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'High valuations are rarely a reason to exit stocks'

Ajay Tyagi, fund manager, UTI Equity Fund talks to us about the fund's outperformance and portfolio

'High valuations are rarely a reason to exit stocks'

UTI Equity Fund's one-year return of 25 per cent is way ahead of benchmark and category returns.

What has resulted in the outperformance by your fund in the last one year?
In terms of sectors, during the last one year, overweight positions in financial services, consumer goods, IT and auto have contributed positively to the outperformance by the fund. As part of our general philosophy, we have stayed clear of businesses that have poor cash flows and a weak growth trajectory and that has helped us significantly in the last few months since the indiscriminate mid-cap rally got punctured.

How do you pick stocks for this fund?
The fund's stock-selection process is driven by the tenets of quality, growth and valuation. The fund has a higher weightage on industries that exhibit stable and secular growth prospects and an ability to generate high operating cash flows, preferably free cash flows as well.

We believe that long-term outperformance can be achieved by investing in companies which, among other things, (1) have strong management and market position, (2) have high and/or improving quality of earnings, (3) demonstrate that management's interests are aligned with their shareholders' interests, and (4) trade at attractive valuations.

We predominantly follow a bottom-up approach, with emphasis on building exposure around strong blue-chip companies that have a high earnings-growth potential on account of the size of the future business opportunity. We focus only on high-quality businesses within those sectors that have the ability to generate long-term wealth, as defined by a high return on capital or return on assets. The portfolio is built with an extremely long-term orientation and hence portfolio turnover is minimal. The strategy is to concentrate on a few good ideas rather than trying to do a lot of things. There is a huge emphasis on building exposure around businesses that can be understood well.

How do you determine the allocation between large, mid and small caps?
The portfolio follows a purely bottom-up philosophy and therefore when it comes to either sector weightages or market-cap weightages, we let the specific merit of the underlying business decide whether it warrants a place in the portfolio or not. The strongest businesses, with the most-convincing growth outlook, are the ones which carry the highest weightage in the portfolio. Having said that, we are aware that carefully chosen mid and small caps provide a longer growth runway and hence the portfolio always has a reasonable mix of them. We feel comfortable with a 30-40 per cent allocation to mid and small caps in the portfolio.

When do you exit a stock?
The decision to sell a security is driven by the following: change in business dynamics of a company or overall business cycle; unanticipated deterioration of investment fundamentals like ROCE or growth profile; forced displacement, i.e., availability of better ideas.

Having said that, high valuations are rarely a reason to exit a stock but they do lead to trimming the position.

Your portfolio P/E, at 32, looks stretched. How do you see that?
Our portfolio is constructed at the intersection of high-quality and high-growth companies. While the quality attribute helps to create economic value on account of the strong free-cash generation, strong growth helps to compound this economic value for years, if not decades, to come. Therefore, from an intrinsic-value perspective, such businesses would trade at valuations that look expensive from the immediate next-year earnings perspective. However, if you are right about the persistence of both quality and growth for many years to come, then these businesses are actually undervalued and would still create wealth, notwithstanding their high valuations.

How do you manage volatility in your fund?
The rigorous stock-selection process, with quality at its core, takes care of volatility. The businesses that we hold have a lower beta compared to the market, despite holding prospects for higher-than-market growth. Businesses with low leverage and high generation, which is the hallmark of the fund philosophy, tend to witness low volatility across market cycles.