The Mutual Fund Show: Two Sectors That Helped India’s Second-Best Mid-Cap Fund Of 2019

2019 was a year which defined quality. So, globally we have seen for the last 5 to 10 years growth and quality have performed over value and it held true for Indian markets as well. I think the basic factor or the basic fabric was that firms where quality was missing- which had high leverage and were suffering from high debt equity ratios or which had lower returns on capital or returns on equity and were not able to service their debt or expand. So, those are the firms which suffered. Apart from those firms, where growth had been low—maybe because they were cyclical in nature or because they had growth issues or internal issues. So, wherever growth also was slow, those firms did not do well. In essence, if I see the full year, it was a year of polarisation—where selective stocks, whether it had been in the large caps or in the mid-caps or were of high quality or high growth, they did very well. The same thing worked for us at Motilal Oswal Mutual Fund. We followed the philosophy of QGLP—which is high quality and high growth portfolio—and definitely it worked for us.

We have two-three aspects that are different from the entire industry, in the mid-cap 30 fund. Even as a house, we have a focus portfolio. So, in the midcap fund we held around 22-23 stocks during the year unlike the industry which on average holds 40 to 50 stocks in the mid-cap category. We had the least number of sorts in the industry and therefore we had a very focused and a tight portfolio. The second point was that we are very averse to the index. So, the index for everyone is the midcap 100 index for most of the peers in the industry. We have only a 15 percent overlap with the index. Basically, it was a bottom-up portfolio. Most importantly, I would say that what led to this outperformance was that, when we measure quality and growth, we had very tangible numbers in mind. For example a portfolio delivered a profit growth of almost 23 percent in last two years and during the same period, the midcap index had a decline in profit by 6 percent. So, the gap was almost 29 percent in profits in a bad environment where growth was languishing for midcaps for two years. Our overall, the average earnings growth was 23 percent. When I define just quality in a couple of numbers—at the return ratios for example. Returns on capital at 30 percent was much higher than the border market and even the debt equity was almost zero-negligible.

I would say the opportunity to buy this quality started from the start of 2018, in January, when the markets peaked and mid-caps also peaked, the index peaked at 21,700 and when we saw the following correction, then it was a good time for the next six months to lap up the quality stocks. But more importantly, I would say growth stocks. The difference in quality stocks, normally they protect you from the downside, they give you margin of safety, but the upside is captured if we invest in companies which have been compounding their profits. So, 2018 was a fertile year to buy stocks for the longer term which fit your criteria of a compounding machine where your profits are compounded year over year and during the course of the year in 2019, the valuations also got expensive because the broader market fell. The broader market didn’t have earnings growth and the quality and growth companies which had earnings growth of 20-25 percent did well. So, I would say the valuations which were reasonable, they have become slightly fair, maybe more on the expensive side, compared to fair. But if you see valuations from a price earnings growth—the PEG ratio—then I would say still it is fair because the earnings delivery is still there.

So, the total AUM of the fund now is around Rs 2,000 crore and the strategy of the fund is, first we think over the long term that when we hold a stock, we have to continue it for like 3-5-10 years. So, basically, we are into the business of buying businesses. When we buy businesses, the basic ingredients on the stock selection criteria which we look at, is the companies who are normally the market leaders in their segment or and those who are gaining market share and those who have a robust business. So, that is from a business model perspective. From a management perspective, I would say high quality management is one that can deliver numbers, was good in the execution, they give earnings surprise and where the culture of the management is good, and it’s aligned to the strategy. The third and the last aspect would be the longevity of growth. So, if you have a long runway for growth, if the quality of growth is good, if it is long, stable and secular rather than cyclical that makes sense. If the capital allocation is good, then definitely it offers you a wide opportunity or a long runway for growth. Lastly, if the moats for the business are increasing over a period of time, I think that is the best combination to have.

So, the themes which we’re playing, broadly fall into two categories. One is value migration and the second is consolidation. So, in the value migration category, the stocks where for example, value is getting migrated from public sector banks to private banks or from PSU insurers or to private insurers. So, there are companies where we see the value’s migrating over a period of time because of the changing business dynamics and some of the banks which you mentioned—whether it be City Union Bank or many of the retail-oriented banks have seen good growth over the past few years. The second and more important theme which we’re playing is, the theme of consolidation. So, we have seen a lot of reforms in the last three years and after demonetisation, when we had GST and RERA, and the Insolvency Code, what we have seen is that the unorganised sector is migrating towards the organised sector. The organised players are gaining market share. The larger players are becoming larger because they’re consolidating, and the consolidation is best seen in the consumer discretionary space. So, there are many companies after the GST—they’re gaining market share. There’s a shift towards lifestyle consumption. The favourable demographics of India is also helping. Overall, we have a lot of stocks in the consumer discretionary space as well to play this theme. So, these are the two broad themes which we’re playing.

The way we look at it is that, let’s say we evaluate whether we need to trim a sector or some stocks which have become expensive. The first criteria would be to reduce stocks or exit stocks when growth languishes. So for example, if we are projecting at 20 or 25 percent profit growth for the portfolio as a whole, but if we believe for the next one or two years the growth will languish in single digits or 0 or the growth goes haywire, then it is a sure shot case of selling or trimming the stock. Till the time we see the growth coming, let’s say 20 or 25 percent which is as per our estimates, there would be times where valuations get expensive but then there could be some time correction and we understand that all stocks will not fire at the same point of time. So, there would be phases out of five years and you know few stocks will do good for three years or four years. For example, one of our stocks in the top 5 holdings, it was flat for two years and in the last three months it has almost doubled. So, if you have conviction in your stock from a bottom-up perspective, if they’re delivering their profits and maybe they could be time correcting because of valuations at some point of time, but over a longer period of time—since our horizon is more longer than the normal industry, then I would say that we sit it out. At various points of time different stocks perform.

In the realty sector, we have a lot of companies which are now benefiting after the RERA because the larger companies are consolidating at the expense of smaller companies. But over there, we need in our QGLP framework. When we look at it in our framework of investing, we hardly find companies which make the returns on equity of 20 percent or returns on capital on 30 percent, with a steady compounding profit growth and with very low leverage. There are companies I would say in realty which can do well in the near term but since we don’t look at the company from a six-month or a one-year perspective—our horizon is for a longer term. We don’t own many of these stocks. So, we don’t want stocks we cannot hold for five years or 10 years where we think that the business is more, structural, secular and stable. So, that is why there could be a few companies which give you a window of opportunity for the near term, but our thought process has been only to hold for long term. In specialty chemicals, I would say they are a few companies which we are also evaluating that have a slightly longer runway of growth. Because of, I would say the concerns in China where they are closing some factories for pollution and environment controls. If one can find good quality companies, good business models and good management over there, then I think that is in an interesting space to look at.

So, I would say I would be a bit contrarian that I still think that since we have seen growth declining with the last two years—whether in terms of GDP or corporate earnings growth, we are at a growth starved environment and growth will normally get a premium for the next couple of years at least in my view. Till the time we see a big rally in earnings growth, the value trade which is happening globally as well as in India will continue to remain subdued. So, for example a lot of industry funds are betting on value stocks whether it be in the PSU banks, telecom, utilities or infrastructure. So, there are pockets of segments where indeed we have value because last 10 years they have not performed. But my view is, further if I see the businesses as such, I would still say that the companies which are delivering earnings growth with low debt and with high return ratios, will continue to perform well over the next one or two years.

So, most of these companies will have a fair or reasonable price. So, I would say they’re not cheap so they would be expensive because quality and growth comes normally you will not get it cheap, but I won’t bet for a re-rating. So, for value stocks to perform, there could be two triggers. One is the earnings growth and the other thing could be the value re-rating as well. For the growth, are quality stocks which we speak about- which are more of compounding stories. We’re not taking a case that evaluation will re-rate, we’re only playing for the earnings growth. In my assumption, if we’re betting or if we are placing our estimates over 20 percent PAT growth over a longer term, we would expect 20 percent returns or compounding keeping the valuation multiples constant. But for value stocks the case could be different. Points of time, when they get some earnings growth, the valuation multiples also re-rate. So, they can get a burst of good performance in between but obviously, it’s very difficult to time when it will happen. We think that longer term compounding works for us.

So, I would say that retail space as such. So, there are many stocks—just to broadly give you stocks—whether it be Bata Ltd., Jubilant FoodWorks Ltd., Avenue Supermarts Ltd.—there are many stocks which are more focused on the retail sector of India, with increasing consumption and which is driven not only by increasing penetration but is also driven by premiumisation and more spending. And fortunately, if we get some cuts in the budget, then definitely it will again be a big kicker for these stocks. So, I think increase the standard of living, the favorable demographics, increasing penetration and premiumisation. So, everything is making way for consumer stocks to do well maybe from Hindustan Unilever Ltd. to maybe smaller consumer stocks. I think consumer staples and discretionary are the spaces, particularly on the retail side where one can get very good earnings growth and very good performance.

We have a few companies. So, when we look at our portfolio valuation, we look at the overall valuations. Let’s say the overall valuation for the portfolio is 30 times for example on the trailing basis which is similar to the mid-cap index which is also trading at 30 times on the TTA basis. Particularly, we’re more bullish on mid-caps now because if you see the one-year forward PE valuations, it is 20 (times) because we are seeing a sharp growth in the index as such after a long period of flat earnings. So, therefore the valuations is also a factor of how much earnings growth you expect and if some of the companies—if they continue to deliver 25 percent PAT growth, which is more likely now because of the cut in the corporate tax rate, then the valuations in next one or two years can appear to be very fair or reasonable.

Definitely. There are companies and when I see my portfolio for the last 10 quarters, the PAT growth has been 23 percent on a CAGR basis. When the index was declining in earnings but if I take a case where the index on the broader market does well and the profit starts growing 10-15 percent, obviously I would assume that this 23 percent would be higher in a favorable condition.

So, the weightage of financials in Nifty is around 35 percent and in mid-cap index to which we are aligned with, is around 27 percent. So, we have a higher allocation to financials that’s almost 30 percent and we have been playing financials on both the large-cap space as well as the mid-cap space. So, if you see our top 5 holdings, the top two of them—AU Small Finance Bank Ltd. and City Union Bank Ltd.—they’re both classic mid-cap banks and we have a very high allocation to them. We also have some NBFCs as well. Financials, mostly in the retail space, are still looking strong I think for the next few years. We have a large window of opportunity; the runway of growth is still very good. It is important to identify the winners and the winners will be the ones where the management strategy is clear, and they have a robust risk-management practice. So, in my view apart from growth which I look at in most of the other companies, the primary thing which I look for in banks would be whether the asset quality and the risk management is sound or not.

Larger players will also gain market share. They are growing more than the system rate and the weaker players are losing market share.

Yes. So, whether in a large-cap or the mid-cap space wherever the management is good and they’re gaining their market share, they would be the winners.

The sunrise sector falls into two categories. One is, for example, within the increasing financialisation of savings and the changing demographics, asset management companies, life insurance companies and to some extent general insurance companies have been big beneficiaries. In fact, in the mid-cap fund we have exposure to life insurance companies and we recently had exposure to asset management companies as well. They have done phenomenally for us- almost both these companies have doubled in the last 1.5 years in terms of price performance. So, these are sunrise sectors, and these are sectors where you find companies in the mid-cap and the large-cap space. They have a very long runway of growth, very high quality and high growth companies. The other set of companies, for example, back-end manufacturing or whether it be maybe in the chemical space. There many of them but a lot of them are in the small cap space or like Dicksons and Ambers which are which are into back-end manufacturing and therefore again, one has to be very choosy and picky while selecting these stocks. I would advise that when you’re selecting a small-cap stock, it is very important to do greater due diligence compared to the other large-cap or mid-cap stocks and management and checking the management integrity and execution is of prime importance.

Yes.

So, as the name suggests—the maximum number of stocks is 30. We are a bit flexible—from 22 to let’s say 25-27, between that range depending upon the market opportunity we would be in that range only. We will never go beyond 30.

So, from a sector perspective we want to play the India growth story, the domestic theme rather than the export theme or the investment theme. So, when we say GDP is equal to C+G+I+X, we’re heavier on the consumption part. Again, as contra investors we’re not very heavy or very positive on the investment cycle at this point of time. Maybe after one year we’ll look at that. Though we have recently added a couple of names over there, but again we think that six months to one year is still more time for the infrastructure cycle to pick up. Even the government or exports I think they are still, maybe they’re not showing so much of promise at this point of time but the consumption theme, which is more value migration consolidation, playing on the reforms and the lifestyles—whether it be through financing the consumption or actually playing the consumption is what I think we’re getting a lot of bottom-up ideas and opportunities.