Where patience is more important than intelligence

After living through a rough patch in 2015, HDFC AMC's flagship equity funds are back among the top rankers in some categories. In this interview with Aarati Krishnan, Prashant Jain, Executive Director and CIO of HDFC Mutual Fund, takes questions on what's driving the comeback and how the fund house coped with the transition.

Edited excerpts.

You have argued in a recent presentation that to sustain long-term performance, HDFC Mutual Fund believes in identifying market cycles ahead of others, and changing its portfolio positioning accordingly. Can you explain how this works?
If one looks back at the history of Indian stock markets over the past 20-25 years, one observes that they have displayed 6-8-year cycles. In each of these cycles, one or more sectors that were often correlated with each other assumed leadership and vastly outperformed the broad market. The next cycle then brought with it new leadership.

For example, between 1995 and 2000, the S&P BSE Sensex rose from 3000 to 4000 (1.3 times), but IT stocks like Infosys and Wipro were up nearly 100 times. In the same period, stocks in automobiles, capital goods, banks, etc., actually declined. This was a period when the Indian economy was not doing well and the economy-sensitive stocks underperformed, while IT, which was a relatively new sector, displayed rapid business growth and also assumed leadership in equity markets.

With the massive returns in this period, IT became overvalued and economy-sensitive stocks that were out of favour became deeply undervalued. As a result of this gap in valuations and as the Indian economy slowly recovered, leadership in markets was transferred from IT to economy-sensitive sectors. Interestingly, between 2001 to 2007, the second cycle, capital-goods stocks, like L&T and BHEL, were up about 30 times, energy companies were up about 15 times, banks and auto companies were up nearly about 10 times, while the Sensex was up only five times. IT stocks, the leader in the previous cycle, and pharma/FMCG were underperformers.

Once again, with this massive outperformance between 2001 and 2007, capital-goods and infrastructure sectors became very expensive. In fact, the market caps of HUL and JP Associates were equal in early 2008! Excessive valuations in capex and infra and undervaluation in out-of-favour sectors, like FMCG /pharma, once again set the base for a new cycle with new leadership. In the next and third cycle between 2007 and 2015, we believe the leadership has been with pharma and FMCG stocks, the underperformers of the previous cycle. In this period, while the Sensex was up just 1.3 times, pharma stocks were up seven-15 times and FMCGs and autos were up three-five times. Refineries, capital goods, corporate banks and metals, the leaders of the previous cycle underperformed. High inflation and sharp rupee depreciation also supported FMCG and pharma and hurt capital-intensive sectors in this cycle.

These different leadership cycles have closely followed business performance, which in turn has also been meaningfully impacted by the environment and macroeconomic factors. Interestingly, macroeconomic conditions in India have completely reversed in the last few years. Inflation has halved, the rupee is appreciating, the current-account deficit is negligible, the foreign direct investment has doubled and metal prices have stabilised at reasonable levels.

The complete reversal of macroeconomic conditions supports, in my opinion, faster profit growth in sectors that were laggards in the last cycle - capital goods, corporate banks, metals. It will slow growth in sectors like FMCG, pharma that were leaders in the last cycle. This once again has created a conducive environment for a new cycle in markets in our opinion. This is what the presentation you referred to deals with.

Is this why we see funds such as HDFC Top 200, HDFC Equity and HDFC Prudence climbing back to the top quartile in the last one year after a weak 2015?
In my opinion, 2015 was a transition year from the last cycle, where leadership was with FMCG and pharma, to the next cycle, where the leadership is likely to be with sectors that are linked to capex, lower interest rates and a stable INR.

These funds have a track record of nearly 20-23 years spanning the three cycles discussed earlier. Wealth in these funds since inception has become 43 to 50 times vs seven to 11 times in the benchmarks. The main reason for the good long-term track record of these funds is that they have positioned themselves ahead of markets in each cycle. HDFC Equity Fund, for instance, has outperformed significantly in each of the three cycles.

This strategy of positioning the funds in the next cycle ahead of the markets, though very successful in the medium to long run, has typically caused some pain in the transition years. For example, in 2007 when leadership changed from capex, banking, commodities etc., to pharma and FMCG, the performance was weak as the fund had moved into the next cycle ahead of the markets. Similarly, 2015, which was a transition year, in my opinion, from FMCG, pharma to the next cycle, was also a year of weak performance for this fund. However, post the transition year, as the changing fundamentals increasingly become visible, the performance tends to rebound. Metals, engineering and corporate banks have performed well in the last year, where the fund had positioned itself early and ahead of markets. This explains its strong performance.

But did you sell out of defensives too early?
We invest with a three-five-year view. Our portfolio turnover ratios are significantly below industry average and in line with this investment horizon. The outcome of decisions should therefore be analysed over the medium to long term and not over the short term. A short-term focus is actually damaging for mutual funds and investors alike. Recall the frenzy in IT stocks in 1999 and in infrastructure-related stocks in 2007. A short-term horizon prevented several funds and investors from moving out of these sectors until it was too late, causing irreparable damage to wealth.

What about your performance relative to peers? Given that the Indian fund industry tends to be so category-driven, isn't it painful to underperform?
We want to avoid making big mistakes. Indeed our funds have avoided the IT bubble in 1999 and the infra one in 2007. But that is possible only by following a long-term approach towards investing.

Equities are a long-term asset class. It is wrong therefore to emphasise short-term performance more than medium- to long-term performance. The short-term focus in neither good for investors nor funds as it leads to weaker long-term returns. It was this short-term focus that caused damage to wealth in the IT meltdown in 1999 and again in 2007 in infrastructure-related stocks.

Besides this, there are no funds that are at the top consistently. The very fact that our funds are near the top now says that the funds that were at the top last year are not there anymore!

So how did you personally deal with this period when your funds were underperforming?
To stay focused on the long term, to stay calm and rational, to handle pressure of short-term underperformance and criticism is what differentiates a great team from the rest. Such occasions, though painful, are also opportunities to differentiate and to stand apart. I am extremely proud of the fact that on not once, not twice but on three consecutive occasions, the team at HDFC AMC has handled such pressures and come out a winner each time.

I must add that me and my colleagues associated with HDFC AMC are extremely fortunate to be a part of HDFC Group, which encourages us to think long term and where honest mistakes are accepted. Without this support, it would have been difficult to consistently think long term and to generate the performance that our schemes have generated.

We also actively engaged with investors and distributors to convey our investment thesis on this market cycle. Most were convinced as they had experienced a similar situation in 2007 with our funds and had stayed with us to reap immense benefits as the cycle turned. I am sure that with things broadly turning out as we had communicated, the confidence of investors and distributors in our consistent, long-term approach will be reaffirmed and enhanced.

Some experts are saying that markets are very expensive as earnings have lagged markets?
This is a very interesting question as these markets have more value than what P/Es suggest. EBITDA margins are below long-term averages and therefore P/E multiples are looking high. Also, equity markets have lagged nominal GDP growth for several years now and the market-cap-to-GDP ratio is near lows. We believe at these low margins, the market-cap-to-GDP ratio is a better tool to analyse markets instead of P/E. With an improving macro environment, improving margin outlook of corporates, sharp fall in interest rates, the outlook for profit growth is also improving.

Corporate results of the third quarter of FY17 have recorded the highest profit growth in last ten quarters for the Nifty 50. This growth was contributed largely by financials (36 per cent), materials (32 per cent), energy (33 per cent) and industrials (15 per cent). Contribution from FMCG and pharma was 2 per cent and -0.5 per cent, respectively. Interestingly, the profit growth is coming from sectors which were laggards in the last cycle and is completely in line with positioning of our schemes.

What is your view on demonetisation? The earnings for the December quarter have been quite good, suggesting that there hasn't been much impact.
A day after demonetisation we had sent a Whatsapp message to our partners suggesting that demonetisation is a good move and that its medium- to long-term benefits for India and its people are likely to be more than the short-term pain and inconvenience. I am glad that Q3 results have vindicated these views.

Demonetisation/increased digital transactions and GST will make evading taxes difficult. Over time, this will increase the tax base, reduce corruption, lead to moderate taxes and improve ease of doing business.

What are the 'big bang' reforms that you think can really galvanise the economy?
Not one but many big-bang reforms are behind us - GST, demonetisation, Jan Dhan, direct benefits transfer (DBT), Ujjwala Yojana, Real Estate Regulation Act (RERA), Monetary Policy Committee, merger of SBI and its associates, SUUTI stake sale, etc., to name a few.

The pace of reforms has never been as good in India as it has been in the past few years. I continue to be very optimistic about continued reforms and economic and social progress in India.

There's a view that Indian active equity-fund managers are able to easily outperform indices because they don't use broader-market benchmarks or total-return indices. Do you agree with this?
If you look at the returns of the five largest equity funds of HDFC Mutual Funds since inception, they have beaten the benchmarks by about 6-13 per cent CAGR over ten-20 years. This is a significant outperformance and has been possible because of a very focused and consistent approach towards investing that HDFC Mutual Fund stands for. Most of these funds have broader benchmarks, like S&P BSE 200, Nifty 500, etc. The gap between normal indices and total-return indices is basically the dividend yield, which is about 2 per cent. The outperformance is thus considerable even against the total-return indices.

What's the one message you would give investors today?
The prospects of Indian economy are very promising. Equity markets have lagged behind economic growth for several years now. Equities have a good compounding potential in such an environment. To effectively benefit from India's growth is simple. Investors should estimate their risk capital (that part of wealth which can be spared for five years or more and on which volatility can be tolerated). This portion of wealth should be invested in three-five carefully chosen funds that have a track record of outperforming markets over several cycles. After this, all that one needs is patience. Patience in equities is more important than intelligence and the most successful investors are typically the most patient as well.