Why have Mahindra Manulife's equity funds done so well? Its fund manager explains.

Building a reputation in the notoriously fickle world of mid and small caps is no mean feat, and that's what Manish Lodha has achieved. Although he has 25 years of experience and is currently presiding over 11 funds at Mahindra Manulife, including the multi-cap fund, it's his recent standout performance with the mid-cap (four-star-rated by Value Research) and small-cap funds that's made him the centre of attention.

During our conversation, Lodha explained in some detail why that's the case. (We are especially intrigued, as it has become increasingly difficult for mid-cap and small-cap funds to beat their benchmarks.)

In addition, the Kolkata native also shares his investment philosophy, explains why he thinks the mid- and small-cap space is "becoming more relevant for the next leg of India's economic growth", and highlights the sectors he finds most promising.

Here's an edited version of our interview.

What initially drew you to equity investing? Was there a specific moment or experience that ignited your passion?
It goes back to my school days in Calcutta (now Kolkata). The Calcutta Stock Exchange was just a stone's throw away from my school. During the mid-90s, the stock markets were booming, and a few of my batchmates would visit the exchange after school. Calcutta was a bustling hub for stock investors, providing opportunities for both learning and earning.

When the markets crashed (following the Harshad Mehta scam), I quickly learned that change is inherent in the nature of the markets, necessitating ongoing learning and research. I began to read newspapers and magazines, which sparked my passion and interest in stock investing. I found a differentiated approach when I could correlate stock movement with the company fundamentals and know more about the management. Later, while pursuing my college degree and earning my chartered accounting (CA) certification, I began investing in the markets, which marked the beginning of my journey.

How would you describe your investment philosophy? What kind of stocks or market conditions get you excited and motivated?
India is a growth economy by nature, and my approach to stock investments reflects this growth mindset. I believe that value and growth are two sides of the same coin; a business that has been growing for the past 10 years may present value, and vice versa. I do not view markets based on whether they are in a bull or bear market, as this would limit my abilities. I always try to see all perspectives related to the market and position the portfolios accordingly.

This has been my core philosophy: every market phase provides opportunities - whether it's for growth or learning. Since India is inherently a growth market, we cannot lose focus on the growth.

What's your investment process? How do you select stocks for portfolios?
Our strategy is based on four important pillars: growth, cash flow, management and valuations. First, we look for companies with consistent growth. Second, we prioritise those generating better cash flows, as we prefer businesses that don't rely on external capital for growth, especially since external capital isn't always available.

When evaluating management, we consider the capital allocations they have made previously. Finally, we consider the valuation. If something is good and appealing, its price-earnings multiples may remain high unless there are changes in the assumptions underlying its growth, management, or cash flows.

Now, when we look at identifying opportunities or stocks, we look at whether the industry to which the business is pertaining is growing and whether the company has the ability to gain market share over a period of time, backed by good and capable management. We always say that one should focus on management, not just stock prices. If you are betting on the management, you are also taking a call on their ability to navigate downturns, upturns, or challenges in the business.

We also monitor macro-level events, link them to micro-level opportunities, and tailor our portfolio accordingly.

The equity markets have been on quite a rally, seemingly defying all odds. What do you think is driving this current surge? Do strong fundamentals back it, or is it more about investor sentiment?
It's a combination of both. If we examine the stock fundamentals, we can see that the Nifty has surged from approximately 18,000 in September 2021 to a current level of around 25,000, accompanied by a rise in earnings. Currently, we perceive India as a relative beacon of hope amidst the global economic slowdown. With its demographics and potential to become the third-largest economy in the next five to seven years, India presents a significant opportunity. These factors are contributing to the positive sentiment amongst investors.

From the domestic investor point of view, sentiments have been positive, notably over the last five to 10 years. Thanks to digitisation and information availability, people have understood that you create wealth if you are in the market for five years or more in an economy like India.

Previously, when markets experienced a correction, investors would either halt their systematic investment plans (SIPs) or withdraw their funds. However, in the past four years, we have observed that during market corrections, investors continue to add to their SIPs and do not stop. Therefore, I believe that their approach towards investing has become more robust, and they now understand that partnering with the right investment partner, fund manager, or fund house can present a significant opportunity for wealth creation over the next five to seven years.

Valuations, especially in the mid- and small-cap segments, look pretty stretched. Are these valuations justified, or are we potentially heading toward a correction? What could trigger such a correction, in your view?
In my view, mid and small caps as a space are becoming more relevant for the next leg of economic growth. Nevertheless, valuations are expensive in some pockets. However, if you adopt a bottom-up stock-picking approach, certain themes and sectors have the potential to grow into large-cap companies in the future. These businesses will become increasingly relevant in the next 15 to 20 years.

For instance, stocks in the electronics manufacturing services (EMS) sector, the entire electric vehicle (EV) ecosystem, non-banking financial companies (NBFCs), the entire capital markets, and the pharmaceutical industry, among others, present numerous opportunities for significant growth in the coming years. Not only is the growth expected to be high but its longevity is also expected to remain high. When we discount back the excess returns expected from these companies or themes over the next five to seven years, the valuations appear reasonable.

Mahindra Mid Cap and Small Cap funds have done well in 2023 and even in 2024. What factors have contributed to the performance, and which stock calls or sectoral allocations have worked well for the funds?
I believe the performance is a result of our robust process. It's difficult to assign one reason for the last two years' outperformance, as we always stick to our core investment philosophies. I can say that we are willing to compromise on returns in the short term, but not on the process. That said, sectors such as capital goods, the entire electric vehicle (EV) ecosystem, a few chemical companies, telecom, and some pharma stocks have been big contributors to our performance.

Even the Power sector has played a significant role, as we are quite bullish on it. We believe that the power story in India is unfolding very nicely. In the last decade, there were no investments in the power sector, but now we are witnessing a growing demand for power on three fronts. One is individual or household power consumption; secondly, manufacturing-led growth in our gross domestic product (GDP) also requires power.

Finally, the emergence of artificial intelligence (AI) and data centres has significantly increased power consumption. India's desire to store data within its borders has led to establishing numerous data centres, which require significant levels of power. I believe these are some of the key themes that have contributed to our improved performance.

Finding value in the mid- and small-cap space isn't easy. Are there any specific sectors or industries where you currently see untapped potential?
We've been focussing on the chemicals sector for the last two or three months. This sector performed exceptionally well in 2021, but after that, there was extensive supply from China for basic chemicals, decreasing the sector's prices. Over the past two years, the sector has experienced a decline in profitability. However, the situation is improving, and we are witnessing opportunities where prices and volumes are rising. Therefore, the mid- and small-cap space may present opportunities in this particular sector.

We're also bullish on the pharma sector, particularly with the applicability of the US Bio-secure Act going forward, which is expected to boost business for pharmaceutical companies.

There are also mid- and small-cap opportunities in the EV ecosystem in terms of battery plays, auto and EV ancillaries, and core sector-related companies.

We've noticed that your mid-cap fund has been generating a lot of its returns from large-cap holdings. With the mid- and small-cap segments starting to look overvalued, how do you plan to manage the fund moving forward?
It will depend on the market opportunities. To give an example, around the same time last year, we looked at specific opportunities in the mining space, where we had not seen traction for almost a decade. However, overall, something was changing, and we thought it was a good opportunity to invest. It's not that we wanted to buy a large-cap name, but we bought a potential alpha-generating idea, which happened to be a large cap. Therefore, I believe our decision was primarily influenced by future opportunities and the potential for alpha generation in the market.

However, we must adhere to the mandate, which stipulates a minimum of 65 per cent for mid-cap funds or a minimum of 65 per cent for small-cap funds. The market opportunities and alpha ideas available in the market will determine the allocation of the remaining 35 per cent, a flexible portion.

Also read: Interview with Arun Sundaresan of Nippon India Life Asset Management