Exclusive conversation with Pranav Gokhale, who manages Invesco India Midcap Fund, about the recent rally and market valuations, how he manages his portfolio, and his philosophy of mid-cap investing
What would you attribute the market rally after the March crash to? How comfortable are you with market valuations now?
Markets always tend to move with the news flow. A once-in-a century event such as COVID-19 was going to affect people/business across every stratum and thereby economies globally. Policymakers world over have extended fiscal support to stressed households and businesses to make up for lost incomes, whilst monetary-policy actions have ensured smooth market functioning as the world continues to battle the pandemic. This has led to a rally across all global markets.
Mid/small-cap companies were available at reasonable valuations even before the pandemic and post the pandemic, valuations became extremely attractive, which has led to a broad-based rally. The broader valuations today are fair after considering the lower-interest-rate scenario, but from here on, one needs to be stock-specific as the incremental returns will be based on earnings progression rather than just valuation.
What are the pain points in the economy now? Which areas have smartly recovered from the COVID-19 setback?
The pandemic has led to significant divergence in earnings for larger organised entities versus the smaller unorganised segments or well-to-do sections of the economy, which have been comparatively lesser hit than the economically backward sections. While on the positive side, companies have been able to cut costs, the flip side to this is that a significant number of people have lost jobs or have lower income levels than pre-COVID levels. The entities in hotels/hospitality/tourism/exhibitions have been hurt while the rural economy and some sectors like consumables/healthcare have seen faster recovery. Some of the entities have also benefited from the government stance of making India more self-reliant and a thrust towards domestic production and consumption.
What would be the long-term investment implications of COVID-19? What are the key takeaways from this black-swan event?
The criticality of how technology can help a corporation from concept and development of product/service to seamless and cost-effective delivery to the end consumers, including taking care of financial aspects, has come to the fore during the pandemic. Companies have become leaner and have used this event to reorganise themselves and reduce a lot of costs, which can lead to higher profitability. This is one important aspect.
Companies which have managed their balance sheet/cash flows rather than just running after growth have been able to tide over the COVID-19 situation better than their aggressive peers. These survivors will emerge as leaders going ahead.
How do you pick stocks for Invesco India Mid Cap Fund? Which ones do you avoid?
We look for scalable business models with credible management at the helm. We like those that exhibit superior return ratios and generate healthy free cash flows over a longer time frame. We tend to avoid companies which look to focus on growth by compromising on the balance sheet or companies which risk long-term existence for short-term gains.
What changes have you made to your portfolio over the last few months in response to the changed dynamics? Which sectors are you overweight/underweight on and why?
Mid-cap investing is more of bottom-up stock selection and to that extent, being sector overweight/underweight is an outcome. We are overweight on technology, industrials and currently underweight on financials and consumer discretionary.
Over the last few months, we have reduced over exposure to consumer discretionary and utilities and increased exposure to healthcare and technology.
We had reduced exposure to financials but have incrementally increased our weights.
You have a diversified portfolio, with the top holding making up under 5 per cent of assets and many others hovering about 2 per cent. What would be your input in the classic debate between focusing and diversifying in terms of mid-cap investing?
The fund aims to give a stable outcome by duly giving importance to the risk and liquidity associated with mid- and small-cap investing. We tend to cap the top weight at 5 per cent of the fund but constantly ensure that whatever stocks we own are always higher than the benchmark. The fund holds a reasonably diversified portfolio of 42-45 stocks. The fund thus adopts a balanced strategy aimed for a more stable outcome by getting the benefits of a reasonably diversified portfolio but also taking active selection bets.
What are the challenges of managing a mid-cap portfolio? What are the benefits of investing in this set of stocks?
The key challenges in mid-cap stocks are the ability of these companies to scale the business and become the large caps of tomorrow and sustaining to stay that way. This many times involves a balancing act of challenging the status quo, adopting best practices but not compromising on long-term goals in favour of short-term gains. The ability of a business to manage the balance sheet as well as grow significantly is a difficult task and very few companies manage to do it on a sustainable basis. The success rate of these companies is low but identifying the right set of companies leads to significant alpha and wealth creation over the longer term.
Generally speaking, mid caps lie in between large and small caps in terms of volatility and returns. How can a mid-cap investor reduce the volatility in his portfolio while boosting returns?
Our policy of adopting a reasonably diversified portfolio but taking active stock bets has helped us tide through volatility as well as create reasonable alpha. We believe this style of investing has the ability to not only generate long-term wealth but at much lesser volatility associated with mid- and small-cap investing.
What are your key investing lessons, especially in terms of managing a portfolio of mid caps?
Any mid-cap investor has to manage the difficult art of tempering the urge to sway with momentum. Many times, companies do exceptionally well due to short-term tailwinds, and one errs by paying peak multiple on peak profitability, which causes large drawdowns.
We tend to invest in companies only if the balance sheet and cash flows are healthy enough to support the company in bad times.
The ability to stay focused on the style which suits you and the ability to avoid certain kinds of companies in the momentum phase are what we believe is the key to long-term success.