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A Smart Jockey

Kenneth Andrade, known for his astute stock-picking skills, discusses his funds in detail in this interview

Kenneth Andrade, CIO, IDFC Mutual Fund, is regarded as an excellent stock picker, specially in the mid- and small-cap space. When asked how he feels about that label, a grin is all you get. Despite 18 years of experience backing him, his down-to-earth attitude makes for an interesting interaction. Here he discusses his funds in detail with Larissa Fernand and explains what he looks for in a mid-cap stock.

There are two funds in your portfolio that do not impress by way of 1-year performance; the India GDP Growth fund and the Strategic Sector fund. Can you explain how you construct their portfolios?

Both these products are of recent origin.

The India GDP Growth fund was launched in February 2009. The allocation of this fund is related to the growth of the entire GDP. We look at the break-up that Agriculture, Services and Industry has to the country's GDP. And then we take a factor of the forecasted growth and build the portfolio accordingly. From the very start, we have closely stuck to the mandate.

The Strategic Sector fund was launched in the latter part of 2008 with the mandate to have 50 per cent into one sector while the other part of the portfolio would be diversified equity. The portfolio has been constructed with a large cap bias.

So what has been the reason for the low performance numbers?
Given the limited time that the GDP Growth fund and the Strategic Sector fund have been in existence, it's a little premature to talk about their performance. Still, if they have lagged in performance it was roughly during the period between March and June 2009. We were reasonably defensive during the period and maintained a low beta portfolio during that time frame. Though we rectified that towards the end of the calendar year, the stand that we took initially is showing up in all performances.

To break it down further, the India GDP Growth fund has got three large components, like I mentioned earlier. Around 8 per cent goes to Agriculture, Services would be around 70 per cent and the balance would be Industry. So a large component of the portfolio is skewed towards Services. Within that a lot of oil marketing companies made an appearance. That has not been a demonstrable part of the entire capital appreciation that has taken place.

The Strategic Sector Fund will have half the portfolio in one single sector, the other 50 per cent will function like a diversified equity fund. That single sector can vary depending on the fund manager's call. In November 2009, the sector was changed to Banking from Energy. Again, in the Oil and Gas component we held oil marketing companies which have not performed very well.

Then you basically you got your calls wrong.
We underestimated the risk appetite in the system. The idea is not about making a market call because we believe in being fully invested. The point is that when we change the characteristics of the portfolio, it sometimes does not perform in line with the market. If you track us right through the cycle in all our portfolios, including the Small and Mid Cap fund which was launched in February 2008, we largely got it right into March 2009. So we captured the entire cycle upwards and downwards. During this time we executed flawlessly. Between April and July 2009 we had a tough period. Since then, we got on track.

What did you do to get back on track?
We looked at all the portfolios and the gaps that were leading to the underperformance and filled them up accordingly. We moved all portfolios to deliver market returns. And in the second phase did what we do best - look for companies that have come through the turmoil and look for market leadership.

In many of your funds, the top sectors are Financial and Energy. But in IDFC Premier and IDFC Small & Mid Cap Equity, it's FMCG and Services. How do you select the portfolio for each fund? Do you start off with a top down approach?
In the diversified space, Banking and Financials are the dominant theme. But once we get into the mid- and small-cap space, we look at opportunities that can be larger over the next few years. So there we play a growth cycle and don't make a valuation metric. So in the diversified space we follow a valuation metric of how businesses stack up. It's not that Financials and Energy are not growing. They do have a large growth element. But in the case of FMCG and Services we are looking at businesses growing significantly larger than the overall market. Moreover, there are not many companies in these two sectors which are significant large caps. It's not possible to create a large cap portfolio in the FMCG space.

How do you distinguish between your two mid cap funds?
In the Premier Equity fund we try to be early in the curve and capture an opportunity at its inception. Once we identify the opportunity space we take the fund and concentrate the portfolio around this trend. To capture this opportunity the portfolio necessarily needs to have a construct of smaller companies. Currently the portfolio of Premier Equity is constructed in the consumer spectrum - mainly the rural economy. So FMCG, Consumer Durables - anything related to the consumer, will be close to 60 per cent of the portfolio. Another 25 per cent of the portfolio is in the value chain of agricultural products. In this case, we try to create an absolute return portfolio over a 3-year cycle. The Small & Mid Cap fund is lower on risk and also much more diversified in its approach. It tracks the CNX 100 index with a tracking error of +/- 10 per cent. Our approach in this fund is to find entrepreneurs in each industry that can actually lead their businesses with higher growth. This keeps the portfolio diversified and relevant to be tracked with the peer group.

The Small & Mid Cap fund is around Rs 462 crore. IDFC Premier Equity Plan A is at Rs 1,252 crore. Both are focussed on smaller companies. How important is size in managing such funds; isn't a smaller asset base more beneficial?
Size definitely impacts flexibility but it does increase conviction.

In a smaller fund, which we would categorise below Rs 500 crore, one tends to jump into most opportunities since the allocation to each will be small. In a larger fund, which is above Rs 500 crore, you have to be doubly sure of your bets and your conviction to stand by them even if things go wrong. In terms of consistency, the larger one will tend to score.

Currently, Small & Mid Cap has just about crossed the Rs 500 crore mark where it gives us flexibility to take advantage of shorter term opportunities while building a consistent top end portfolio that will give us consistency.

Is that the reason you have stopped subscriptions to IDFC Premier Equity?
Here, I would like to clarify that it is open for SIP and STP, not bulk subscriptions. Because the latter tends to destabilize the fund since money comes in and out based on momentum.

When we launched this fund, it was to be a flagship in terms of performance, not AUM. When we launched it, during the NFO period, we wanted to garner Rs 300 crore, but ended up with Rs 330 crore. Today the NAV of the fund is around Rs 28. So by pure migration of capital appreciation the fund is around Rs 1,000 crore in terms of AUM. So the incremental amount from the NFO is around Rs 400 crore. In terms of assets, a fund manager can accommodate a lot more money in a diversified portfolio, which is more benchmark driven.

When you analyse a mid cap stock, how does your analysis differ from a large cap one?
I'm not sure how we do things differently. But in the case of smaller companies, there is always a mortality risk. Any problem with the external environment will cause these companies to freeze in their tracks. That is where you get your best bets. The players who survive grow to be strong. We like to see how business plans materialise in a down cycle.

But what are the determining criteria that will make one mid cap feature in your portfolio and not another?
There are two moving parts in an equity stock price.

One is the underlying growth of the company, which is a measure of profitability. So if the profits are growing at 30 per cent per annum, then the stock price will grow at 30 per cent per annum. The second is the expansion of the PE multiple where there are other factors working. If you get both right the compounding increases.

Let's look at some broad examples just to illustrate my point and not as recommendations or portfolio suggestions. In my opinion, the only factor that creates a difference between an Infosys and a DSQ Software is that one of them had the DNA to transform itself through a crisis to emerge as a leader. If one had to make a portfolio of quality stocks in Technology, Automobiles, Telecom and Financials, then a mix of Infosys, Hero Honda, Bharti Airtel and HDFC would feature; all leaders in their respective fields. Why does DSQ Software, TVS Motors, Himachal Futuristic or Global Trust Bank not feature? All the companies had the same platform and the same opportunity. Over the past two decades, it is not that their respective industries have de-grown. And all are free market enterprises. I am not even looking at Cement, Petrochemicals or Manufacturing which had a licence raj headstart.

If you look at the specific characteristics of each of these businesses, it will come across why one company emerged as a leader while the other did not.

There are two elements that will help a company survive. Either it has the best cost or is a thought leader. HDFC Bank, Infosys and Hero Honda are both thought leaders and did things differently to scale their business and lead their respective industries. Bharti Airtel was a cost leader and executed brilliantly. Execution in all these cases was the key. Having an idea is just not enough.

These were four industries and all these companies were mid caps once upon a time. It's not about picking the right industry, every industry will throw up its leader.

How closely do you monitor the benchmark when you construct the portfolio? We are very conscious of it as the benchmark is a measure of how well you are doing. We are well aware of the gaps, in terms of sector weightage and we do correct these if there is a large tracking error opening up.

How do you manage risk in your portfolio?
One way to manage risk in the portfolio is to ensure good-quality stocks. The moment you deviate into companies which are extremely small in the business, then the risk shoots up. Such companies must have a very small allocation to the overall portfolio. Our sector exposure per fund is limited to 20 per cent and the stock exposure to 8 per cent.

Do you think mid caps will continue to rally this year?
That's a very generic comment. There will always be opportunities in the mid cap space. In a growing industry, you will always find potential leaders. During the Technology bubble, Infosys was not a large cap company. During the Infrastructure bubble, Jaiprakash Associates was not part of the index. The next big opportunity has to come from this space.

You are very bullish on Financials. Am I right in saying that most banks are trading near their all-time high valuation in terms of PB? <.br> That is only true of public sector banks. In the case of private sector banks, they are not at all-time highs.

So are you betting on private sector banks then?
In a sense, yes. Valuations are in their favour and I believe they would have a growth profile which is higher than that of the PSU basket. Further, in the next three years if the banking business will be led by retail lending, then private sector banks should lead this space. The past three years were led by corporate lending, where public sector banks stood out.

What makes you bullish on this sector?
The financial markets are virtually 50 per cent of the economy. For every asset there is a liability created. Be it infrastructure, retail, consumer or government, banks play a very important role. So there will always be opportunity to pick the right bank at the right price. Banking is also 24 per cent of the index.

What about IT? Is it that clients' discretionary spending, which had a complete embargo for past two years, may resume?
There are signs of it happening already. Look at the hiring that is taking place. It is at its three-year high. That's a strong indicator of how optimistic or pessimistic companies are. There is always work to be done and market share to be taken.

How do you view mid caps in the IT space? Are the operating margins of mid-cap IT companies generally lower and highly sensitive to currency fluctuations?
Right now we are casting our lot with the big players. We do have a couple of mid-sized names but not significant allocations. It is the big players that are expanding their market shares. The smaller players have seen a significant amount of volatility. Also, the business is coming to bigger companies with a larger footprint. So between the large and small players, the differentials in growth are not too large.

You are bullish on FMCG. Are you a great believer in the India growth story?
Over the last few years, the approach towards the consumer has been changed. A few years ago, the average daily labourer would get between Rs 35-75 on the ground. When NREGS was announced, it gave a family Rs 100/day for three months towards unemployment, the average daily labour rates moved towards Rs 140-200, depending on the geographical location. So this effectively stepped up the standard of living of the country. The Indian consumer is actually moving up the value chain. India is one of the fastest growing consumer markets in the world and the consumer is aspirational, be it rural or urban. Take a premium product like say a Dove shampoo. It is supposed to be a high end product. Yet it is being retailed in Rs 5 sachets, a premium to its competitor products.

The pay hike of the central government employees and public sector units will have an effect on spending. If India can sell 7.5 million motorbikes a year, the very same number of washing machines too can get sold. After 60 years of Independence, the Indian consumer has probably just arrived. And the consumer will upgrade, not downgrade. So yes, I am very bullish on the consumer space, of which FMCG is just a part.

Like the detergent war eventually got over, do you see the Telecom war ending?
Right now there is just one leading player in this space which has broken even on cash flows. As an industry we have moved from two operators in a circle, which got increased to four and now eight. And all of them have money to burn. Someday they will run out of it. So the company that has the positive cash flow will be the winner. The largest player will start consolidating market share. In India it's easier to acquire market share than companies. The cost of acquiring a consumer in this industry is high. There is so much of pressure and fragmentation of market share that it is safest to stick with the leaders rather than believe that a very small player will one day turn out to be very large.

What hindrances do you see to the economy? Inflation? Fiscal deficit?
I think corporate capex will be a big problem. It has to return. They invested in 2007 and then demand fell. The biggest spender right now is the government. As a country, we will have to live with fiscal deficits to manage whatever growth we want to maintain. As for inflation, when we look at the Budget, we see an inflationary trend of more money in the hands of tax payers and prices going up. It appears that the government is of the opinion that growth is easier to manage than inflation. So with inflationary growth, the onus of controlling inflation falls to the RBI.

GDP: Gross Domestic Product / FMCG: Fast Moving Consumer Goods / PE: Price to Earnings / PB: Price to Book / AUM: Assets Under Management / NFO: New Fund Offering / NAV: Net Asset Value / SIP: Systematic Investment Plan / STP: Systematic Transfer Plan /NREGS: National Rural Employment Growth Scheme / RBI: Reserve Bank of India