'I won't say there's a 0% chance IT becomes a value trap'

Summary: Is Indian IT services a value trap or a bargain? In this interview, Manish Gunwani of Bandhan Mutual Fund weighs in on Indian IT services, his funds' performance, and his investment philosophy.

The Indian IT services sector has had a torrid run. With AI threatening to automate coding, BPO and a host of other functions, and the Nifty IT correcting sharply, investors have begun to ask whether the sector has become a value trap. But Bandhan Mutual Fund’s Manish Gunwani doesn't think so, at least not entirely. He recognises the genuine risk AI poses, but also notes that cheaper technology tends to spur far greater demand. Even so, he is far from optimistic in the near term, putting the odds at roughly 60:40 that IT services avoids turning into a value trap.

Gunwani is presently the Chief Investment Officer – Equity at the fund house, where he manages seven funds. Of these, the Bandhan Small Cap Fund and the Bandhan Large & Mid Cap Fund both carry a five-star rating from Value Research.

In this interview, he also discusses the capacity constraints facing his fast-growing small-cap fund, his preference for financials, how he defines innovation, the thinking behind his balanced advantage fund and where he sees the next big rerating opportunity.

You cover around 700 companies, which requires significant resources. At a time when many AMCs are leaning more on quant models, why do you still invest so heavily in fundamental research?

I don't see it as an either-or choice.

We have also invested substantially in quant capabilities. We've launched a multi-factor fund and, in our SIF business, several strategies are largely quant-driven. So we're not opposed to quant investing.

The way we think about it is more philosophical. Fund management is a creative profession. Different people create alpha in different ways. One analyst may excel at evaluating management quality. Another may be exceptional at reading annual reports and financial statements. Someone else may be strong at channel checks, industry research or synthesising sell-side insights.

Because of that, we don't believe in dictating how analysts or fund managers should generate alpha. Our role is not to manage inputs. Our role is to evaluate outcomes objectively.

Quant is simply another input. We make it available to the active team. It's up to them whether they use it. Similarly, AI is another input. Some people may find it valuable; others may rely more on traditional research methods.

We take a decentralised approach. We provide analysts and fund managers with a broad toolkit and let them decide which tools help them make better decisions.

Globally, quant investing is a significant part of the asset-management industry. We respect that. We run quant-based products ourselves. But when it comes to active fund management, we prefer giving people the freedom to use whatever combination of tools and inputs they believe will help them create alpha.

Your small-cap fund's AUM has grown at a CAGR of roughly 115 per cent while the category has grown at around 17 per cent. As the fund gets larger, how are you thinking about capacity constraints? And at what point does size become a real concern?

First, it's important to remember that the growth rate looks dramatic partly because we started from a relatively small base.

That said, when a fund grows 10 or 12 times over three years, some things naturally change: the liquidity profile of the stocks you buy matters more. The impact cost of transactions becomes more relevant.

But I think the discussion is often framed incorrectly.

The right way to look at it is through the lens of free float. We should compare the amount of institutional or mutual fund money invested in a segment with the free float available in that segment.

When you compare the free float available in mid and small caps with the amount of institutional money invested in each category, the picture isn't as alarming as many people assume. In fact, when I last looked at the data, the ratio for small caps was not meaningfully higher than for mid caps. It may even have been lower.

Another factor is that the small-cap universe continues to expand. New companies come to market. Existing companies grow. The investible universe evolves.

Large and mid caps are much more constrained because the number of companies in those categories is relatively fixed. Small caps, on the other hand, constantly create new opportunities.

I don't subscribe to the view that institutional money is excessively crowded in small caps. Active managers still have a significant opportunity in the segment because information availability and sell-side coverage remain relatively limited. That's precisely the environment where active management tends to work well.

Markets can misprice companies for extended periods. A stock may remain depressed because of a large seller. Or the market may take time to appreciate how good a business has become. Those inefficiencies create opportunities for active managers.

Given our current size, we're not particularly worried about capacity constraints. We remain focused on finding opportunities and deploying capital effectively.

You had flagged AI as a risk for India's IT services sector in our last conversation. The Nifty IT has since corrected sharply. Where do you stand today?

I'll start with a disclaimer. Whenever you're investing in technology or businesses where disruption is a major topic of debate, it's dangerous to hold a fixed view. My opinion may change every three months.

Today, I am slightly more positive on the sector and perhaps, marginally overweight.

In some cases, free cash flow yields are now 7-9 per cent, which is comparable to fixed-income returns. Value is clearly there.

The debate essentially comes down to two opposing forces.

The first is the productivity benefit from AI. AI is clearly improving productivity in coding, application development, BPO operations and a range of other functions. Depending on the task, productivity gains could range from 30-40 per cent to even 70-80 per cent. That is obviously a risk for IT services companies because fewer human hours may be required.

But there is a second effect. As technology becomes cheaper, usage tends to increase dramatically. If software development becomes much cheaper because of AI, more companies will automate processes and build software. In other words, the overall demand for technology may rise substantially.

So the question becomes: Which force dominates? Will productivity gains reduce demand for services? Or will lower costs create so much additional demand that the industry continues to grow?

The honest answer is that nobody knows. All we can do is continue researching the sector and adjust our views as new information emerges.

As valuations become cheaper, there comes a point where the risk-reward becomes attractive. Perhaps over time, the increased demand for AI implementation and technology adoption will start to outweigh the productivity impact.

We saw something similar during the cloud computing transition around 2016, though AI is a very different technology, and the comparison is not perfect.

So I wouldn't say there is a 0 per cent chance that IT services become a value trap, nor a 100 per cent chance. Today, if I had to put probabilities on it, I might say there is a 40 per cent chance it turns out to be a value trap and a 60 per cent chance it doesn't. Valuations influence that assessment.

At current free cash flow yields of 8-9 per cent, I don't think we're taking an enormous risk by owning some of these companies and waiting to see how the situation evolves. And given that many of these stocks have already delivered very little over the last five years, I don't think investors are likely to lose 30-40 per cent from here simply because another AI breakthrough occurs.

For now, I think it's worth taking a measured exposure.

Your Innovation Fund has significant exposure to consumer services and healthcare, but technology is closer to benchmark levels. How do you define innovation, given that most people would expect a tech-heavy portfolio?

We spent a lot of time thinking about how to define innovation. Eventually, we settled on a fairly simple framework.

Our starting point was that innovative businesses should generally have a high price-to-book ratio. That's because innovation is typically driven by intangible assets: brands, technology, network effects and intellectual property.

If a company trades at a very low price-to-book multiple, it usually means physical capital is driving most of the value creation. That tends to be the case with commodities, banks and other capital-intensive businesses.

As a result, we decided that companies qualifying as innovative should broadly fall within the top 40-50 per cent of the BSE 500 on a price-to-book basis. In practical terms, that usually means a price-to-book ratio of around four to five times or higher.

Of course, there will be exceptions. Occasionally, a non-innovative company may trade at a high price-to-book multiple for cyclical reasons. Those can be filtered out. But as a broad framework, we felt it was a reasonable way to identify businesses where intangible assets play a major role in value creation.

But doesn't a portfolio built on high price-to-book multiples naturally become a growth portfolio?

Innovation has to be a growth portfolio. It can't be a value portfolio.

What we have generally articulated to investors is that they should think of it as the Indian equivalent of the Nasdaq.

A useful way to think about it is this: India today resembles where the US was in the 1970s and 1980s. After World War II, the US spent decades building physical infrastructure: highways, telecom networks, banking systems and so on. Once an economy reaches a certain level of development, most of the physical build-out is already done. Population growth slows, and there is only so much additional infrastructure you need to build.

That was around the time Nasdaq began to emerge as a major force. Over the following decades, it broadly outperformed the S&P 500 because many traditional businesses with low price-to-book multiples tend to go through cycles but don't necessarily compound at very high rates.

By contrast, technology companies, pharma companies, internet platforms and other innovation-driven businesses continued to create value and drive long-term growth.

Our Innovation Fund is built around that idea. It's not a cheap portfolio. By definition, growth is high, and valuations are high. It will be volatile. Just as Nasdaq went through major corrections during periods like 1999-2000, this type of portfolio can also see sharp drawdowns. But if you have a five- to 10-year investment horizon, high-growth companies with strong returns on capital should outperform lower-growth, more capital-intensive businesses.

Most of your funds have had relatively limited exposure to PSU stocks despite the sharp rally in PSU stocks over the last few years. Was that a deliberate call, or did you miss the rally?

We don't begin by saying we will or won't own PSUs.

There were some PSU segments we owned and some we didn't.

One area where we haven't participated meaningfully is defence. That has obviously hurt performance over the last three years, as defence stocks have performed exceptionally well. Our concern was fairly simple. Many defence PSUs essentially sell to a single customer: the government. At the same time, margins in several of these businesses have risen significantly above their historical averages. What we were never fully convinced of was why these companies should sustain margins substantially higher than their long-term averages when their primary customer has such strong negotiating power.

That concern stayed in the back of our minds. As a result, we didn't build very large defence positions. In hindsight, that has hurt performance. The call didn't work. But at least there was a process behind the decision.

On the other hand, if you look at power-related financials, we generally held a reasonable amount because we were positive on the broader power capex cycle. That thesis largely played out. Today, many of those stocks are no longer particularly cheap, so our exposure is lower than it was a few years ago, but we still own some.

Similarly, with PSU banks, we've never had a blanket rule against owning them. Whenever valuations have made sense, and the macro environment has looked favourable, we've owned them.

That said, there are certain realities investors have to account for. First, these companies are not managed solely for profit maximisation. We see that with oil marketing companies. Second, given the pressure on government finances over the last year or so, investors should assign some discount to valuations because divestments can happen more aggressively. We're already seeing that. Over the last few weeks, several PSU stakes have been sold into the market, increasing supply.

Those are factors that need to be incorporated into valuations.

Across most of your funds, except for the Innovation Fund, you're overweight in financials. What's the case for that today?

Generally, we try to buy sectors where valuations are reasonable, which often happens when a sector has gone through a difficult phase.

What's interesting about financials is that, while the operating performance of many companies has been broadly in line with expectations, foreign investors have been persistent sellers. As a result, many of these stocks haven't gone anywhere for two or three years. Valuations have therefore become much more reasonable.

Another way to think about it: many fund managers view financials as part of a broader domestic cyclical basket, which includes financials, autos, cement and capital goods. Within that basket, we currently find financials more attractive than many of the other sectors. The growth rates remain healthy, yet valuation multiples are considerably lower than in several other domestic cyclical sectors.

In autos, for example, there are questions around technology, competition and future market leadership. In some other sectors, valuations remain elevated. So from both an absolute and a relative perspective, the risk-reward appears attractive in financials. That applies not only to lending businesses but also to non-lending financials such as insurance and wealth-management companies.

Your Balanced Advantage Fund's equity exposure has largely stayed in the 40-60 per cent range over the last couple of years, even though your in-house BAF model allows it to go as high as 80 per cent. What would it take for the model to move more decisively in either direction?

We are pretty happy with the model.

Over the last two years, the fund has broadly avoided meaningful drawdowns, even as equity markets corrected.

There are three or four major inputs. The biggest one is real returns. Historically, real equity returns tend to mean-revert towards 6-7 per cent. That's an empirical observation that has worked surprisingly well. We calculate real returns across different time horizons and average them. At the moment, that indicator is broadly around fair value.

Some other indicators are pointing in different directions.

For example, our currency model currently suggests higher equity exposure because the rupee has depreciated significantly, not only against the dollar but also against a basket of currencies we consider relatively stable. Relative to inflation differentials, the currency appears attractive.

However, credit spreads are telling a very different story. Credit spreads are extremely tight and remain near historical lows. That tends to be a mean-reverting indicator, and at the moment it argues for lower equity exposure. What's surprising is that even after events like trade tensions and geopolitical conflicts, credit spreads have remained unusually low.

So one set of indicators is encouraging us to increase equity exposure, while another set is encouraging caution. The real-return indicator is somewhere in the middle. As a result, everything effectively cancels out, and the model remains close to its midpoint.

Indian equities have underperformed several global markets over the past couple of years. Yet your international allocations have been very limited. Is that mainly because of RBI limits, or are there other reasons?

It's a combination of factors.

You're right that RBI limits have been a practical constraint for most of the period since we started operating in our current form.

But beyond that, we simply haven't had the bandwidth. Remember, we're effectively building this franchise from scratch. Three years ago, we covered around 250 companies. Today, we cover more than 700. Three years ago, we had three analysts. Today we have around 10. We've expanded the fund-management team as well.

Building that entire research platform has consumed a tremendous amount of time and energy. As a result, researching international stocks hasn't been a major priority.

Today we're in a better position. If RBI limits were relaxed, we would probably have the bandwidth to start exploring global opportunities in a more structured way.

That said, I don't think it's a particularly high priority. Even if a portfolio has 5-10 per cent international exposure, the key driver of outcomes remains the other 90-95 per cent. If you don't get that right, the international allocation won't make much of a difference. Unless we see an exceptionally attractive opportunity overseas, it's not something that keeps me awake at night.

PSU banks rerated. Defence stocks rerated. Broader PSUs rerated. Where do you think the next big rerating opportunity is?

Not necessarily a traditional sector, but I think manufacturing, broadly defined, could do very well.

The reason is simple. India's services-export model becomes increasingly difficult to scale from here. One challenge is AI. Another is that services exports tend to create significant inequality because average incomes in those industries are much higher than in the broader economy. For the bottom 80-90 per cent of the population, we need a stronger manufacturing engine. That's how large-scale formal employment gets created.

The good news is that the global environment appears supportive. Over the next few years, I think there's a reasonable chance of a major global capex cycle.

One driver is AI infrastructure: data centres and related investments. The second is defence spending. Given recent geopolitical developments and shifting global alliances, countries across Europe, Japan and India are likely to increase defence spending. The third is energy capex. Once some of the ongoing conflicts eventually end, there will likely be significant investment in energy infrastructure and reconstruction, particularly in regions such as the Middle East and, hopefully, Ukraine.

That should create demand for manufactured goods.

There is also a currency angle. When I look at the yuan relative to the rupee, I think there is a reasonable chance the yuan will appreciate over time. China has a fundamentally undervalued currency, a large trade surplus and very low inflation. That could provide an additional tailwind for Indian manufacturing.

So across sectors such as pharma, capital goods, auto components and chemicals, I think investors should continue to look for opportunities. I believe China-plus-one will play out in a meaningful way over the coming years.

Also read: Why Bandhan Small Cap is okay with liquidity risk