Prashant Jain, ED & CIO, HDFC Mutual Fund, talks about reforms, the coming recovery, and how funds that do well in the long-term often do not look good over short periods.
What is your reading of the Indian economy and of the reforms moves of the new government?
The economy has recovered significantly over the last few years and I feel confident that things will continue to improve with each passing day. The economy should achieve materially higher growth over the next two years.
The policy direction is right and we are making good progress on most fronts. Initiatives to replace physical subsidies with cash transfers, resolution of regulatory issues in the telecom, mining and roads, significantly higher budgetary allocation towards capital expenditure, steadily reducing number of stalled projects, safeguard duty on steel to encourage new capacity addition over time, steady reduction in fiscal deficit etc. are key positives. Changes on the anvil are an arbitration law, bankruptcy law, GST, resolution of SEB (State Electricity Board) problems and so on. This is the best pace of reforms that India has experienced in a long time.
It is interesting to note the shift in headlines from shortage of power generation capacity a few years ago, to the shortage in coal, and now to idling power plants, lack of purchasing capacity with SEBs and shortage of transmission capacity. This shows that while India is changing, the planning could be better. In my opinion, there is realization of this and the system is beginning to come to terms with the desire of the new establishment and people alike, to move at a faster pace.
Finally, we need to keep in mind that India is a large and complex country and the speed of the real world is slower than the speed at which financial markets react.
How do you think the Chinese collapse will play out for the Indian economy and markets? Input prices are coming off, but India Inc seems to be quite worried about Chinese dumping.
While I am no expert on China, in my opinion, there is a lot of misunderstanding about China.
Doomsday forecasters are likely to be proved wrong. My understanding of China is that while investments in that country are slowing, consumption continues to grow at a steady pace. This is a natural transition for any economy over time and China is experiencing it presently. In my view, China will continue to grow at a healthy but lower rate. Fears about instability in China are wrong - China has one of the largest forex reserves, large BoP surplus and these are powerful tools to facilitate an orderly transition to slower and more consumption-led growth.
The recent 3 per cent yuan devaluation has also caused much misunderstanding. China has little to gain in competitiveness by devaluation - as the subsequent depreciation of emerging market currencies has suggested. I think this is well understood.
The following quote by Chinese premier at the G 20 summit is self explanatory- "The continued devaluation of the yuan is definitely not conducive to the currency becoming internationalized. This is not our policy preference."
For India, the slowdown in China should lead to low commodity prices and import-led price pressures. It will also lead to cheaper input costs for several Indian companies and for India. Where needed and justified, it may also necessitate policy action to safeguard the interests of local industry, as was done for steel industry recently.
The top-of-mind concern for many of our readers is that HDFC Equity Fund and HDFC Top 200, two funds we've been recommending for many years now, have seen a sharp slippage in performance this year. Can you tell us what has contributed to this slippage?
HDFC Equity Fund and Top 200 Fund have a track record of 20 years and 19 years respectively. Let's take a good look at the long-term data. Since inception, these funds have delivered a CAGR of 20.1 per cent and 21.4 per cent as against benchmark returns of 9.7 per cent and 13.3 per cent respectively. The original money invested in HDFC Equity Fund and HDFC Top 200 Fund has appreciated to 44.4 times and 39.4 times respectively since inception.
This has been possible because we have followed a process of investing in reasonable quality and attractively valued businesses. Good businesses are available at attractive valuations when these are passing through challenging times. While this approach creates good wealth over medium to long term, it can and does impact performance in the short run.
Selling IT stocks in 1999 and buying old-economy stocks instead caused pain in the short run, as IT stocks continued to rise. But this led to immense gains in the subsequent years. Something similar was witnessed in 2007, when not owning real estate, power utilities etc caused pain in the short run, but the gains in the subsequent years were disproportionate. But an excessive focus on one-year performance would have encouraged one to buy and not sell IT stocks in 1999-2000. Likewise for real estate in 2007.
In my opinion, the Indian economy is in transition. Unlike the past few years which were characterized by a weak capex cycle, high inflation, high current account deficit and a depreciating currency, over the next few years, growth should be led by a recovery in the capex cycle, interest rates will move still lower and depressed margins in corporates impacted by the slowdown in capex, will recover smartly.
With this view, our funds have moved their portfolios closer to capex-related businesses. While this has impacted performance in the short run, as was the case on earlier occasions, in my opinion this is right strategy for the future. We invest with a 3-5 year view and that shows in the average holding periods of the portfolios as well. Thinking long term and thinking ahead of the markets is one of the key reasons for our superior long term performance. I think it will be appropriate to focus on returns over similar periods and to judge the outcome of this strategy over a time when the economic recovery is stronger.
The last few years have seen strong performance from midcaps. What are your views on that?
Again, the data tells an interesting story when we look at the performance of midcaps versus largecap stocks. As can be seen clearly, the last one year has been a year of record outperformance of mid caps over large caps. Presently, the P/Es for mid caps are higher than large caps. This, in my opinion is unsustainable in the long run.
This record outperformance of mid caps over large caps has also impacted relative performance of funds with lesser exposure to mid caps. This large gap in performance of midcaps over large caps should not be extrapolated.
Your funds own overweight positions in financials, with quite a few PSU bank stocks. The prevailing view is that PSU banks will lose market share to private banks because they will be impacted by NPAs. Do you have a contrary view on this?
We have always invested with a 3-5 year view and according to our convictions. At times, this leads to a significant contrarian call on some sectors. Taking such non-consensus calls has on few occasions caused pain in the short run, but has resulted in immense gain in the long run when our views have turned out to be correct. (For instance, when our funds reduced exposure to IT in 1999 or when we purchased FMCG, pharma and automobiles instead of real estate and infrastructure in 2007)
In my opinion, public banks (especially the large ones) are sustainable and growing businesses that are undergoing pain due to asset quality challenges. This pain has depressed valuations and that creates an opportunity for long-term investors. An improving economic outlook, falling interest rates and high focus of government, central bank and lenders to resolve the NPAs will improve things steadily. Since economic cycles are longer than one year, it would be more appropriate to judge these investments over an economic cycle or at least half a cycle! Market shares are less important for banks compared to balance sheet strength and profitable growth.
As Warren Buffet said - "The future is never clear. You pay a very high price in the stock market for a cheery consensus. Uncertainty is the friend of the buyer of long-term values."
HDFC's equity portfolios seem to be tilted towards stocks with low price-earnings. But in recent times, the majority of Indian fund houses seem to be making a beeline for highly priced stocks provided they meet 'quality' criteria. Their credo seems to be that no price is too high for quality. Your views on this?
The table captures the performance of S&P Sensex companies from 1999 to 2009.
The returns clearly show that businesses to some extent and stock markets to a higher extent, go through cycles. Good businesses at wrong prices don't make for good investments. Besides, I have observed that the definition of 'good' tends to change with the changing environment. In every cycle, markets try to justify the high valuations of winners with some arguments. Did the markets not try to justify IT stocks at 300 PE in 1999? Or very high real estate valuations in 2007?
How does the recent rate cut by RBI change the outlook for rate-sensitives and banks?
For last several quarters, we have been of the clear view that interest rates in India will come down. Even after the higher-than- expected rate cut in the last credit policy, there is room for further cuts. The RBI governor has stated that RBI's stance will continue to be accommodative. This helps rate-sensitives and banks in my opinion. Lower rates will aid faster economic growth, reduce interest expenses for corporates. It will therefore reduce asset quality pressures for banks and also increase treasury gains.
What is your view on gold and how should one allocate one's savings into various asset classes?
Indians are sitting on a gold-mine of equities. Unfortunately they seem to have confused gold for a gold-mine!
It's interesting to look at the ownership of Indian stock markets and gold imports into India.
It is quite clear FII ownership of our markets has witnessed a steady rise from nil in 1992 to 23 per cent in 23 years. A growth of 1 per cent every year. The dollars gained in this process have been deployed into gold by local investors! This is not a smart thing to do.
While gold returns have averaged near 11 per cent since 1979, the S&P Sensex has delivered returns of 17 per cent.
It is thus hard to justify the high asset allocation to gold by Indian households. Gold over long periods has delivered returns close to fixed income but these returns have been quite volatile. My point is simple - if one is able to handle volatility and hold for longer periods, then equities are a far superior choice. If one's ability to handle volatility is low, then simply buy fixed income investments - either fixed deposits or fixed income mutual funds. In any case, with the low inflation across the world, with improving economic conditions in US and in Europe and with the prospects of rising US rates, gold prospects do not look encouraging.
With an ever rising variety and number of schemes, how does one select mutual funds?
I have observed a simple tendency in investors. They tend to always chase returns. 1999 marked massive inflows into IT stocks and sector funds. 2007 marked massive inflows into real estate stocks and infrastructure funds. In the last few years, a lot of money has moved into gold and real estate. Investors tend to judge mutual fund schemes also in a similar fashion, but the data shows that this not rewarding. If we look at the long-term history of the ten largest diversified funds, one sees that there is never a consistent winner or loser over more than one year. This is simply because one year is a very short time frame for equities and there is a tendency of mean reversion in the markets. In lighter vein, investing in funds that have a weak last year is probably a better strategy than investing in the best performing fund for one year!
A simpler and more effective manner of measuring performance in my opinion is to simply look for funds that have outperformed the markets with a high degree of consistency across market cycles. Consistency of outperformance is possible due to a consistent and disciplined approach to investments and this is what should lead to better performance in the future as well.
Look at the performance of HDFC Equity Fund over last 20 years for each calendar year. It can be observed that the Fund has outperformed the benchmark with a very high degree of consistency over 20 years across two- three market cycles.
This is a simple and effective framework to evaluate fund performance. Funds that have outperformed markets with more consistency are better funds. It is as simple as this. Investing is quite simple. I would recommend to investors to simply divide their surplus capital in two parts - risk capital and safe capital.
Risk capital is that part of capital that can be spared for few years and on which volatility can be tolerated. This should be invested in equity mutual funds. At this point of time, in my opinion, a higher allocation should be given to large cap oriented funds.
Safe capital is that part of capital on which volatility is not acceptable. This part should be invested in fixed income - either through mutual funds or otherwise. In fixed income mutual funds, preference should be given to duration funds presently as they stand to benefit from lower rates.
I would like to conclude by quoting Leonardo da Vinci who said that "Simplicity is the ultimate sophistication". I urge investors to focus on asset allocation and to benefit from the promise of growth that India offers.
The interview has been edited for brevity.
This interview appeared in the November 2015 Issue of Mutual Fund Insight.