'Growth is stronger, earnings are catching up'

Summary: HSBC Mutual Fund’s CIO – Equities discusses why he remains overweight on mid- and small-cap opportunities, despite the recent market correction and how he navigates cycles, risks and global diversification, in this interview.

Despite the late-2024 correction, parts of the market still look expensive. But Venugopal Manghat, CIO – Equities at HSBC Mutual Fund, argues that the picture is more nuanced. He believes valuations appear richer largely because of an earnings slowdown and that multiples need to be viewed in that context. However, with earnings stabilising and several pockets having meaningfully corrected since then, Manghat now sees selective valuation comfort, especially in financial services and tech. This reset, combined with a more supportive macro backdrop, is also why he remains overweight on mid- and small-cap stocks that offer more compelling long-term entry points.

In this interview, Manghat explains the principles behind his stock-picking framework, how he balances large-, mid- and small-cap exposure, and the safeguards he uses to avoid value traps in cyclical sectors. He also discusses HSBC Mutual Fund’s international offerings and how they open up opportunities beyond what domestic funds can provide.

Manghat currently manages an asset base of Rs 38,500 crore across four schemes, including the HSBC Value Fund, which carries a four-star rating from Value Research. Below is an edited transcript of our conversation.

With markets at all-time highs and some pockets looking pricey, where do you still find genuine valuation comfort today and which areas make you cautious?

After three or four years of strong market performance post-Covid, by September 2024, valuations had risen, and ownership levels had also increased quite significantly. But more than that, I think you have to look at valuations in conjunction with earnings growth and return on equity (ROE) expansion. Earnings growth was weak, and since September 2024, we have seen a slowdown at both the macro and corporate levels, which has made valuations look even more expensive on the surface. I think that's been the cause of worry.

We've seen a time correction play out in pockets. I still think valuations are reasonable, for example, in the financial services space, let's say banks and NBFCs. I believe valuations are reasonable even in the tech sector. On a five-year relative valuation basis, we see valuations at a reasonable level, though again, I think growth has slowed down there. So, one needs to be careful.

Also, in this market, many stocks have corrected significantly over the last year. Post-September 2024, the indices have remained flat to marginally negative. But if you go down into and outside the index, you see many stocks in pain, having corrected quite significantly. So, it's a bottom-up market. Leadership is not there at the moment, so one has to look for ideas where corrections have already taken place, valuations have become reasonable and earnings growth is maybe returning to normalcy.

Your style is rooted in owning high-quality businesses at reasonable valuations. How do you stay disciplined when quality stays expensive for long stretches?

It is tough in an environment like this, where good quality gets expensive. Let me explain our approach. We like good-quality businesses. Good-quality businesses are well managed, have a long runway of growth ahead of them, have moats and some competitive advantage, and are less prone to disruptions, whether from technology or other external factors. Those are typically the businesses we like, and good-quality people run them. Those are the businesses we prefer.

In the current period, as the strong market rally that lasted until September 2024 ended, many of these companies reached fair to high valuations. And it is tough to really keep your faith in these companies and remain invested, but that's what you need to do. You have to be disciplined. At the same time, we try to avoid putting fresh money into companies at very high valuations and don't chase them at any price.

Our basic approach again is to buy companies at reasonable prices based on growth. So, we try not to overpay for what we buy. And thus, incremental money is not chasing any of these. Some of them, where we had invested in the past and which have done very well, and where we think the longer-term story is intact and earnings continue to grow, we remain patiently invested. We may adjust the portfolio's overall exposure, but we remain invested in these companies.

Across the funds that you manage, could you elaborate on the core principles – the non-negotiables – that guide your stock selection, and how these investment disciplines have evolved with changing market cycles?

Our basic tenets of investing remain the same. We are long-term investors. We invest based on fundamentals. When I say 'long term,' we generally see less churn in our portfolios. We remain invested patiently for longer periods and let companies and businesses compound, unless valuations become too expensive or structural changes in the business force us to reduce our positions or exit. Otherwise, we remain patiently invested in companies.

We are active investors, so we don't really shy away from taking positions outside the index. We, in fact, encourage fund managers to look outside the index and the broad market for opportunities to generate alpha. Our firm belief is that this is the only way to generate alpha and create wealth over the long term. And therefore, we are benchmark-aware investors. But never go very close to the benchmark, and we don't have a philosophy of being plus or minus specific basis points or percentages from the benchmark. We don't follow that kind of approach.

We have a bottom-up approach to investing. So, every company is added to the portfolio based on its own merit. The top-down view is used only when, for example, a large-cap portfolio or a thematic fund like an infrastructure fund or a business cycle fund requires you to have a top-down view of which sectors are doing well and then decide which stocks to include in the portfolio. Even there, stock selection comes from bottom-up evaluation of these companies and businesses.

And so those tenets remain the same, and we are true-to-label investors. We have always stuck to our mandate. We believe strongly that investors give us this mandate to manage money based on the objectives we set for each theme, and that we must maintain portfolios aligned with those objectives throughout. This is true whether it is infrastructure, small-cap, value or any of the other funds we run.

Since you are overweight on the small- and mid-cap segment even going forward, how do you balance the valuation gap between small, mid and large caps in the current market scenario?

There are always phases when one segment catches up with another. It is part of a normal market cycle. For three years, small and mid caps did very well, and valuations moved up, while large caps lagged. More recently, we have seen a period in which large caps have done better, and that catch-up has played out. Incidentally, this phase also coincided with a weaker growth environment, risk-off sentiment, currency volatility and sustained FII (foreign institutional investor) selling.

Now, you are back in a situation where growth is stronger, earnings are catching up, the environment is conducive, liquidity is strong, inflation and interest rates are lower, and all of that is actually good news for smaller companies in the market. On a stock-specific basis, valuations have corrected in small- and mid-cap stocks. However, in diversified funds, for example, in the Value Fund that you spoke about earlier, more than 40 per cent remains in large caps. We still have banks and other sectors where large caps are dominant. But at the same time, we continue to balance the portfolio with mid- and small-cap stocks that have become attractive to generate alpha over a longer period.

So, that's the endeavour. We try to balance portfolios wherever possible. Obviously, in a small-cap fund, you have to focus more on small caps. However, we've remained true to the label; we haven't played large caps there; we've played only small and mid caps, predominantly small caps in that portfolio. So, for us, the mandate is essential, our conviction is important and we put money where we think the longer-term business performance can deliver and valuations are reasonable.

HSBC AMC also offers a few distinctive international strategies, such as the Brazil Fund and the APAC (ex-Japan) Dividend Yield Fund, which have been running for many years. Could you help viewers understand the rationale behind these offerings, and what differentiated opportunities they provide that Indian investors typically can't access through domestic funds?

These are fund-of-fund (FoF) structures. We invest in funds outside India, and this is offered as an addition to the bouquet of products we have on the domestic side. If investors want or need to diversify their portfolios outside India, these funds are helpful and therefore add to the bouquet. That's the only idea behind this.

I continue to believe that India offers the best opportunity for investors in the long run because it is the fastest-growing economy with this size of population, the age of its population, strong demographics, a strong focus on manufacturing and government investments and a strong balance sheet at a macro level. All of that means India is a great place for investors to invest and remain invested.

But if somebody wants to diversify outside to hedge their portfolio or take advantage of other bets, like emerging markets outside India, we provide such opportunities as well.

Cyclical sectors like Industrials and Materials can often turn into value traps. What guardrails help you distinguish between temporary dislocation and structural challenges?

I think it's important to understand the cycles. When you get into cyclical sectors and stocks, you have to understand the businesses, how their cycles behave, where they are at this point, and therefore take exposures within the portfolio accordingly.

Understanding the cycle is extremely important. And for cyclical businesses, you can't just sleep at the wheel and let it go for a long period. You have to keep revisiting the model and the variables to see if there are any indications of peaking or overheating. One has to look for signals like margin pressures, deteriorating working capital conditions or cash flows; you have to keep a watch on them to see if there is any deterioration. ROE expansion is another variable to watch.

You could also look at capital allocation. A large number of companies engage in mergers and acquisitions; they over-invest and undertake significantly larger capex, extrapolating demand for their businesses or products. So, many of these factors must be considered when investing in cyclical companies. And of course, valuations are important.

Which parts of the market look most crowded today? Where do expectations seem well ahead of fundamentals?

There are parts of the market that look more expensive, but you are seeing a lot of sector rotation at this point, given the uncertainties and the lack of leadership. For a period of time, one sector would move up and become expensive, then fall, while another sector would take its place. So that's what's happening.

Overall, banks and financials, as I mentioned, are relatively cheaper. If you look at the last five-year period, IT sector valuations could be among the cheapest. But on the overcrowded, expensive side, I think most IPOs )initial public offerings) today are priced at high valuations, especially in new and sunrise sectors. In sectors like Electronics Manufacturing and Defence, where enthusiasm is very high, I see overvaluation. I think that's the risk to this market, and one needs to be careful.

Also read: Valuation remains a challenge for the Indian market: SBI Mutual Fund's Dinesh Balachandran