Working on Stability

Rajat Jain
CIO, Principal Mutual Fund
Being fully invested in the markets paid off for the fund house, helping it gain handsomely last year as the stock markets rewarded investors across-the-board. Rajat Jain, explains the thought behind the strategy.

Principal Emerging Bluechip did extremely well last year. Was it great timing? The moment the market picked up from March onwards, the fund was on a roll and the June 2009 quarter saw an impressive performance.
We did enter when the market was somewhat low, but timing would be a small contributor to the performance.

Initially we had some large cap stocks when we first launched and had to deploy the funds. Gradually we added mid cap stocks. Between January and March 2009, large caps did better than mid caps. From March onwards, mid caps began to rally and by then we were invested in mid caps.

But what actually worked in our favour was that we were true to label. In some funds, managers were wary of mid caps. Hence a lot of funds held some sort of a large cap tilt, despite the mandate of being a mid cap fund. We stuck to our mid cap orientation which means at least 65 per cent of the portfolio is in mid caps at all periods of time and at least 5 per cent in small caps. So any point of time, 70 per cent of the portfolio of Principal Emerging Bluechip will be in mid- and small-cap stocks. So when the market began to rally, our true-to-label positioning helped.

What was the reason for mid caps rallying to such an extent?
There was a significant valuation differential between large- and mid-caps. And the differentiation, though narrowed now, still exists in favour of mid caps.

So you see mid caps rallying in 2010 too?
Mid caps comprise of a fairly large range. In a number of mid caps we see a good business plan, good management and a great business. It's just that the company is much smaller. But the size does not translate into them being weaker in their space. It's simply a matter of size, not quality.

What specific parameter do you use to select a mid cap, as against a large cap?
Generally, the stock analysis of both will be the same. But in the case of a mid cap company, a lot more time is spent looking at the capability and quality of management. Scalability too is an issue. A large cap is much more tested, tried and adequately researched.

A number of mid caps are leaders in their own space, though they may not be large.

Were there any specific sectors that worked in your favour where Principal Emerging Bluechip is concerned?
No. We had a diversified bet across sectors. We did not have any strong individual sector or stock calls.

What is the highest individual stock and sector exposure you can take in this fund?
Currently, as of January 2010 portfolio, the highest exposure to a sector was 8.5 per cent. We have around 55 stocks in this portfolio. The highest individual stock exposure can be 5 per cent. The sector exposure is controlled vis-à-vis the mid cap benchmark.

The fund is small at around Rs 200 crore. Why not a much tighter portfolio?
In a large cap fund I would probably hold under 40 stocks. But in a mid cap fund one needs to be more diversified simply because the stocks are inherently more volatile. A concentrated mid cap portfolio would be a volatile one, something we do not want.

Is large size a hindrance in managing a mid cap fund?
Yes. In a large mid cap fund the options available to buy into stocks gets very constrained. Because you have to have a certain exposure to a stock for it to impact the performance. If it's a large fund it does pose a problem. But that is only at a particular level. So a Rs 1,000 crore mid cap fund is as good as a Rs 200 crore mid cap fund.

Why was the cash position in Principal Emerging Bluechip high over the past two months - December and January?
We are in the process of lowering it. We got a lot of inflows and now have to deploy that money. It is not as easy deploying money in mid cap stocks as it is in large cap stocks. A lot more research is needed.

Is it right to say that Principal Mutual Fund is a very conservative fund house, in terms of investments?
I would not say we are conservative. Our attempt is to be consistent and not volatile. We are still beating the benchmark, handsomely. We don't believe in avoiding risk, but certainly believe in controlling risk.

Your top holdings are much less concentrated than the average sector.
That is generally true of all our funds, though the large cap funds may be more concentrated. We follow the benchmark closely. So if Reliance Industries Ltd is 10 per cent in the benchmark, then even if I am underweight, I will have to have a 6 per cent holding. So we may be more concentrated in our large cap funds but when compared to the category average, we will not be concentrated.

There are two factors that work in a fund manager's favour: good stock selection and good portfolio construction.

What goes into good portfolio construction?
The risk parameters laid down. The maximum exposure permitted to a stock or sector. The amount of diversification. The tracking of the benchmark. Even if you seriously believe in a stock and it does not do too well, it must not hurt your portfolio in a serious manner. So even if I like a stock I cannot make it 9 per cent of the portfolio if the benchmark is, say, 3 per cent.

Another point I would like to make is the importance of sticking to mandate, which I believe we do. You have to do what you state you will do. You cannot keep changing the complexion of the portfolio to suit the market environment. So if large caps are doing well, I cannot tilt my mid cap portfolio towards larger stocks and vice versa.
Our cash allocation is generally around 4-5 per cent and we usually do not go more than 10 per cent in cash. That is why we suffered in 2008, because we did not go heavy into cash. But we were rewarded in 2009 because when the market picked up we were fully invested.

Principal Mutual Fund emphasizes that its schemes must closely monitor the benchmark. Is it not limiting being restricted to the benchmark?
It is a part of risk control and does give the fund manager ample leeway. You can be overweight or underweight on the stock. This is what brings about consistency and lowers volatility.

How much of a leeway do you get to invest in stocks or sectors outside the benchmark?
If a stock is not in the benchmark but I choose to invest in it, I can go up to 3 per cent in that stock.

What if a stock has a 10 per cent weightage in the index but you are not bullish on it at all. Then how underweight can you go?
Around 5 per cent. And if I am really overweight, I can go up to 10 per cent which is the SEBI regulation on investment exposure.

Personal Tax Saver has slipped from its top slot.
Personal Tax Saver is an ELSS which has a large cap focus. It is not doing too badly. It is not a top quartile performer but neither is it a bottom quartile performer. It is more of a second quartile performer.

Earlier it had more of a mid cap bias. Now it is more in sync with its benchmark, the BSE 100. So when you say performance has slipped, I agree that it has not done as well as a mid cap fund. But it is certainly doing what a BSE 100 benchmarked fund should do.

Financials has been one of your highest sector bets for a while. But the allocation to this sector has been falling. Why?
We do believe that this sector is part of the India growth story going forward. But in the public sector bank space, we have a slight concern with non-performing assets (NPAs) going forward and bond yields rising slightly. As a fund house, we have gravitated more towards private sector banks.

Even in our large cap funds, we are slightly, but not substantially, underweight in Financials.

What about Technology? Are there not sufficient opportunities in the mid cap space?
Not really. Of late, there have been downgrades in the mid cap Technology space. The smaller companies are not that suited to go through challenging times, the larger ones can deal with it much better. So in our large cap funds, we do have large cap names in this space. But we are not overweight, just neutral.

Neither do you seem to be bullish on Healthcare.
In the large cap fund we are overweight on Healthcare, but not in the mid cap funds. In this space, we mostly play the Indian companies, not the multinationals.

Does the Infrastructure theme have lot of steam left in it?
The Infrastructure space has not done well in the markets of late, but yes, there are tailwinds behind it. This is a space where you have a lot of visibility in terms of growth. You see the order books growing. The supply is not growing, there are not too many new players coming into this space. So the existing players will definitely benefit because the order flow is strong and there is no fresh competition coming in.

Do you think the Telecom war will last forever or like the detergent war, it will eventually end?
The intensity of competition in Telecom is led by the newcomers wanting to gain a presence in the market and having the funds at their disposal to do so. Going forward, not all companies can continue to burn cash and we do see consolidation over the next few years. So clearly we see the intensity of competition weakening.

Do you see a rising interest rate scenario hitting the Auto sector?
The kind of volumes we saw in 2009 may not be witnessed this year. But the valuations are supportive of stocks in this sector. Also, the growth in the rural areas will help. A lot of these companies see a lot of their sales come from rural areas. Farmers have made huge amounts of money this year in terms of cash crops. So demand will rise. There is more hiring this year in corporate India. The rural system is holding up. Valuations are still good. All this bodes well for the Auto sector. The impact of higher interest rates will not impact the growth rates significantly. Raw material prices have gone up but will not continue to rise.

Which sectors are you bullish on now?
We are neutral to overweight in Financials. We have added to our private banking space but cut down on public sector banks.

We are neutral on Technology and Energy. Though we are slightly overweight on Oil Marketing Companies.

Overweight on Auto and Capital Goods. In Pharma we are slightly overweight.

Which sectors are you totally avoiding?
We are underweight on Telecom and hold just one stock. We have no Real Estate in our portfolio. But by and large, there is nothing that we totally avoid simply because we do follow the benchmark closely.

How do you see the market panning out this year?
I do feel mid caps, as a category, would do better than large caps. But there is still value in some large cap companies. There are some good options at 12x-13x FY11 forward earning multiples. So valuations are still not all against you. But the key event is going to be the macro situation. Emerging markets as a category should do well and I see money coming in.

What are you wary of?
FII flows is a matter of concern. On account of government borrowing, IPOs and QIPs, there is a need for capital. We would see strong flows from the insurance companies and would need strong flows from the FIIs as well.

Do you see credit growth picking up this year?
Yes. I see decent credit growth numbers. All the banks that we talk to are sitting on sanctions. Disbursals will start soon. I see interest rates rising in the second half of the year.

Do you not see inflation as a threat?
Inflation has been led by primary articles but the risk is that expectations build up and it spreads to other areas. We still do not see general inflation level getting out of control as we see the RBI acting to take preventive action.