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Revival in Sight

Follow and focus on a proven strategy, says Huzaifa Husain, Head-Equities, PineBridge Investments

Follow and focus on a proven strategy is the mantra that Huzaifa Husain, Head-Equities, PineBridge Investments, India swears by. In this interview with Chirag Madia, he details the investment strategy followed by him which has helped his funds to do well in every kind of market.

What are your core investment beliefs that drive your portfolios?
We follow bottom up stock picking, where we focus on understanding companies and their characteristics. It is always easier to analyse a company than the macro economy as the variables involved in the latter are far more than the former. In analysing a company, we study its business franchise, management capabilities and valuations. This doesn't mean that we completely ignore macro trends as we are quite aware of important economic developments. Sometimes though, we may get a contradictory signal between our bottom up analysis and macro indicators. In such a case, the decision is based on our bottom up analysis.

First, we look at the business franchise as to whether it can survive and thrive during business cycles. We look for businesses which generate huge cash flows-in fact so much that they don't know what to do with it (chuckles). With such amount of money, they can either invest in their own company or give it back to the shareholders. So the economics of the business has to be extremely good and defensible and should be a proven success typically for over one or two decades.

In the recent fact sheet, we have talked about two companies-Nestle and Larsen & Toubro. If we go back to 1991 when the economic reforms started and take these two companies which were well known even then, we see that they have given similar annual returns of 23 per cent and 22 per cent respectively (with dividends reinvested) till date. This demonstrates that, irrespective of sector or macro developments, companies with robust business models end up doing well over a long period of time. This proves that the strength of the business is not related to the sector and that is why we look for companies which have survived many cycles.

Second, we look for management which is both capable and honest. The most important job of the management is to allocate capital efficiently. We do not prefer companies that diversify into another unknown business just for the sake of expanding. For example, we own Shree Cement which makes good cash flows and continuously ploughs them back into the business at similar economics. As a fund manager, I find it quite an ideal situation because everyone knows that if India needs growth, it will need lot of cement as our cement capacity is one tenth of China. But if someday Shree Cement decides to move into the business of say, making steel, then there will be reason to worry. On the other hand, a company like Hero MotoCorp, which we also own, generates more cash than it can efficiently deploy in the business, and ends up paying it out as dividends. Hero, since 1991 till date, has given one of the best returns with dividends re-invested making us prefer such management. We therefore tend to stick with such management of companies which not just make a lot of money but also either reinvest it in the same business or give it back to shareholders. We also look for companies where its managers report their profits conservatively. Generally, one needs to do some adjustments to figure out how much cash a company makes which can be different from the profits it reports. We favour companies which tend to show profits which are very similar to their cash flows. It gives us confidence in the management.

Third, everything boils down to valuations. Once the company is good and management smart and honest, we need to buy it at a price where we can make a reasonable return. Given that most of our companies report profits which have high cash flow efficiency, we use price to earnings (PE) ratio to determine their valuations. One needs to be careful when assigning high multiples and the best way to get that confidence is by studying the history of the company and its ability to cope with various business cycles.

What investment strategy you follow for PineBridge India Equity?
As explained above, broadly the strategy is to invest in companies which meet our criteria of passing the three filters described above. But I would say that this is a fund for investors who would like a steady portfolio, with not much risk. If you look at the history of the fund, it has given slightly less returns when the market goes up, but has outperformed the index on the downside. So for a period of 3-5 years, the fund has managed to outperform the broader index.

We invariably tend to invest in companies that have survived market cycles, have a history of giving strong dividends and are cash surplus. As a fund manager, we don't try to tinker much with such strategy. There is no aggressive churning and we don't play according to the present 'theme'. We invest in strong companies and let their results reflect in the net asset value (NAV).

Any tactical change that you have made post the election results?
No, we haven't made any significant changes because our stance was geared towards an investment recovery over the past many months. Last year, we came out with a report stating that, in spite of 2014 being an election year, we are still positive on markets, especially on the investment cycle. We believed that India would see a revival because of three major factors. Firstly, there were regulatory issues where companies had bid for projects and were unable to deliver due to various reasons. But solutions started popping out during the last regime where we saw some clearances happening in electricity and road sector. Secondly, in the past 12-18 months, we saw acquisitions gathering steam which helped companies de-leverage themselves. Thirdly, there were some major concerns on banking sector's ability to lend because of high NPAs. Even here, there were some steps being taken. With a new government in place, these actions have intensified and hence business confidence has improved. The one area which is yet to be tackled well is banking which needs a lot of capital, and we have to wait and watch what steps are being taken to resolve this issue.

In the past few months, we had made sectoral tilts towards cyclical, industrials or anything that has to do more with the investment cycle because we thought investment cycle had to restart under any circumstances. India can't keep on buying what somebody else is producing; we have to produce to consume. In the past few years, the government gave a lot of stimulus to promote consumption which went up and up because of which we had to import a lot. This eventually saw a rise in inflation and correspondingly interest rates shooting up, so this cycle had to turn. We believe our portfolio is in such a situation that it is likely to benefit whenever the economic growth picks up. We don't know when actually the recovery will happen but whenever it happens, we are likely to benefit as we feel that we are perfectly placed to cash in on the recovery.

In your view which segment of market is most promising and vulnerable at this point of time?
When one looks at sectors purely from a growth perspective, one would tend to prefer names and sectors linked with a revival of investment cycle. These would be sectors linked with infrastructure like capital goods, cement, utilities, etc. But then one has to keep in mind the valuations at which these names are being traded. No matter how good the growth outlook, if one pays too high a price to buy, one would end up getting mediocre returns. Therefore, we would say that the most promising names are the ones which have a strong balance sheet to capture this growth, trade at valuations which are still below their estimated peak cycle earnings and have a management which is dedicated to shareholder wealth creation. We feel companies with highly leveraged balance sheet which need to either sell some assets or dilute their existing shareholders to raise monies may be vulnerable in case of any volatility in economic recovery.

What will be the investment strategy for PineBridge Infrastructure & Economic Reforms fund?
Our basic equity investment strategy does not change. We use the same filters described earlier but restrict the universe to infrastructure names. This gives the investor a pure-play opportunity to participate in the investment growth of the country. We use the 'infrastructure' definition given by the Committee of Infrastructure appointed by the Government. I think picking up stocks in infrastructure is a bit more challenging because unlike defensive sectors, this sector has seen a lot of companies fall by the wayside. The ability of companies to manage risks is sometimes inadequate and the fund needs to avoid such names.

For example, a consumer company won't see a permanent damage to its franchise just because one or two of their products fail. But in the case of infrastructure companies, if they bid for one project incorrectly and it happens to be a large portion of their net worth, then there can be enormous stress on their balance sheet. Hence, a company which can manage risks well can be a great investment. As I said, Larsen & Toubro or even an ABB, despite belonging to the infrastructure sector, have managed risks well thereby giving fantastic returns since 1991. We all know that infrastructure has to grow but risks are high; hence we feel our philosophy of buying good companies can considerably restrict exposure to the risk inherent in this sector and yet deliver decent returns.

How seriously can high oil prices and a bad monsoon impact the market?
Equity markets will always have to deal with some issue or the other and that's the nature of investment business. High crude prices or a drought like situation can cause medium term damage to economic growth. Having said that, if we pass this phase comfortably, there will be some new issues to talk about. Till last month, everybody was talking about politics; now everybody is talking about monsoons and crude oil. Next time, they might talk about fiscal action or central bank action. So this story will always go on. When we make the portfolio, we know that we have to deal with uncertainties. The key is to ensure that the portfolio weathers such crises.

Since 1991 till 2013, markets have given decent returns, and there are stocks which have given 20-30 per cent compounded returns. During that same period, we have gone through so many bad phases like the Iraq war, Asian crises, dotcom bust and the recent economic recession. These things are bound to happen and therefore like a sailor, one needs to decide whether to sail in a ship which can navigate the roughest of seas or take a dinghy hoping the weather will be calm and quiet. We think it is better to invest in strong names rather than making predictions of the future and to keep changing ships!

What kind of stocks and sectors you don't want to invest in now?
When we look at the aggregate market valuations, we think a ratio like market capitalisation to GDP is a better indicator, especially during times of low margins. The fair value of this ratio in our opinion is closer to 100-110 per cent. At this point, it is around 80 per cent. Hence, we think the aggregate valuations of the market are still cheap. Of course, this aggregate number hides the fact that some names are cheaper and some are expensive.

We believe when one is evaluating various names, one needs to build in a cyclical recovery and then estimate earnings of various companies. One should be careful not to give too much weight to the present low cycle earnings. When we do such an exercise, we notice that we are comfortable paying a fair price for a good business rather than paying a cheap price for a mediocre one. Hence, with a very high probability of an investment led recovery, companies which have the ability to grow are the ones with a very strong balance sheet, and which have invested in expanding their capacity to deliver products and services. We, therefore, have picked such names and populated our portfolio. On the other hand, we generally would avoid over leveraged companies and those which have not respected the rights of minority shareholders in the past.

How long is your watch list that is not part of your portfolio and how do stocks enter your portfolio?
We currently have 35-40 names in our portfolio. Apart from these, we have another 40-50 names which we think we understand and have passed the two filters-good business franchise and good management. But either due to their absolute valuations or relative (to stocks in the portfolio) valuations, they have not yet entered our portfolio. We monitor the relative valuations of the names we own and the names we do not own and act on it when we find a reason to do so. We also simultaneously work on finding more names to increase the size of the universe from which we can draw upon.

This interview appeared in the August 2014 Issue of Mutual Fund Insight.