Volatility to continue; margin of safety higher in large caps: ICICI Pru fund manager

The Indian equity markets have hit a rough patch, with the Sensex shedding nearly 11 per cent in the last four months. According to Ihab Dalwai, Fund Manager at ICICI Prudential Mutual Fund, market turbulence isn't going anywhere, given India's lofty valuations and global uncertainties.

Overseeing assets worth over Rs 1.36 lakh crore across four funds, including the four-star rated Infrastructure Fund and Large & Mid Cap Fund, Dalwai hunts for opportunities in "segments experiencing temporary stress", emphasising his countercyclical approach.

In this interview, Dalwai explains why quality stocks present attractive entry points after their recent underperformance and shares his perspective on tactical asset allocation in volatile markets. Below is the edited transcript of our discussion.

Given the current market landscape, do you expect the ongoing volatility to subside soon, or should investors brace for extended fluctuations?

It's crucial for us first to understand the underlying cause of this volatility. I believe it's primarily due to the macroeconomic factors or possibly the administrative changes in the US. So, I think volatility will persist until all these issues are resolved.

Secondly, we must also look at the valuations of the Indian equity markets, especially in the mid- and small-cap segments. In brief, the volatility will likely continue due to the relatively higher valuations of the Indian market and global uncertainty from
macroeconomic and administrative changes.

What key factors or catalysts do you believe will drive a recovery in the Indian equity markets in the coming months?

One of the key drivers of market recovery is earnings. During the post-Covid-19 period, we witnessed a robust recovery in earnings, leading to increased investor confidence and optimism. But in the last two quarters, we have seen certain misses in earnings. The market's expectations exceeded the actual earnings delivery, leading to a recent decline in investor sentiment. So, as a result, we're seeing some market corrections currently, primarily driven by the earnings miss plus the global uncertainty.

Regarding earnings, I feel that over the last two to three years, earnings have been delivered by margin expansion across various market segments. In the future, the headroom for margin expansion is somewhat limited, and to improve it, we must solidify topline growth. Now, this topline growth ultimately depends on how government spending shapes up, how corporations start spending or investing to increase capacity and how retail or households start spending. So, broadly, all three segments of the economy have slowed down, and as a result, the topline is also not coming in as what the market has been expecting, and the headroom for margin expansion is low. I feel this is a temporary blip. I don't believe there is a structural issue with the ability of all three participants to spend; however, there could be a trigger once all these segments start spending.

Could you share your core investment philosophy and how it adapts to different market cycles, especially during periods of high uncertainty?

My thought process of investing is trying to identify segments or the pockets of the market undergoing any specific or temporary issues. However, from the medium to the long term, the fundamental story of those companies or segments of the market is intact. One can classify this as a countercyclical or non-consensus style of investing.

So, my hunt has always been to identify those market segments that today may be under owned, disliked by the market or underperformed on a three-year basis. This is the general area I am focusing on. I don't want to bucket it into either a growth, quality or value style. I would be open to investing in either of the three segments. However, my initial focus is on underperformance, under-ownership and a market segment experiencing temporary stress, as I feel this approach offers a strong margin of safety regarding
the business value and the price I'm willing to pay to acquire those businesses.

Sankaran Naren recently mentioned that quality stocks are looking attractive after a period of underperformance. Do you share this perspective and see quality investing as a key theme moving forward?

As discussed earlier, in my initial framework, I look for companies that have been underperforming over a three-year time frame and those that markets are not interested in. I think most of those tick boxes have been done for quality as a style because it hasn't performed over this period. Many of these quality businesses, which have a high return on equity (ROE), have not been re-rated. I would say that only the IT sector has re-rated, but outside this sector, I think there are a lot of segments that haven't been re-rated. So, being associated with quality stocks today has hurt fund managers if they've been invested for three years.

I think the existing holders would be under stress from a performance perspective, too. But anyone looking at quality today can be a good entry point for me because I'm not carrying the baggage of underperforming quality stocks. So, if I'm trying to enter it today, I'm getting that these businesses may not be at a very cheap valuation. Still, I feel relative to the market, it is a fair valuation to be associated with or be invested in quality stocks today.

What's your view on the mid- and the small-cap segments? Have they started to look attractive after the recent correction?

I think we need to look at mid and small caps on a relative basis versus the valuations of the large caps. I was just going through the data, which showed that Sensex has underperformed gold over five, 10, 15 and 20-year periods. So, suppose I am getting these mega caps at a relatively underperforming level to even an asset class like gold. In that case, I think the margin of safety is significantly higher in that segment of the market today.

Secondly, as I mentioned, mid and small caps have had a better earnings growth profile versus large caps, and that's why they have done well and even got re-rated. So when the earnings growth moderates, I think multiple compression is possible, with a higher probability of multiple compression in mid and small caps. Thus, from a relative basis, I would be more inclined towards mega caps and large caps versus mid and small caps in today's market.

If the valuations are expensive, where do you find the opportunity to invest in mid caps in the ICICI Pru Large & Midcap Fund?

Yes, in the large and mid-cap scheme, I need to mandatorily invest at least 35 per cent in the mid caps, and for that allocation, there are opportunities even in the mid-cap segment of the market. Again, here, I use a filter similar to the one I mentioned earlier; it has to be something that is currently under certain stress.

So, though I mentioned earlier that most of the margin expansion in the broader market has taken place, there are pockets in the mid-cap space where the companies are going through certain downturns, or the margin expansion is yet to play out. There are three-year underperformers in mid caps as well. So, I think there are opportunities within the mid- and small-cap space. But the point I'm trying to make is that there are limited opportunities.

In 2024, we saw a broad-based rally across equity, debt and commodities. How do you see multi-asset space evolving in 2025?

I think 2024 was a unique year in which all three asset classes performed decently. Hence, going ahead, clearly, it's difficult to call out a winner in terms of the three asset classes. All three are susceptible to various triggers, such as a reduction in interest rates for debt, a decrease in US Treasury rates for gold or an increase in earnings for equity. Thus, there are triggers for all three asset classes.

Our core belief is that we must allocate dynamically among these three asset classes. I feel one will have to be tactical in approaching the three asset classes. As I mentioned at the start of the conversation, there will be volatility this year, so dynamically managing allocation amongst the three would be the key rather than having a static allocation to each asset class.

Funds like the ICICI Prudential Balanced Advantage Fund have faced challenges during bullish market conditions, as the model suggests reducing equity exposure. How do you envision this strategy evolving, especially if the market undergoes more correction?

The broad setup for the fund is countercyclical. If the market goes up, it reduces the net equity level. As the market has corrected, the net equity level is expected to increase. So, we are comfortable with the broader framework of managing asset allocation within the balanced advantage fund. I would say a bit of volatility was missing because this product has been designed to generate returns in volatile environments.

Historically, if you look at the track record of this fund, it does well in a volatile market. So, suppose the expectation is for volatility to come back. In that case, I think this product should do well, be dynamically managed, and follow a set process for managing the net equity level. In an upward-trending market, generally, I think this fund would give decent returns but may not end up satisfying the investors' expectations instead of what a fully invested fund would do.

Also read: Why is PPFAS's flexi-cap fund sitting on 20 per cent cash? Raunak Onkar explains.