down. Two years ago a lot of money came into the balanced fund for the wrong reasons like dividend. As a category it still merits for first time investors who are looking at only one option. So, balanced fund fits that bill well.

You’re coming up with a fund from the healthcare space. What is your view on the sector?

In healthcare sector, pharma is a large component. Last two years weren’t particularly great for pharmaceutical companies, specially the top company because the problem was on the U.S. side. A lot of companies had exposure to the U.S. generic space where there was a severe price erosion because there was a consolidation on the buying side of the distributor. We feel the erosion has come down from 10-15 percent to around 4-5 percent. That steep decline is easing off.

Many Indian pharma companies have invested in research and development in the last 7-8 years. The R&D spends has gone up significantly from around 3 percent to 8.5 percent. Specially most of the spends have gone into high-end generics, complex generics, specialty or biosimilars where the benefits are likely to flow through and that should be seen in earnings in the next couple of years. That’s on the U.S. side where we see the pressures easing off. Domestic pharma is looking much better where we see a steady growth of 10-11 percent.

Also, the government spend on healthcare through various insurance programmes means that the spend on medicines will increase secularly. So, these are some structural drivers for the domestic pharma space. Lot of Indian companies where large companies with a dependence, 50-60 percent value, was coming through the U.S. side and that proportion has gone down to 20 percent or so. The bulk of the value is coming from India, which is steady and has more secular growth. If you look at multiples than what they were in historical averages, it is one of the sectors which is quoting below that. With risk reward too, it is looking much more favorable here. There are structural drivers on domestic pharma side which makes it a compelling case to invest now. If you look at healthcare as a larger basket then you have other sectors doing much better like diagnostic space which is growing at around 20 percent. There is enough room to grow because of the unorganized sector and it is a profitable space. Hospitals are still a under-penetrated category in India and there is good long-term opportunity over there.

Besides, there is CRAM story which is Contract Research and Manufacturing Services. Wellness is also an emerging theme. There are not many players, but we can see new companies coming in that space. Specialty chemicals is another area which has done well in the last two years because of the clampdown in China because of pollution control and a lot of Indian companies have been able to take advantage of it as we’re strong in the chemistry part and specially into specialty chemicals which normally go into the pharmaceutical sector. That sector looks exciting.

The valuations are good. The risk reward is favorable and over next two-three years, it should give reasonably good returns.

Do you believe that the business robustness which of the major component of the health care space which is the pharma companies is looking strong? Day after day we hear brokerages is coming out with reports which is not exactly painting a rosy picture as yet. So, is this view slightly ahead of the optimism coming in print?

You’re right. It’s not going to be the same story as it was in the pharma sector. If you look at the last decade or so, if you take out the last two years, it has been a huge success story for the Indian pharma industry because the U.S. generic space was growing around 20 percent. It’s going to grow—at least for Indian companies—at around 8-10 percent in that range. So, it’s not going to be a robust story. There isn’t a big tailwind as to what was there in this sector in the last decade. But we’re not seeing any big opportunities anywhere where the same tailwind is there.

There will be some challenges, you will have company-specific risk in the pharma sector because of plant issues which could be there. So, while those issues are also there, Indian companies have kind of moved up the learning curve over there. So, the instances of that will be much lower. So, we are not seeing a scenario where there is a big tailwind in the sector. The U.S. market is going to grow into double digit, it’s going to be a moderate growth but there is enough reason to believe that the earnings growth in the next couple of years will be fairly good than what we have seen earlier. And the valuations are comfortable. So, there is a reasonable upside in this sector. If you play the basket, the pharma and the health care have enough opportunities to generate decent alpha. And we think it’s the sector which can be a good contrarian buy.

The new fund offer is the Aditya Birla Sunlife Pharma and Healthcare Fund would focus on all of these themes—pure pharma companies, healthcare companies and specialty companies?

Also, the diagnostics. Hospital sector, specialty chemicals and even for that matter some of the global pharma names. So, the companies which can’t participate in India but there are a lot of good companies globally either in emerging sectors or it could also be in traditional sectors where large global players are available at good multiples. I think we’d also look at some of these names.

So your fund has an option to buy into companies which are listed not only in India but abroad as well?

Yes, so initially we can invest 25 percent into global pharma names. The idea is not to invest in similar companies like we don’t invest into large U.S. generic space because Indian companies are much better off. But there are companies which are doing unique things globally. So, initially we will not really have a large exposure, but we will start off with a couple of names on the global front to take opportunities which you can’t really participate in the Indian market.

Two points here. Whether it make sense for somebody to invest if a person understands the theme well, is that a reasonably strong advice? Secondly, you are not the only NFO or the only healthcare fund fourth or the fifth one as well. What about the timing of this?

Thematic funds have to be sold by either somebody understands the sector, who has a clear view. This is one way to participate instead of investing directly. Or advisors can recommend to their client within a certain part of the allocation. So, typically you would say that a thematic fund or a sector fund should be around 20 percent of your total allocation. It could be one-two themes which shows a strong promise over the next three years and one can allocate to that. So, I think this would be part of that allocation. For a first-time investor, you normally look at a more diversified fund but as you add more to their basket... more evolved investors would fit into the fund.

Into the timing I would like to say we were looking at this idea a year ago. So we got an approval, but we stepped back because we were still seeing some pitch wasn’t clear on the U.S. side, which still had pricing pressure. And we didn’t get that comfort. The commentary that we have seen recently from the large pharma player, even the Indian pharma players as well as global generic players, suggests the sharp erosion in prices is kind of easing off.

There is a certain trade-off in terms of what the value is today or how much the market is discounting the negatives and how much of upside is there. The risk reward as a result of that looks fairly compelling.

I think there will be some challenges. Stock specific negatives will always be there. It’s not like, there is a huge tailwind as I mentioned but there are enough opportunities to play in the pharma sector. It might still remain a bottom-up story, but the risks are coming down. That’s the reason why we thought that this is the right time.

Domestic pharma has been providing good support. One is the overseas U.S. part but the domestic story looks much more compelling. The valuations for most of the companies are such that 70-80 percent of their value are explained by the domestic part. So, that’s makes the downside protection much more and as the earnings flow, we see the sector doing well.