Corporate Earnings to Grow

Harsha Upadhyaya, CIO-Equity, Kotak Mahindra AMC, is optimistic of the markets. In this interview with Chirag Madia, he shares his views and the framework on which equity funds are managed by Kotak AMC

What strategic or tactical changes have you made in your portfolios, since the post election market upswing?
By May 2013, we were moving money from some domestic names to export names because there were multiple concerns on rupee, current account deficit (CAD) and fiscal deficit. Clearly, the rupee was under risk and we were looking at companies that would benefit from possible rupee depreciation. So we were looking at global and export oriented businesses. As the year progressed, we realised that CAD is not going to be as worse as it was projected at the start of 2013 and we felt that many of the actions undertaken by the RBI and the then government had started showing positive results. The investment case for looking at possible domestic recovery plays was developing.

By late 2013 and early 2014 there were early signs of domestic economy bottoming out and we started shifting from export oriented theme to possible domestic revival theme in our investment approach. But we were aware of the event risk of general elections in front of us. So, we stayed away from high beta names and sectors where government intervention is too high. We knew that irrespective of the government, some of these sectors would continue to do well. So we moved into good quality cyclical plays and that call has worked well for us. That positioning still continues and 70-80 per cent of our portfolio continues to be in the domestic recovery names.

Post-election results, we have added exposure in domestic cyclicals with high operating leverage. For example, auto and cement are sectors where volume growth is beginning to gain momentum and pricing has started to improve. By and large competitive landscape has remained more or less similar in these sectors and has consolidated in favour of leaders in the last three-four years. In addition, there is not much debt on the books of the auto and cement companies. The profitability improvement is going to be much stronger once demand picks up on a sustainable basis, so we are betting on these two sectors. Post-election we also increased our weight in oil & gas sector where positive policy action as well as soft crude prices have resulted in almost wiping out entire under-recovery in diesel. We expect meaningful improvement in profitability and cash flow situation of oil marketing companies.

What is your view on the current stock valuations and the outlook for markets?
Corporate earnings growth has improved quite a bit over the last year or so, and we expect that trend to continue. We expect corporate earnings to grow anywhere between 16-18 per cent over the next 2-3 years. Currently market is trading in fair range of valuations. Even without assuming any further re-rating, the market upside can be similar to earnings growth going forward. From flows perspective, things have started to improve on the domestic mutual fund side. For the past few months, we have been witnessing consistent inflows. Foreign interest in Indian equities continues to be strong. So, overall we remain positive on equity outlook.

What framework is followed to manage equity funds at Kotak?
Our investment style is predominantly growth at reasonable price (GARP). We follow a blend of top-down and bottom-up approach for portfolio construction in order to derive value from macro trends and security specific opportunities. From a top-down perspective, we adopt a thematic approach, whereby we identify themes that will likely out-perform or under-perform the market over a rolling 12-month period. Once the themes are identified, we drill them down to sectors or sub-sectors that will benefit or fail to benefit from these themes. Our expectation of the direction of macro variables as well as the way market is positioned, play an important role in identifying the right themes.

Sector exposures also rely on change in future return on capital employed (ROCE), return on equity (ROE), free-cash, earnings momentum and are passed through relative or absolute valuation filters. Our bottom-up approach adopts the Business, Management, Valuation (BMV) approach to stock picking. We try to look for businesses that are scalable in nature, where capital efficiency is high and that have reasonable competitive edge in their respective areas of business. We also very keenly look at the management track record and its quality. The final filter is valuation in every case. All equity funds under our management follow this broad approach, while sticking true to the spirit of their respective investment mandate.

What will be your strategy for Kotak Select Focus Fund?
The investment philosophy of Kotak Select Focus is built on the premise that different sectors of the economy perform varyingly over different periods of economic cycle. The investment focus in the fund is to invest in select sectors that are likely to outperform broader market at various points of time. Once the sectors are selected through top-down analysis, the individual investment ideas within those sectors are picked up through bottom-up approach. The fund maintains 4-9 sectors in its portfolio. So, while it is a concentrated strategy at the sector level we keep it diversified at stock level with around 45 stocks in the portfolio. Its investment mandate also provides flexibility to move across market capitalisation. Investments in mid-cap and small-cap stocks can go up to 50 per cent of the portfolio.

In this fund, we explore sizeable opportunities and take aggressive bets. For example, we like agri-chemicals as a sector but we don't find many sizeable bets in those businesses, so we haven't invested. When we had invested in telecom sector, we were carrying 10-11 per cent in the sector as compared to about 2-3 per cent in the benchmark. So, it doesn't matter if that is a small sector, but we should have sizeable opportunities available for taking aggressive positions. Since we are restricting the number of sectors in this fund we don't want to get into too many sectors with very small weights.

What is the strategy for Kotak Opportunities? Are you finding enough opportunities when markets are at all time high?
Kotak Opportunities is a diversified fund which invests across market capitalisation. It is more diversified in terms of sector allocation as compared to Kotak Select Focus. The exposure to mid-cap or small-cap stocks is capped at 40 per cent. Overall investment strategy remains similar to what we have adopted in other equity schemes like focussing on GARP approach.

While the index levels are at new highs, the valuations are still around fair levels. Just like in any market condition, there are some sectors which are expensive at this point of time, but at the same time there are many industries and companies which are just coming out of downturn. They have enough capacity on ground and when demand revives, since they have taken pain to streamline their operations in the downturn, the upside can be very large. So we want to remain in sectors which have the cyclical upside. There are enough opportunities in the markets and we believe equity as an asset class has just started to perform once again and we are at the beginning of a larger bull market if things fall into place.

How long is your watchlist which is not part of your portfolio and how these stocks enter the portfolio?
Generally we have about 320 stocks in our investment universe and this universe is reviewed every quarter. Apart from regular periodical review we also debate on IPOs or new stocks for inclusion in the universe. There are around 150 stocks which are part of the portfolio from this set and other stocks are reviewed continuously for potential investments in future. These stocks are tracked on a regular basis by our research team. Our research team maintains model portfolios (large-cap and mid-cap) and also each analyst runs sector model portfolio. These model portfolios assist fund management team in terms of well researched investment ideas.

So, what kind of stocks never enter your portfolio?
We don't like sectors and stocks that require capital on regular basis and those with high degree of leverage. We also tend to avoid companies that have high level of policy or regulatory risk. We avoid betting on event based plays. Typically, we look for compounding characteristics of earnings growth at reasonable valuations, and build a portfolio around that strategy.

With high valuations right now, what kind of stocks and sectors you avoid at this point of time?
At present we have underweight exposure in metals as we are unable to find value because many stocks have run up sharply in the recent past. Many companies in this sector also have large amounts of debt on their books. Utilities are another sector where we don't have much presence because in an economy which is set to revive there are better cyclical opportunities than utilities. In the past we have seen some regulatory interventions that have been negative for the sector as well. As far as FMCG stocks are concerned we have remained underweight over the last two years and we continue that on concerns of rich valuations and moderating growth.