'Innovation Fund carries higher risk than flexi-cap funds'

Summary: The manager of a five-star-rated fund breaks down his investing playbook, one that blends probability, patience and contrarian calls. In this wide-ranging conversation, he explains the rebound in his focused fund, how he defines innovation and why stock selection matters more than ever in a neutral market.

Vinay Sharma doesn't believe in labels. For him, investing isn't about categorising stocks as 'growth' or 'value.' It's about spotting where real value can be created. At Nippon India Mutual Fund, he manages about Rs 18,500 crore worth of assets across three equity schemes, including the five-star-rated Nippon India Banking & Financial Services Fund. His approach is rooted in probability, patience and the willingness to go against the crowd when markets misprice opportunity. These lessons, honed over 20 years, have shaped a style that's flexible yet disciplined, contrarian yet calculated.

In this conversation, the senior fund manager opens up on his investing philosophy, the approach behind Nippon India Innovation Fund and why the second half of 2025 could test investors' ability to stay stock-specific.

Now that we’re past the initial volatility of early 2025, how do you see the Indian equity market shaping up? Would you say we’ve crossed the worst phase of earnings downgrades?

That’s a tough one to answer at this point, as there are many moving parts and a lot depends on how the second half of the Indian economy pans out. Looking at the domestic front, I believe the Reserve Bank of India (RBI) and the government have recognised that we are facing a growth issue. The revenue growth of large caps over the last two or three quarters is likely growing at single-digit rates. This is a phenomenon that spans sectors, whether domestic or global, and has been ongoing for some time now.

I think the RBI has realised this. On the domestic front, the good news is that we now have surplus liquidity across the board, and the RBI has cut interest rates very sharply. On the global front, several issues remain, including tariffs. How will the tariff situation be resolved? Will the US experience a slight slowdown due to tariffs or not? Generally, the global economy is in a bit of uncertainty, and how that plays out in the second half will have a bearing on your question.

However, I believe that if both the RBI and the government work in sync to revive growth, at least in the domestic sector, the worst of the earnings downgrades might be over. As for how the markets look, we are in a very stock- and sector-specific market. Because there are so many moving parts, some things will pan out okay. If growth revives, domestic sectors may start looking much better in the second half. However, as of now, markets are not cheap, so I would say it’s a neutral environment where one has to be very stock-specific, sector-specific and industry-specific.

Could you walk us through your core investment philosophy for managing equity portfolios? How do you go from spotting an idea to actually building it into a significant position in your portfolio?

There are two parts to this answer. One is the usual expectation that you look for sustainable growth and sustainable competitive advantages in companies and industries, and you look for management teams that strive to create value, are shareholder-friendly, and so on.

What I have learned over the last 20 years, and what I now strive to incorporate into my stock selection and portfolio construction, boils down to two or three key principles. First, we strive to avoid any style bias. The way we look at stocks is purely based on their potential for value creation. If there is value creation potential over the medium term, it doesn’t matter whether you classify it as a growth stock or a value stock. We try to stay away from such classifications because we believe that if you’re investing in something today, over the medium term, it has to create value—and in that sense, it becomes a “value” stock.

The second is that we do a lot of probability and scenario analysis. When analysts or team members pitch ideas, I overlay them with my own worldview and economic outlook for the next two to four years. Within those scenarios, we assess the probability of value creation and whether the risk–reward is in our favour.

Thirdly, perhaps once every two or three years, there are times when you have to acknowledge that the market is not always correct. Markets tend to overestimate or underestimate certain changes or fundamentals, and one must be prepared and willing to bet against them during such times. This can be a significant part of portfolio construction, as getting it right can generate substantial alpha for your portfolio.

These are two or three big lessons I’ve learned and tried to incorporate into my investing style over the past five to seven years.

The Nippon India Focused Fund had a challenging 2024, but it’s been a strong performer so far this year. What’s been driving that turnaround? Any particular sectors or stocks that have really made the difference?

It’s been a mix of some top-down calls going right and some bottom-up stock selection working out—things that didn’t work last year. I think one of the biggest contributors, if I recall correctly, has been our overweight position in the financial sector. We were quite sanguine on large private banks, and most of them have delivered decent returns year-to-date.

One primary reason for this is that the revenue growth differential between many other sectors and Financials has narrowed significantly over FY24 and FY25. As I mentioned earlier, Indian large caps are growing at single digits in terms of top line, and the same is true for the financial sector. The revenue growth gap that was quite evident in FY23–24 is no longer there, which has helped.

The second driver has been pockets of Consumer Discretionary, particularly upper-middle-class consumption categories. Some of these categories are still delivering mid-teens to over 15–20 per cent revenue growth, and we have held some of these stocks, which have done very well in the past six to nine months.

Third, there were a few “under-loved” stocks where the market was extrapolating a few quarters of sluggish growth into a long-term slowdown. We had the opposite view that over the next two to three years, growth could look different in some of these sub-segments. While growth acceleration hasn’t yet occurred, there has been a bottoming out, and as the market begins to believe that growth is stabilising, some of these stocks start to perform well.

So, it’s been a combination of sector strength, selective consumer plays and contrarian positions in certain underappreciated stocks.

When picking stocks for the Innovation Fund, how do you define and identify innovation? Do you look for specific themes or is it more about attributes like R&D focus, disruptive business models or market leadership?

We have not gone into very stringent quantitative factors for defining innovation, because innovation as a concept keeps evolving depending on the economic phase a country is in. We can’t compare ourselves to China or the US. The kind of innovation happening there is different from what is happening in India.

We define innovation using three or four basic parameters. One is whether, over the past 8–10 years, the company has evolved its business model and entered new products or business segments. Has it been among the top quartile in its industry in terms of introducing new products, processes and other innovations? This applies across sectors—we look for top-quartile innovative companies everywhere.

Then there are some sectors where the entire industry is undergoing a technological shift, requiring every company to adapt. For example, in the Automotive industry, we are transitioning from ICE to electric, hydrogen and to hybrids, and every company will have to undergo this technological change over the next 5–10 years. Similarly, Renewables, Defence and some of the higher-end IT services are sectors that constantly evolve and therefore form part of our innovation universe.

Therefore, it’s a combination of company-specific factors and sector-specific trends, which form the criteria for our innovation universe.

Which kinds of stocks in your Innovation Fund would you avoid in the Flexi Cap Fund, even though both can invest across market caps? What makes them a better fit for the former?

There will be considerable overlap between a diversified equity fund and the Innovation Fund, but there are distinct differences. Many companies in the Innovation Fund are at a stage where their growth outlook for the next few years is higher than that of the Nifty 500 or BSE 500 universe. These could be companies at the early inflexion point of a technology cycle, those that were in the private market until recently and have now gone public or companies from new-generation sectors such as food delivery, artificial intelligence, renewables or defence.

A typical characteristic of the Innovation Fund is that its universe offers higher revenue growth potential over the next few years compared to the broader market. Another key difference is that we don’t use the index as a guiding principle, unlike many flexi-cap or multi-cap portfolios that hold the top seven or eight large caps commonly seen across the industry. Instead, we aim to make this a pure thematic fund, focusing on higher revenue growth, greater value creation potential and possibly higher technology risk compared to a flexi-cap or multi-cap fund.

When you're building portfolios for Innovation versus Flexi Cap, which key factors differ, let's say, in terms of earnings visibility, valuations or risk tolerance?

As I mentioned, the first criterion is that most Innovation Fund stocks should have higher revenue growth potential than a typical flexi-cap or multi-cap portfolio or the BSE 500/NSE 500 universe that we generally use for stock selection.

Second, there should have been or expected to be some significant technological, product or process change in the industry or company over the last 5–6 years or in the foreseeable future.

In terms of earnings visibility, some innovation-oriented companies may exhibit greater volatility. Many companies may still be in the early stages of profitability, so their current profitability may not be established. Our focus is on future profitability potential for those sectors or industries.

Regarding risk tolerance, given the larger technological element involved, the risk profile of the Innovation Fund may be slightly higher than that of a typical flexi-cap or multi-cap fund.

Finding the right kind of growth

At Value Research, we believe long-term investing is about backing businesses that can create real value over time. The goal is to identify potential and stay invested with conviction.

That’s why our Analyst’s Choice list includes funds that focus on consistent performance, sound strategy and thoughtful portfolio construction, qualities we’d look for if we were investing our own money.

When you find the right approach, labels don’t matter; outcomes do.

Explore Fund Advisor today