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We've Been True to Diversification

Ravi Mehrotra, president, Franklin Templeton, a quintessential high-flyer shares his experience in the mutual industry in an interview with Mutual Fund Insight

Ravi Mehrotra is the quintessential high-flyer. He started his career in the mutual fund industry as fund manager of Kothari Pioneer, which quickly gathered a reputation of being second to none in its ability to reward its investors. And this reputation has survived untarnished in the difficult decade that has passed since then.

Through its turbulent ownership history that saw Kothari Pioneer become Pioneer ITI and then Franklin Templeton, Mehrotra has tended one of the most consistently well run fund management outfits in the country. And this track record has paid off: except for UTI, which is hardly a fair comparison, he runs the largest corpus of equity investments in the country. When the Mutual Fund Insight team met him for a free-wheeling, hour long conversation in November 2002, it was obvious that while he takes pride in his funds' past, his confidence in their future is far greater.

On his career
I was born and brought up in Bombay, where I did my school and college. I did my MBA from XLRI in 1985 and joined Bank of America from the campus. I was there for about seven years; I started off in corporate credit analysis and subsequently moved into treasury, where I used to run the bank's SLR (statutory liquidity ratio) portfolio.

My first job change was when four of us left the bank and started Prime Securities for Great Eastern Shipping. It was a private company then and we were managing a proprietary portfolio, which was owned entirely by the shareholder of the company. I was with Prime for two and a half-year till I joined Kothari Pioneer in 1993.

On his days at Prime Securities
In Bank of America treasury, the exposure was only to bonds and government securities and to Unit-64 which was traded a lot in those days, but the US had a law, the Glass-Steagall Act, which did not allow US banks in investment banking and to equity related activities. My exposure to equities was more personal, and also because while the bank was involved in just bonds and gilts, equities, bonds and interest rates are so closely related that to understand one you have to understand the others also.

Prime was into bonds as well equities-we were all over the place. It depended on where the markets were heading and where the volatility was. We were a classic hedge fund and we made money depending on which market was moving which way. We were able to take very large leveraged positions-forwards, futures, whatever. We were able to create interest rate scenarios and actually use a lot of instruments available to take outright positions on bonds and various securities. In those days there was Badla, and you could actually carry forward position on stock exchanges, you could leverage, you could roll over positions and do other interesting stuff.

When we joined Prime, we had a capital of just Rs 1 crore and of that as much as Rs 50-60 lakh was tied up in housing deposits of employees. So we had to build on a capital base of just about Rs 40 lakh. We were a very small team, Neeraj [Batra] and I were the senior guys, Neeraj was the CEO. It was really a situation of seeing opportunities, figuring out where there were market imperfections and having a real understanding of the players and the market dynamics. It was a very small market in terms of people, but it was highly liquid, and one could actually do fairly significant trades, almost as large and equivalent as ten years later now in government securities. It was a nascent market so there were imperfections right across. One could synthetically create a forward position, on a security that was actually fairly large arbitrary charge, between actual prices and interest rates. So theoretically you could have funded it for six months and actually sold a six-month forward at a fairly large spread.

There were a few players who truly understood the market. There was Citibank, there was Grindlays and there were some brokers who had actually been running the market for 20-25 years before the foreign banks entered it. It was a market that was extremely lucrative in terms of market imperfections.

I left Prime and joined Kothari Pioneer in 1993, at a time when it was a start-up—in fact, it was literally just a dream.

The start at Kothari Pioneer
It's an interesting story. Vivek Reddy (Kothari Pioneer's CEO till Franklin Templeton acquired the asset management company) and I knew each other during our days on the tennis circuit when we were teenagers. During the Prime days, he gives me a call out of the blue. He said, "Can I meet you?" He and Shyam (Shyam Kothari, one of the AMC's original promoters) dropped in. He was looking to start a mutual fund, and I was the only guy he knew who was associated with the capital markets. Over the next six months, he dropped in a few times figuring out whether he was going in the right direction. So it started that way, he was bouncing ideas on me, learning what really happened in the capital markets, to some extent and where mutual funds fitted in and what sort of stuff made sense. At that stage there was no tie up with Pioneer; that was still up in the air, in terms of whether it is going to be a joint venture or whether it was going to be just the Kothari group.

By that stage it was clear to me that the hedge fund-like structure of Prime was not sustainable. The rules and regulations were changing, it was an opportunistic business, not something that could run for three to five years. The mutual fund business was interesting at that stage and it was obvious to me that this was something with a bright future and so I moved to Kothari Pioneer.

On the early years at Kothari Pioneer
The mutual funds business took a lot longer to stabilise and grow than I would have expected. The industry has really started to grow only in the last two or three years. When it started off in 1993, there was no apparent reason why it should not have grown, except that there were a lot of building blocks that were not in place. The way we distributed funds when we started off was like an IPO (initial public offering). You printed forms, you sent them out, there were the 60-80 IPO brokers, there was a lead-manager sort of a thing, there were parcels of application forms being sent out to many locations, the stock exchanges, roadshow, it was really the way IPOs were being sold.

Banks were not distributing. People didn't understand enough about the taxation element-the fact that a mutual fund does not pay taxes. The education process was nascent. There wasn't much in place except Unit Trust of India, which was a quasi-guarantee sort of a thing.

One of the things that helped us-I don't know whether it was providence or foresight, I think a bit of both-was that Pioneer encouraged us to launch an open-end fund. We were planning to launch just a closed-end fund. They said closed-end funds are a thing of the past. They were quite keen on doing things looking into the future, and we thought it sounded like a great idea but how do we service them? You can't use Karvy or some other registrar for that and in those days there were no distributors, only registrars. They decided to throw in their technology to help us service that. Early in the game we decided to have both an open-end fund and a closed-end fund.

Our prospectus promised 48-hour redemptions. I remember the other fund guys coming up to me on roadshows and say you guys are mad-he said it in a nice way-and that it is not possible to run an open-end equity fund. That was the thinking at the time-people just looked at the negative side. They would say, suppose you have a Rs 50-crore fund and somebody comes and asks you for Rs 5 crore, you are eventually going to give it to them in T+2 and the settlement cycle in those days was two weeks, so where is the liquidity? And this was the difference where Kothari Pioneer and Pioneer ITI, in a lot of ways, as an organization, kept rewriting the rules. We did 24-48 hour redemption, we did redemptions on forward pricing, and we did daily pricing.

The research set-up
We started off with three analysts, two portfolio managers and me. Two of those analysts are still with us, after nine years. Just one analyst and one portfolio manager has changed. The first change was 18 months after we started, when Sukumar (fund manager for some of Franklin Templeton's equity funds) joined. The process has become more sophisticated over the years. We have never had a list of what we cannot do. The way we looked at businesses was completely different in the early days. Things were simpler-we were a lot more focused on the profit-and-loss and P/E. Today we are lot more focused on the balance sheet.

We try and understand the company and its cost structure, and the sustainability and authenticity of that cost structure. One thing we have learned over the years is to not talk to the finance guy. They are used to talking to people like us and have a nice story to tell. The value addition from meeting them has come down over the years. We have also learnt to question and revalidate our assumptions in our interactions with companies. We meet a lot more people in companies nowadays.

Certainly, the attitude has changed. Earlier they thought they were doing a big favour by talking to us. As we have grown in size, we have become large enough not to be ignored. Also, companies have realised that we are both on the same side. We are both interested in the stock moving. The realisation of value--sustainable value--has dawned on companies over the years. Of course, a lot of this has not happened with every company but the more forward looking ones have changed.

In some ways the industry has become more demanding than it should be. There is this whole issue of guidance-why should companies provide guidance? What are the analysts supposed to be doing?

His stock selection philosophy
I wish that life were that static. I wish that it were that easy. Then I can say that I have got this nice formula, and it is time tested and what worked now will work eight years from now. But it doesn't work that way. It is like any other business with so much change. There will be times at which there are theme bets, sector bets, but we have methodologies by which we evaluate all this.

For example, on a sector bet, we look at the dispersion of returns within a sector. We track that and if we find that across sectors there are dispersed returns, then it tells me that stock pickings rather than sector themes is what is happening right now. Then you have to make an informed judgment. On the other hand, if you find roughly similar returns across a sector then you know it is time for sector bets.

You have got to adapt, you have got to figure out what you want to do, but the basics are clear. You are buying companies, you are buying businesses; there is no doubt about that. The other thing is that you are marrying risk with that business. I may be in love with this business but I may not like the price. So there is always a trade-off. Take Wipro for example. I think it is a great business; it has all the ingredients of a good investment. Do I like the Rs 1,400-stock price? Probably not. So will I own it? Maybe. Will I own it lower down? Surely.

We are buying companies but what we are also doing is that once we have constructed a portfolio we are marrying it with a little bit of a top-down screen for diversification and for sectoral weights. This is purely a matter of de-risking a portfolio. It may appear to be sub-optimal at some stages in the market, but in our experience it pays off in the long run. We are sticking to companies, we are picking individual companies that we understand, but then we are going to trim back at some stage on sector weightages.

We have internal processes, which restrict individual stock weightages in a portfolio. They also restrict sector weightages within the portfolio. This prevents us from making the kind of mistakes that are easy to make when a particular sector is hot.

The big mistakes and the big wins
I am more interested in the losers than in the big wins. Hindsight is always 20:20. You always come up with the numbers; they were fairly decent. You always look back, should we not have seen the technology meltdown? But I think the right thing we have done is being true to diversification. One of our big strengths is that we stayed away from obvious mistakes the ones that seemed obvious to us! It turned out okay but they were expensive mistakes at the time. There were some stocks that had no fundamental basis for going up and when the market corrected, they did not correct. There were three to six month periods when we looked like we were underperforming because we didn't own those stocks. Neither did we get the upside nor did we get the downside protection. So when those stocks corrected, they corrected 99 per cent. And there were a whole lot of these kinds of stocks--the momentum stocks.

On his funds' recent underperformance
I think the difference is not qualitative, what we missed last year was the small-cap rally. If you actually look at the funds, they have done reasonably well. I can think of Polaris for example. It was Rs 58, now it is up to 210. Mphasis BFL was Rs 60, today it is Rs 500. If we had loaded up on these small-caps, we would have done extremely well. What we believed and what we continue to believe is that the large-caps have more robust business models. So if you look at our short-term performance, you are right-it's probably middling. But if you look at a longer period of time, we have done far better.

And a lot of the companies that I am talking about are not tech companies, but I was more focused on the diversified equity funds where the numbers have been pretty good. We have been more disciplined in not chasing what I would call the obvious risky propositions.

See there are two ways to make money on stocks; you can make money for the right reasons and for the wrong reasons. By and large, we would like to know why we are making money. But that's a matter of philosophy. Some guys don't do it, and that is fine by me. As for others they can do it consistently. That is the style. That is a little more deliberate.

The Templeton impact
Templeton is very large internationally. It has got four parts of the business, Franklin, Templeton, Mutual Series, Fiduciary Trust. The four have very different investment styles, some are deep value, some are growth, some are value, so there is a wealth of understanding of different types of investment styles and from that perspective, it is going to be a change.

I have had conversations with them internally and they say we like what we see, so please don't change what are you doing. People were fairly confident that the team on the ground is doing reasonably well and nobody wants to change what is working.

From another perspective, there is lot of opportunity of actually integrating with a larger company with operations in various countries. This is a business of information and analysis. The more you know about a company somewhere else, say a petrochemical company in Taiwan or an auto manufacturer in Korea, vis-à-vis what is happening in the US and Europe, the more you can understand a similar business in India.

On the future as India's largest non-UTI Fund
Sizes really doesn't matter. The one thing I have always focused on is on doing the right thing when the size happens, rather than actually focusing on growth. We all like to grow but from business point of view size does make a difference. You make a little bit more money. There are certainly more resources to plough back to research and development.

At this stage, I am very excited about the mutual funds industry. I don't think the industry is going to go on growing at just 10 to 15 per cent kind of rate. If memory serves me right, in 1979 the US mutual fund industry was about 50 to 60 billion dollars. Today it has grown to about 6 trillion dollars—more than fifty times the size. That's the kind of growth that could happen in India also.

I think all the elements are in place now. Look at the way the fixed income and short-term plans are on a hot run today. The way its income funds today, it may be may be equity funds tomorrow. Remember, no where in the world do equity funds grow in a horizontal or linear way. Equity fund growth is a kind of a step function and that is the nature of business worldwide.

The Indian market is still very small. Microsoft's market cap is around 260 billion dollars. The market cap of all Indian listed companies is around 130 billion, so there is obviously some screw up somewhere.

In terms of absolute size, the Indian fund industry is way too small for the size of our economy. I think the industry is poised to grow dramatically. I wouldn't be surprised if it grows at up to 50 per cent compounded for the next 5 to 7 years. In fact I think even that could be a conservative estimate.