Has your outlook for equity changed with a new government?
The new government was voted on expectations of strong governance and growth agenda. It has strengthened our conviction that Indian equity market is well placed to deliver good returns over the next several years. While macro-economic concerns persist, we believe that growth had anyway bottomed out and things would only get better from here. A Government with majority ensures political stability and lends itself better to speedy and effective decision making which is required to steer the economy on to a higher growth trajectory.
The FY15 GDP growth is expected to pick up, the extent of pick up would partly depend on the monsoons and is likely to range between 5-5.5 per cent. Corporate earnings which have seen a downgrade phase till a few quarters back have been seeing moderate upgrades. We do not expect significant upgrades for FY15 but we do expect that growth initiatives, if implemented effectively would result in meaningful earnings traction in the second half of FY16 or FY17.
The next one year would be more about laying out a broad economic vision with a detailed roadmap for achieving it. Beyond the Budget, we would see lot of policy announcements, some addressing the existing challenges and some relating to new initiatives planned by the Government.
The markets being always forward looking, would be driven more by these policy measures and announcements in the near to medium term than only earnings. Nevertheless, it is fair to expect some amount of volatility and corrections in the light of the strong rally so far and lack of trigger from an earnings perspective. There is opportunity for long term investors to add to equities. Overall, we believe it is an opportune moment to take a 2-3 year view of the Indian market for returns of 15-20 per cent per annum and potentially more over the next few years despite the recent rally.
What will be your investment strategy now?
The investment strategy is to focus on sectors and companies which would be beneficiaries of a significant pick-up in economic growth. The last few years have seen a slightly higher focus on near term (typically next one year) earnings momentum but we believe the time is appropriate to take a slightly strategic and longer view for sectors and companies in order to capture their true earnings potential and hence potential returns.
Our portfolios are positioned to capitalise on a pick-up in the growth of Indian economy. The allocation towards defensives was already on the decline over the last 2-3 quarters, in favour of domestic cyclicals. We have added a fair amount of beta to the portfolio, both in terms of choice of sectors and companies and wherever the mandate permits, in terms of increase in exposure to mid-cap and small-cap stocks.
We have been actively looking at opportunities in companies which would benefit from repair of stretched balance sheets and where the growth opportunities are looking distinctively better. You could say that our portfolios have a distinct growth bias at this point of time, but given our core strategy of focusing on good bottom-up opportunities and given the sharp rally in the market, we would also opportunistically look at beaten down stocks or contra bets.
What is your investment approach for Principal Growth Fund?
The Principal Growth fund is a multi-cap fund benchmarked to the BSE 200, so the portfolio comprises large-cap and mid-cap stocks above the threshold market capitalisation (above the lowest market capitalisation of the BSE 200 universe). While we follow a combination of top-down and bottom-up approaches, we have a distinctly greater emphasis on stock picking as a way of generating alpha. We are aware of the benchmark but not driven by it in constructing the portfolio, but we do have prudent sector and stock exposure limits which we strictly adhere to.
You could say that the portfolio construction is driven by our conviction and the best opportunities in the market. There is great emphasis on in-house research and modelling, our own earnings estimates, especially for companies where we think differently from the market. Our preference is for companies with sustainable improvement in growth prospects over the next 2-3 years, having a meaningful position in their respective sectors, scalable business models with a good management track record and trading at attractive valuations.
We are happy owning companies that fit these criteria but are under-owned by institutional investors. As a fund house, we are very target-price oriented and while we do take a long-term view of companies, we are happy booking profits at least in part, if our target prices are achieved with no meaningful revision in fundamentals.
What worked most for Principal Growth Fund?
Several factors have contributed to the good performance of Principal Growth fund. In the last few years, despite the macro challenges and the negative news flow, we have by and large reasonably stayed invested in the market. As I said earlier, our core strategy has been to identify good bottom-up opportunities with reasonable growth prospects and trading at attractive valuations; this most often involves modelling in-house earnings which may be meaningfully above market expectations.
We built meaningful portfolio positions in several such stocks and held them through the ups and downs with strong conviction till the full story played out. This has several dimensions; at times it could mean being contra or sometimes just being able to spot opportunities ahead of the market through our in-house research. Sometimes focusing on the larger picture instead of the near term earnings outlook and at times doing nothing but holding on to positions with patience and conviction. What also helped was our view that economic growth seemed to have bottomed out several quarters back and the steps initiated by the previous Government to revive growth by clearing stalled projects would only gather greater momentum and put the economy on a better growth trajectory which only gets stronger with a majority Government now in place. In summary being pro-cyclical rather than defensives also helped.
What changes have you made given the sharp run-up in the equity markets?
Our portfolios are well placed to capitalise on the expected pick-up in the economic growth and to that extent sector exposures have largely been recalibrated towards the new environment. Sectors we are overweight or have a large weight in the portfolio include Autos, Construction, Cement, Industrials, Financials and those we are underweight include Pharma, Consumer and IT to some extent.
However, given the challenges that still exist in the global environment and the local challenges, we do believe that some part of the portfolio will have to be tactically managed depending upon how the scenario plays out. The challenges include very heightened expectations from the Government, the time lag before improvements are visible, the possibility of a poor monsoon and high inflation among others.
But that would be a relatively smaller part of our portfolio, with the core portfolio being built with a 2-3 year view and well placed to capitalise on a significant pick-up in economic growth. At this juncture, we do not see the need for any major changes in our portfolios, with most having been done in the run-up to the elections or immediately thereafter. From here on, there would be some periodic tweaking which is a little more tactical or opportunistic.
How is Principal Tax Saving Fund different from Principal Growth Fund other than the three year lock-in?
The Principal Tax Savings Fund and the Principal Growth Fund are both managed as diversified or multi-cap funds and benchmarked to the BSE 200 index. Therefore, both have identical portfolios, except for minor differences that may exist as a result of differences in flows into or out of the two funds.
The fact that ELSS schemes have a three-year lock-in does not impact the portfolio construction significantly as our investment process anyway focuses on buying stocks with a 2-3 year view. We believe this is an optimal way of ensuring that only our strong conviction stocks make it to the portfolios because of the sharp focus that a single multi-cap strategy brings in to the process of portfolio construction.
In your view which segment of the market is most promising and vulnerable at the moment?
We believe domestic cyclicals are the best placed to deliver above market returns over the next few years should the growth story gather momentum. I would like to highlight the fact that there would be volatility and possibly sharp corrections along the way up because the improvement in financials would follow with a lag. But for investors with a 2-3 year view, we think these stocks would deliver much higher returns compared to the market as a whole.
Another caveat that I would highlight is that it is very important to focus on companies with strong and scalable business models, and a proven management record since we believe these companies would be better placed to exploit the growth opportunities. In terms of vulnerability, we feel it would be more a case of relative underperformance rather than absolute returns of defensive sectors. We believe sectors such as FMCG, Pharma, IT would deliver positive returns but possibly in line or lagging the market. Of course, we would never rule out the bottom-up or tactical opportunities that these sectors throw up.
How long is your watch list and how do stocks enter your portfolio?
Typically, at any point of time, each analyst would be working not only on maintenance research for existing portfolio stocks but also on a list of stocks that could potentially form part of the portfolio.
It is quite conceivable that at any point of time each analyst has 6-8 new stock ideas, making a watch list of 40-50 stocks. The process by which these stocks may enter the portfolio has several steps and filters.
For a start, these stocks must meet the market capitalisation threshold. Then the analyst does a detailed review of the company in terms of past financial performance, outlook for the sector and the company over the next 2-3 years. Then there is analysis of key financial parameters, peer-comparison analysis, which are prima facie done to establish the existence of investment worthiness.
All this is followed with a meeting with the senior management of the company to get an in-depth understanding of each of the key drivers and key risks for the company, from which follows a detailed outlook for the company.
Typically, we do try to quantify the outlook in terms of expected profitability and using relative valuations project a target price. Stocks that are attractive from a risk-reward perspective and offer potential for reasonable returns are added to the portfolio, subject to stock and sector exposure limits. We also ensure all our portfolios meet our liquidity criterion. Finally, stocks that are part of our portfolio undergo periodic reviews to ensure the outlook meets our expectations if not better. If not; they would make way for other stocks that offer better return potential.
So, what kind of stocks never enter your portfolio?
We prefer to avoid stocks with poor track record of execution; those with dubious accounting standards and many a times fringe players within a sector. We strictly adhere to the minimum market capitalisation criterion for stocks and would avoid those that do not match the threshold level despite the potential lure of significantly higher returns.
This interview appeared in the August 2014 Issue of Mutual Fund Insight.