Jayesh Gandhi, fund manager, Morgan Stanley, attempts to bring a superior product before wooing investors…
26-Apr-2011 •Research Desk
Morgan Stanley Mutual Fund has gone very slow in their pursuit of new offerings. Jayesh Gandhi, fund manager, Morgan Stanley A.C.E., has attempted to bring out a superior product before wooing investors with a new one. Here he speaks about his strategy and how he generates alpha on his portfolio.
Why is it that Morgan Stanley has just two equity products even though the fund house has been around for so long?
One thing that we were keen on doing was demonstrating our long-term track record. In April 2011, Morgan Stanley A.C.E., our multi-cap fund offering completes three years, which is an important milestone that distributors, particularly banks look at. We wanted a demonstrable track record of strong performance which we have been able to do before going to the investors/distributors again with a new fund offer. From a pure equity fund stand point, our next offering could be in the mid- and small-cap fund space since we already have a large-cap and multi-cap fund.
In terms of timing as well we think the current environment is appropriate since the space, mid- and small-cap stocks, has underperformed significantly over the last 3-6 months and now offers substantial value. We think that investors could make disproportionately higher returns over the medium to long term in mid-cap stocks. In the last 6 months, in A.C.E., we have cut our mid-cap exposure of 35-40 per cent to 15 per cent currently. In an environment where we were trimming mid-cap exposure, it did not make sense to approach investors in the market to get into a mid-cap fund. We believe that an opportunity to re-enter into mid-caps will emerge in the second half of the year, and we intend to launch a mid-cap fund at that point.
So the fund house just plans to grow the asset base of the existing funds?
Not really. A.C.E. started with an initial corpus of Rs75 crore, today we are close to Rs400 crore. Even in the last two months when the equity market has been in a corrective mode, we have seen inflows. Amongst the various multi cap funds, we have been within top five funds in terms of net inflows in 2010. Most distributors, private bankers, brokerage houses are comfortable with our investment style and strategy and are recommending A.C.E. A number of distributors, who require a 3-year track record in order to recommend a fund to their clients, will also look at this fund in a few months. Having said this, now that we have an established distribution reach, and track record, we will look to launch more funds, for e.g. mid-cap, and grow assets through that route as well. We also have plans to launch liquid and fixed income funds later this year, with a focus on increasing presence amongst institutional clients.
After a very good performance in 2009, Morgan Stanley A.C.E. was not that impressive in 2010. What happened?
If you look at our performance, we have consistently delivered alpha (fund returns in excess of benchmark) in each of the last 3 years. For the 8 months of 2008 our alpha was 4.9 per cent, in 2009, it was 16.4 per cent and in 2010, it was 7 per cent. The alpha generation in 2010 has to be seen in the context of the overall market. In 2009, BSE 200 delivered very high returns hence the alpha was also high. The returns dropped to 16 per cent in 2010. So when one takes a look from that perspective, we have done quite well. This is a relative performance fund, so you have to see our performance relative to the benchmark returns.
Take a look at peer group comparison. Out of 59 funds in the multi-cap category, this one just about managed to get into the first quartile with a ranking of 14 in 2010. In 2009 it was the fifth best fund. Even if you look at current 1-year returns (March 7, 2011), it is certainly not the worst (-8.14%), but is far from the best (16.35%). This fund has returned 5.54 per cent.
Short-term returns vary across market cycles and are, therefore, not the best way to evaluate fund performance. Our portfolios are more broad market driven portfolios and the broad market sold off in the last quarter. The index stocks form only 50 per cent of the portfolio. So generally speaking if the broad market does well, our funds will do much better. Nevertheless, that does not mean that we do not generate alpha, it is just that it may happen to a lesser extent. To generate returns in excess of benchmark, we have to look for stocks that are outside the benchmark. Or even take sector bets that differ from the benchmark. For instance, over the past 6-12 months we have not held a single telecom stock in our portfolio. Similarly, in 2010 we were underweight Metals, but today we have an overweight in the sector. The change in sector allocation or finding that unique stock is what adds to the overall returns.
There are three basic sources of alpha for our fund, namely sector allocations, stock picking (selecting stocks that may not be part of the benchmark) and changing our market-cap composition of the portfolio. Our cash levels in the fund are also moderate compared to many funds in the peer group, with around 5-10 percent in cash. However, taking big cash calls can affect fund performance both ways; hence, we need to be consistent here. End of the day, we believe, that if we manage to deliver alpha year after year, we would be able to deliver top quartile performance in the long term.
So missing the rally in Metals hit performance?
Historically, post recession Metal prices remain low for many years as the demand takes time to pick up. However, this time, post 2008 recession, Metal and commodity prices moved up sharply and quickly because of a lot of money and financial investments flowing into it. Hence, we have seen large price increases in copper, crude oil, etc. Over the last two years, we have been under weight on Metals and Commodities. Hence, with the sharp rally, we were impacted initially, but have now adjusted the sector weight accordingly.
But crude oil prices rising are also due to the extremely cold winter in the Northern Hemisphere and the political turmoil in the oil producing countries.
Yes I agree. Currently, prices are volatile and there is high level of speculation. Therefore, these prices have gone up quicker than anticipated. It was initially driven by the argument of global recovery and recovery in US economy, which is by far the largest consumer of oil in the world. However, the last month’s spike in oil has happened largely because of geo-political tensions. It is extremely difficult to predict the outcome of events of this kind. But if the crude oil prices remain high, say above US$ 100 for an extended period of time, then the global growth recovery would be at risk. Further, inflation expectations would go up significantly in the developed world which could lead to rise in interest rates. Therefore, the entire global economy including India could suffer if the oil prices remain high for a long period and that is the most significant risk for global equities.
What about India’s growth?
The government is looking at 9 per cent. My sense is that the economic growth for FY12 will be a function of inflation, particularly industrial inflation and, hence, crude oil prices. For our economy to grow at 9 per cent, it is very important that crude oil corrects down significantly over a short period of time. The domestic food inflation will subside over summer this year. Barring a few cases such as coal and iron ore, outlook for Metals is not very strong because of China’s slower growth outlook. So now crude becomes the critical factor to watch. Once crude oil cools off, inflation expectation will subside and so will interest rates. Economic growth will then be back on track; else we are likely to be disappointed.
At one time you were very bullish on Pharma.
It continues to be an overweight. The allocation has dipped slightly because we have booked profits in some of the mid caps. Pharma continues to remain a good medium term story, particularly generic exporters to the US market. To give you some statistics, pharmaceuticals exports have been rising at the rate of 20 per cent during the last five years, but the exports to US have been growing at 30 per cent+. This trend is likely to continue and there is a huge opportunity for Indian companies to capture market share in US as it shifts more towards generics. In the next few years growth will be tremendous because of record number of branded drugs going off patent in the US and that is the opportunity which we are targeting through our invested companies.
You say that allocation has dipped because you booked profits. If that be the case, how will you up your allocation since you are bullish on this sector?
We will look to add new names in the sector into our portfolio, very soon.
How do you construct the portfolio?
Our portfolio construction process is very clear. We use both top-down as well as the bottom-up approach. Our sector allocation as well as market cap mix is determined by our top down view. For example, currently our mid-cap allocation is low as the top-down view we have is that mid-cap companies may find earnings growth difficult to come by in a high inflation, higher interest rate and slower economic growth environment.
We look at the sector weight in the benchmark and then we break up the sector into subsectors like public sector banks (PSU banks), private banks, banks lending to housing, non-banking financial companies (NBFCs), brokerages, etc. The objective being to identify the areas where we want exposure and areas we want to avoid or be underweight. The individual stock picking is always done on a bottom-up basis. For instance, we like the real estate sector, particularly residential real-estate because the income levels are rising, pent-up demand is very high in India and credit availability is good. But when we look at individual stocks, most companies are high leverage, operating cash flows are missing and there is poor corporate governance. Hence we have been very selective although our sector view is robust.
How easy is it to manage the market cap exposure?
It’s not easy to change allocation quickly to and from mid-cap to large-cap and vice versa. It has to be done gradually over a period of time. We changed our weight in mid-caps and brought it down significantly in the last 6 months from around 35-40 per cent to 15 per cent today. If you look at mid caps, we want to own some stocks from a long term perspective. In August 2010, we began to feel that mid caps were relatively overvalued, having outperformed significantly in second half of 2009 and first half 2010. So we began to gradually cut our exposure. Now we believe we should start looking at mid caps from a 2-year point of view. Mid caps are a great source of alpha if one can manage the risk. Our prime focus today is to first manage risk and then look at generating alpha.
How do you manage risk in your portfolio?
Firstly remember that equity portfolios and funds are all about taking risk and bets on the equity markets. In this context, there are multiple dimensions to risk management, in the sense it is done at portfolio level, sector level and then at stock level. Risk management is about ensuring that the portfolio is well balanced and diversified, for e.g. without any unusually large sector bets, cash bets or bets on illiquid stocks, since we manage an open ended fund. We do our due diligence on stock picking stringently so that quality companies figure in our portfolio. Focus is on portfolio churn management to ensure that it does not become unduly high. Risk is monitored by a separate team which sits in New York, using a variety of proprietary risk assessment software. The portfolio managers have interactions with the risk team on a monthly basis to know the areas of concern and take quick remedial action where required.
What is the universe of stocks that your fund house monitors?
Around 250-300 stocks. The stocks that make an appearance in our portfolio will be around 40-50. We meet a lot of companies but often our company meetings or conference calls are to gain a better understanding of the sector and outlook. Of the 300 stocks that we track, the investible universe would be much smaller.
What do you look for in a stock?
We look at a large number of qualitative and quantitative factors. Ours is a growth oriented fund so I look for is growth in earnings. We are not value investors. Growth at a reasonable price (GARP) is the first criteria.
Promoter integrity and shareholding follows closely as the second parameter. One can only make money when the investors’ interests and promoters’ interests are aligned to enhance the market cap of the stock.
Strong and sustainable growth dynamics in the sector and sub-sector is important. The tail wind from the sector growth is very important for the company to do well and the growth opportunity should be large and sustainable.
The business must generate superior returns and demonstrate capital efficiency such as high return on equity (ROE), operating cash flows, etc.
Is there any sector you will never touch?
All sectors move in phases. Take the example of stock brokerages; few years ago it was in the midst of a boom. Today the consensus is that we have an over capacity scenario. It is an industry where margins are declining and revenues are not growing. So one cannot commit to a sector the way one does to a stock. So while there may be certain stocks that we stay away from, that will not be the case with a sector.