Since the market today is not cheap and the valuation differential between large caps and mid and small caps has narrowed, GARP is the strategy to follow, says Pradeep Gokhale, Fund Manager of Tata Tax Saving Fund, in this quick chat with Vibhu Vats.
How do you select a stock?
At Tata Mutual Fund there is a system of approved universe, which has some 400 stocks. A Tata fund manager has to select stocks from this approved universe. This universe is reviewed once a year for deletions. However, additions can be made to it anytime. The universe can be divided into two categories. First, we have core companies, in which the bulk of investment is made. Core companies typically have features such as compounding characteristics; strong growth potential; good management; good capital efficiency; strong entry barriers in business such as strong brands, a superior technology, etc. The advantage of investing in such companies is that even if your entry is mistimed, the downside is limited as these companies can grow well. Such businesses are what I call high-quality businesses. The second set of the universe is more opportunistic in nature. It comprises okay businesses, which could be a good investment at a certain valuation.
We have certain parameters to evaluate a business. These are:
- Efficiency in use of capital and return on capital employed (ROCE): Over the long term, this parameter shows how good companies are in their areas of business. During a bad phase, the ROCE may decline but over a long term good companies maintain a decent ROCE.
- Management quality and corporate governance: How fair the management is with minority shareholders; whether the management has the ability to drive growth of the business; how the management has grown the business and performed over a market cycle.
- Earnings growth prospect over the next two-three years
- Valuation: Valuations within the sector. Sometimes you have to see the overall valuations in the market to find a bargain.
- Liquidity: The volume should be good enough to enter into and exit from the stock.
When do you exit from a stock?
Our exit from a stock is determined by three reasons:
- The stock has reached a level where you feel the risk-reward ratio is not favourable.
- If the assumptions about the future of the company and its earnings that we made while buying the stock don't pan out as expected, we may consider selling the stock. If we had some events lined up which don't unfold as expected, we may decide to sell the stock.
- If there are some other alternatives which look more promising and have better prospects, we can think of replacing an existing stock with a better one. Since there are limited funds to invest, relative returns are an important criterion.
The performance of the fund has lagged behind its peers' on a time horizon of one-five years. What may have led to this? Are you taking any measures to boost the performance?
Tata Tax Saving Fund is a four-star-rated fund by Value Research, which implies a good performance. As compared to other similar funds, our performance has been more consistent across market cycles. One reason for underperformance over the last one year is our lower allocation to mid caps as compared to the competition, and mid caps have done substantially well over the last one year. At the same time we didn't increase our allocation to cyclicals relative to competition, particularly prior to the elections in May 2014.
Are you looking forward to increasing your allocation to mid caps in the future?
Today the market is not very cheap. We don't see a large valuation differential between mid caps and large caps in the current market. I would not take a call on increasing allocations to large caps or mid caps purely on the basis of their sizes. We need to see how good the management is in delivering the expected earnings growth. So, I would be interested in GARP (growth at reasonable price) stocks irrespective of market caps of stocks.
What sectors are you most bullish on?
We are positive on domestic cyclicals and within that category in auto and auto ancillary and capital goods. Within capital goods we are more interested in transportation infrastructure, roads, urban infrastructure, defence-related manufacturing, etc, than power-generation- or metals- or refineries-oriented capital goods. We think in the coming phase of growth, capital goods have an important role to play. We are also bullish on the cement sector. We think more capex will happen through government spending as compared to the capex by private players. As income growth improves with GDP growth, auto ancillary and consumer good stocks will do well.
What sectors would you stay away from?
We are underweight on metals, minerals, and oil and gas due to the global commodity cycle. Other sectors where we have some underweight positions are FMCG and IT, more from a valuations and earnings growth perspectives. We are also not overweight on banks, though it's not that they are a strict no-no for us.
You say that you are not positive on banks. However, with interest rates poised to come down, banks will be a key beneficiary.
We are not very overweight on banks. We have been selective and relatively underweight on public sector banks. At current valuations, part of macro improvement is also factored in the prices of banking stocks. Valuations of private sector banks are no longer cheap. We are not sure of the asset quality cycle of public sector banks. I have a few banks in the portfolio but they are not my key overweights.
What is the outlook for equities in 2015?
Market valuations are at fair levels, both on the P/E basis and the P/BV basis. Our macroeconomic outlook has improved in the past one year and this is already factored in the current valuations. We shall have to focus on the medium-term picture. You can't have 30-40 per cent gain year after year. Since valuations have narrowed between large caps and mid caps and between cyclicals and true growth stories, one has to be more stock-specific. We have to be very sure of the earnings growth projection. Where we are sure of earnings growth, we can have more weightage. Also, we have to be mindful of the margin of safety because if valuations are not cheap, then margin-of-safety considerations become more important. So, we would follow the GARP strategy in place of going for value plays or turnarounds or stocks that are under restructuring. Inherent strength of business, management competence and financial position of the company become important. While the macro situation improves, we need to know which companies are well-positioned to benefit from the opportunity. Bottom-up approach within sectors is needed.
What are the most valuable lessons you have learned in your investment career?
In equities, beyond a point, macros don't matter as much as valuations do, when it comes to returns. Looking at companies' individual businesses and valuations is much more important. During the first half of the previous year I didn't put enough money in mid caps or cyclicals, when the valuation differential between large caps and mid caps was higher but the macros hadn't improved much. This is the lesson I have learned over the past one year.
What can an investor expect from your fund for a holding period of three years or more?
We have consistently outperformed the market by a considerable margin and lower volatility. Investors can expect better returns than market returns, along with lower volatility across market cycles over time.