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A heterogeneous universe

Franklin Templeton Investments-India's Janakiraman R. talks about his plans to tackle the surge in mid-cap prices and other strategies

One of investors' biggest fears is when a high-performing, long-term fund manager of a successful scheme leaves and someone else takes over. Franklin Templeton Asset Management (India) Ltd went through this change when in 2014 Sivasubramanian K.N., chief investment officer, Franklin Equity-India, left the fund house to pursue other interests. But Janakiraman R.-who took over Franklin India Prima Fund (FIPF) in 2014-maintained its performance. Janakiraman and Sivasubramanian were co-fund managers of FIPF since February 2008. He spoke to Mint about his plans to tackle the surge in mid-cap prices and other strategies. Edited excerpts

High valuation in mid-cap calls for caution in risk frame

Valuations in the middle- and small-sized companies have become quite high. As a mid-cap fund manager, does it scare you?
One has to take cognizance of the fact that valuations have indeed inched up a bit. Which means that the margin of safety is now really low. So, the risk assessment framework becomes a bit tighter now.

Other than that, it is business as usual. Let me also add that while at the index level it appears that the mid-cap valuations have gone up significantly, at the portfolio level, they are still quite low. The mid-cap universe is heterogeneous. So, the overlap between index and portfolios-in my funds' cases as well as for those of many peers'-is low. Therefore, the index valuation in many cases may not be truly representative of the category valuations.

I can confidently say that that's the case with Franklin India Prima Fund (FIPF) and Franklin India Smaller Companies Fund (FISCF), where I haven't seen the underlying companies' valuations go up materially in the past one year. In fact, in that period, the underlying earnings growth in both the portfolios has been comfortable.

So while I agree that in the past 2-3 years valuations in the mid-cap space have gone up, and this definitely calls for more caution on risk frame at a portfolio level, we haven't reached alarming levels.

Do you change the strategy for FIPF and FISCF at these times, when market valuations are high?
In general, my competitive advantage-and what has helped these two schemes in the two decades or so-is identifying reasonably good quality businesses and then remaining invested in them. If you look at the way the portfolios have performed in last 6 years, there has been no change in this approach. The idea is to identify, preferably early, companies that have good quality attributes; combination of return of capital, ability to generate free cash flows, businesses which are not very capital intensive, combined with reasonably good management.

These are the features we keep searching for in companies and it's been the same irrespective of market levels.

Having said that, some business' valuations are at 2 or 3 standard deviation over their normal levels. Either we try to reduce exposure to these businesses, or stop putting in fresh money there. For instance, in the past, we have had a good exposure to companies like Bosch India and Wabco India Ltd.

Both are good businesses, but at some point over the past 1 year or so, their valuations reached a level where the next 3-year return, in my opinion, did not look all that attractive. So, these are the two specific cases where valuations led me to exit the positions.

Also, as FISCF's size grows, so will the number of its underlying holdings. Now we have about 70 stocks in there. Our team's size is comfortable enough to monitor these many holdings. Also, since the average size of a small-cap position is lesser than that of a mid-cap position, the number of stocks in FISCF will be more than in FIPF.

But now that FISCF is open-ended (it was launched as a 5-year closed-end fund in December 2005), does it add to the challenge? Would you have rather preferred it remained closed-ended, or are you fine with the open-ended structure? What's your preference?
There is no a priori answer to that. In the past when FISCF crossed ₹1,000 crore and then again ₹2,000 crore, we had this question in mind, whether we'll be able to run a small companies' fund with these kind of assets or have we reached the limits of scalability. FISCF became open-ended in (January) 2011.

So far it hasn't been that challenging in order to scale up this product to this level (presently its corpus is a little over ₹3,000 crore). If it becomes very challenging or difficult to find incremental ideas, then again this question will crop up, perhaps louder. But right now, I don't think so.

Ever since you took over FIPF from Sivasubramanian K.N., you have sustained the strategy and performance. In fact, the fund has grown. What changes have you brought in your portfolio?
I don't think I have brought in any fundamentally new dimension to this analysis framework. To some extent, what we have done in the past 5-6 years is that we have tried to limit the number of mistakes. So while earlier we had a reasonable amount of winners, we also had a share of losers, which took some sheen away from performance. The endeavour over the last 5-6 years has been to plug the leakages from adverse selections.

But, I wouldn't want to take credit for this. In the past 5-6 year period in the equity markets, the better quality businesses have done well.... Clearly, this approach won't do as well when risk appetite in the markets is high and where a quality conscious approach may not be the best way forward. But we prefer to stick to it nevertheless.

So you have turned FIPF into a more conservative fund?
There is a bit more emphasis on quality.. to ensure that the quality of businesses is thoroughly vetted and assessed during the selection process. The objective is to generate attractive returns on a risk-adjusted basis.

Do you get good companies at these valuations?
It is becoming progressively more challenging, especially in the small-company space. At mid-cap level, there are enough business that one can find with these quality attributes and at valuations that are not so high that they dampen the 3-year returns.

Any particular sector you'd be keeping an eye out for?
The growth in aggregate demand over the past 5 years is quite broad-based, with a skew towards the consumer demand. I cannot think of stand-out sectors that have played an influential role in this period.

While not pivoted to any sector or theme, we look out for good businesses through a prism of growth, quality and valuation. There are a few sectors where the changes in the global cost structures have given us a benefit, which could perhaps last for a while in terms of cost competitiveness. An example is speciality chemicals. This calls for strong knowledge of chemistry and chemical engineering. India has quite a few such companies that have started to see brighter business prospects.

Also, the ongoing growth in consumer discretionary demand facilitates various sectors. Automobiles, home improvement or appliances, financial services, pharmaceuticals are some of the sectors that are witnessing better demand. Having said this, our focus is far more on bottom-up stock picking to build portfolios.

In arrangement with HT Syndication | MINT