From 'Growth at any price' to 'Growth at a reasonable price'

Aditya Khemani, new fund manager of Motilal Oswal Long Term Equity Fund, talks about his stock-selection approach and changes he's making to the portfolio of this top-performing ELSS

From 'Growth at any price' to 'Growth at a reasonable price'

For the investors of Motilal Oswal Long Term Equity Fund, 2019 was a year of change. During the year, its fund manager was replaced twice. In May when Gautam Sinha Roy quit, Akash Singhania took over the reins only to pass on the baton to Aditya Khemani, who joined the AMC in July 2019. But interestingly, the performance of the fund has stayed the course through this transition.

During this short time frame, Aditya has made big changes to the fund's portfolio. In this interview, he talks about his stock-selection approach, fund management style and the thinking behind the ongoing major shift in the portfolio.

What are the key attributes you look for in a company while forming your convictions?
The stock-selection approach obviously rests upon the QGLP (Quality, Growth, Longevity, and Price) model, which is the philosophy of our fund house. But talking about some specific attributes or metrics, one key criterion is whether or not the company is a leader in its sector or industry. So, the market share of the company, as well as how it has moved incrementally over the last two-three years, is very important to me. But one should not just stop at market share by volume. The market share within the profit pool and cash flows of the industry also need to be looked at. These two should be higher than the volume market share, indicating the robustness of the business model. After all, ultimately, every business has to make money for its owner.

Cash flows are very important. One should focus on operating cash flows (OCF) or free cash flows (FCF), depending upon the kind of the industry the company is in. If it is a cement company which needs capital expenditure for incremental growth, OCF is a better metric. However, in the case of an asset-light model, one should look at FCF. Also, when cash flows are good, their balance sheet invariably is also healthy with either net cash or very minimal debt. You will see most of the companies in the portfolio would have net cash or very minimal debt.

Then, I believe that the return on capital employed (ROCE) is an extremely useful metric to form an aggregate view of the business model, the management and the promoter. That's because to earn a good ROCE, all three have to be good. You would see that most businesses in my portfolio have a very healthy ROCE.

When it comes to portfolio management, I follow a barbell approach wherein there would be two parts of the portfolio. Firstly, there would be roughly two-thirds of the portfolio comprising secular growth stories, compounding earnings at 15-20 per cent every year for a reasonably long period of time. And the remaining one-third would be the companies that are quality franchises but are currently going through some growth challenges at the cyclical level and therefore, are priced attractively. There is a fair chance that this bucket could give me outsized returns when one sees growth come back for these companies. Hence, the endeavour is to have an optimum balance between the two.

You've overhauled about 40 per cent of the portfolio of your Long Term Equity Fund in a short span of six months since you took over as the fund manager. Can you take us through the thinking behind it?
Sure. When I took over this fund around six months back, I was clear that over the next two-three years, mid and small caps would catch up with large caps and there would be a mean reversion, as they have underperformed large caps massively over the last two years. So, increasing allocation to mid and small caps has been one of the key drivers of change. When I took over the fund, it was about 12-13 per cent. And as we talk now, it is about 33-34 per cent. And going ahead, it will be run with a multi-cap approach wherein mid and small caps would be between 30-40 per cent, depending on opportunities.

Secondly, in keeping with the 'quality at reasonable price' approach that I prefer, I have exited a lot of stocks that had become too expensive. From that perspective, the portfolio has moved from 'growth stocks at any price' towards 'growth stocks at a reasonable price'. For instance, I have made some changes to the NBFC space by selling very expensive stocks to reasonably priced stocks. Also, consumer staples have been trimmed.

So, does the switch from large caps to mid caps signal a style shift for the fund or more of an opportunistic call?
Movements between large, mid and small caps would always be a function of where you will find pockets of valuation comfort. One of the advantages of an ELSS fund is that it provides a fund manager with the flexibility to move across different market caps, depending on opportunities available in different parts of the market. At this juncture, I could see value in mid and small caps, so I increased allocation there. But one thing I can tell you is that the fund will not go back to 90 per cent of large caps over the next one to two years, unless we see value there. From a multi-cap point of view, my definition is about two-thirds in large caps and one-third in mid and small caps, with more of mid caps and less of small caps.

The macro concerns tend to hit mid and small caps harder. The Indian growth story had been struggling to get its mojo back but now there could be additional headwinds from the coronavirus outbreak. Given this context, can your shift towards mid and small caps at this point backfire?
That's actually a risk management issue. It boils down to how I manage the risk. For one, I do not allocate high weightage to any stock of mid- and small-sized companies. Most of the mid caps would not have more than 3 per cent allocation in my portfolio. And in the case of small-cap stocks, I make sure they are not more than 2 per cent.

The other important point is the type of companies you are buying in the mid-cap space. As I said earlier, I prefer market leaders that have good ROCE, good cash flows, good market share and a good balance sheet. Although mid caps can witness periodic slowdowns in line with the broader economy, their survival may not be at risk. Hence, they are like large caps in character. There are many pockets in the market where the market leader itself is a mid-sized company. So, I think buying the leader in the mid-cap space itself mitigates the risk to a large extent. Hence, you would see, I own the leader in various spaces, including diagnostic, luggage, gold financing, mall management, consumer durable, premium innerwear, restaurant, etc. Therefore, the choice of stocks and portfolio allocations help me control the risk.

How much role do benchmark allocations play when you are sizing up stocks or even sectors in your portfolio?
As a fund house, we are completely benchmark agnostic. We run a focused, high-conviction portfolio. For me, the construct of the benchmark is not at all important for building the portfolio.

How unhappy are you about the fact that now there is an alternate tax regime where ELSS will clearly not be a preferred investment choice?
We deliberated upon this. At Motilal Oswal, we feel that very few people will shift to the new slab structure. Most people are likely to stick to the old one. That's because you'll have to give up on a lot of deductions to avail the new slab structure. Therefore, we believe that the ELSS category will continue to do well.

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