After the announcement of the corporate tax cut and the brief rally that followed, the market seems to have again slipped into uncertainties. This is testing the patience of investors. We speak to R Srinivasan, who manages SBI Focused Equity Fund. The fund has assets of over Rs 5,700 crore as of September 2019. We ask him when he sees a recovery in the market, how long the era of corporate governance crises will go on for, and how diversified a stock investor should be, among other questions.
In spite of the recent corporate tax cut, the markets don't seem to be too excited. What's keeping them depressed? When do you see a recovery?
Well, I'd say the markets are pretty excited. It seemed like they were on their way down and they recovered smartly. Very smartly! Why do you say the markets are depressed? Rather, the economy is depressed. Earnings are depressed; and for quite some time now! The market, on the other hand, has re-rated and seems pretty optimistic about future prospects despite being let-down year after year.
In this market, your fund is one of the top performers over one year. How did you achieve this?
In the Focused Equity Fund, we run a bottom-up portfolio that targets absolute returns (in a long-only context!) and is largely benchmark-agnostic. Due to liquidity constraints and a dearth of conviction ideas, we've got biased towards quality and growth and this style, I reckon, has done particularly well. To be frank, our portfolio has hardly changed over the years even in terms of the top holdings, so the reason for doing well last year wasn't really something designed or premeditated. For the record, our top performers over the last one year were Bajaj Finance, Interglobe Aviation, HDFC Bank and Kotak Mahindra Bank, among existing holdings.
What are your stock-selection criteria?
We look for three characteristics: a good business, a great management and an attractive (read reasonable) price. A good business is something that has competitive advantages (Google's economic moat). Two, it needs to or needs to be able to generate a reasonably high return on capital. Three, it has to be scalable. To be able to generate high returns on capital and at the same time grow at a fast clip is like the best of both worlds. Four, low capital intensity. Five, high cash conversion. Six, pricing power. Seven, longevity or a low risk of business disruption, etc.
Managements can be cross-referenced for integrity, capability and vision through their track record; we look for transparency, accountability and clarity of thought in our interactions and analysis.
A good price is something that gives you a margin of safety. That is not only in terms of price-to-earnings and price-to-book ratios but also in terms of the stability of the business model and the earlier factors put together. We try and think of these not in black and white but in different shades of grey. You never get the ideal condition. It's about weighing the different variables for their intensity or closeness to where you want them to be and choosing the best combination.
Corporate governance has been a major issue with many companies over the last one-two years. What has led to the corporate-governance crisis and how deep does it go?
Corporate governance has always been an issue. It's standing out now probably because the incidence of crony capitalism is coming off. Thanks to the environment and the government. This is only good in the long term but creates short-term disruptions as people change and adapt. Let me confess here: this is less of a commentary and more of a hope sentiment. And I'm not being a pessimist here. For every fraud, there are probably a lot more doing a wonderful job and delivering outstanding results.
How do you avoid wealth-destroying stocks?
That's the easy part! We avoid companies with corporate-governance issues. That's a shade of grey again but basically, we stay clear of what seems darker. Our stock-picking philosophy, as elaborated above, is clearly biased (whether we like it or not!) towards quality and growth. These stocks do underperform during certain periods but generally don't destroy permanent capital. As you would already know, we are the pioneers in the adoption of an ESG (environmental, social and governance) framework in our research and portfolio-management process.
The fear in the market has made quality stocks even pricier. How comfortable are you with valuations of such stocks? Should an investor buy them at the current levels?
This is our biggest worry, too. And I don't have a clear answer. There is a very high polarisation in favour of quality and valuations do not offer a margin of safety. Maybe it's to do with a zero-interest world. Maybe it's just liquidity. Or maybe it's just a TINA (there is no alternative) factor for investors. I don't know! I can just say that valuations are indeed very important for prospective returns and investors, I guess, have little option but to get their return expectation down relative to what they have had in the past.
Your portfolio features Alphabet as a holding. What made you pick this stock? Are you planning to add more stocks listed overseas?
That's a corollary of the earlier question. We bought Alphabet because we thought it offers a better risk- return trade-off than the majority of Indian stocks we owned. We don't have a pre-determined allocation in mind for international stocks, nor is this a diversification strategy. We'll take it as it goes. I'm pretty sure we'll look to add more purely because the international market offers a wider universe to choose from.
Which sectors are you bullish on? Which would you avoid?
Please note that the Focused Equity Fund is sector agnostic. As a fund house, we are positive on financials, industrials, telecom and cement and negative on consumer staples and IT, among others.
You run a focused fund. What is the optimum level of diversification that a stock investor should target?
We own between 20-30 stocks in the Focused Equity Fund. If you research portfolio construction, there is more than enough evidence to suggest that diversification peters out significantly after 15 stocks. We have 25! Also, to be frank, I'm a lot more worried about the quality quotient in the fund and how much benchmark underperformance that might lead to if the market does really well.