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'Valuations are elevated even after considering growth in earnings'

Vetri Subramaniam of UTI AMC talks about the economic scenario, corporate earnings and market valuations

'Valuations are elevated even after considering growth in earnings'

The meteoric rise in markets has puzzled most investors. While the earnings haven't disappointed yet, inflation has started inching up. With respect to the pandemic, we aren't out of the woods yet. Amid this, we speak to Vetri Subramaniam, Group President and Head Equity, UTI AMC, about a range of issues, including the economic scenario, corporate earnings, market valuations, among others. He also shares details of the fund-management approach at UTI.

Rising inflation has become quite a concerning factor globally. The US FED has indicated that there is a possibility of a rate hike coming sooner than previously anticipated. The recent CPI and WPI numbers for India have also breached the comfort zone. What could be the reasons for this and how worrisome is the situation? What actions do you expect the RBI to take over the next one year?

The US Federal Reserve and the other central banks have flooded the system with money and kept rates low in response to the pandemic. Simultaneously, fiscal policy has also been used to varying degrees by governments to provide support to citizens and businesses. As economies get back to business, supported by vaccination, and growth picks up steam, we cannot expect this unusual monetary and fiscal policy setting to continue. This is the typical passing of the baton in a relay, as economies exit the crisis and return to normalcy. If the growth recovery were to gain momentum sooner than expected, then it is likely that the policy settings will also be readjusted to align with the growth surprise. This need not be disruptive for economies or markets. The scenario we would worry about is a sharp rate hike being carried out as a preemptory inflation strike, even when the economy is not back at optimal levels of activity.

As regards the current spike in inflation, we believe that it is caused by pandemic-related supply disruptions; incomes are not elevated and there is a positive output gap. The RBI has reiterated a pro-growth approach and believes that the inflation numbers will be transient. In the second half of FY22, when there is increased confidence about our growth trajectory, the RBI could look to normalise its policy settings.

A section of the markets believes that we are headed for a big crash, citing the blatant currency printing by the US. What's your view on this? How is your portfolio positioned for any such adversity?

Our investment process is not predicated on forecasting the market direction. It follows that we do not attempt to change our asset allocation in the portfolios in favour of cash or equities because of a view on the market direction. Our equity oriented funds have remained at 95 per cent or higher levels of investment through this period. So far, our portfolios have weathered the pandemic - an event that we did not predict or have any knowledge about and the subsequent recovery - quite well. We see no reason to move away from the basics of our stock selection and portfolio-construction strategy which is specific to each of our equity funds.

Can you explain the team structure for equity fund management and research at UTI AMC? How big is the universe of stocks actively under the coverage of your research team?

We currently cover about 340 stocks and have a 20-member research and fund-management team. The research team has eight experienced analysts supported by three investment associates and functions under the supervision of a head of research. The research effort is organised by sectors and a few analysts also shoulder fund management responsibilities. The fund managers may manage more than one fund but in most cases their funds are linked to a specific strategy that is implemented across the funds they manage. The pillars that underpin our research framework are consistent operating cash flow and the level of return on capital. Our philosophy is that companies that generate consistent cash flows and then re-invest it in their business at a return well above the cost of capital generate wealth; but we also recognise the existence of cycles. This syntax is then carried over into portfolio construction by the fund managers. They are guided by metrics of these companies and the valuation approach of the strategy in creating an appropriate portfolio. There is a comprehensive dashboard that acts as a guard rail for the fund managers. This drives consistency and guards against strategy drift. We also share this dashboard with our investors and partners every month, so that they can monitor our positioning and consistency.

Key to any fund-management process is the culture of team interaction. A disciplined system of agenda-driven daily meetings, new idea generation, quarterly fund reviews and other regular forums support vigorous discussion and debate within the team. Every single team member invests time and effort in these forums and thereby learns from each other and simultaneously share their experiences.

You joined UTI in 2017 after a long stint at Invesco and helping it boot up from the beginning. Did you bring about any changes in the investment framework at UTI from your learning at Invesco or has it remained pretty much the same?

The bottom-up research process is very strong at UTI. There was no need to change anything on that front. The framework of cash flow and return on capital was implicit - all that I did was to convert it into an explicit framework. As regards portfolio construction and strategy discipline, that required an overhaul. Partly due to our legacy, we had a multitude of funds and approaches. We aligned the funds around strategies and fund managers with a clear articulation of the guard rails and integrated the research framework into portfolio construction. Today, I believe, we are well-organised around the principle of 'one team, one process, diverse strategies'. We are bound together by the process and its syntax not by a singular house view or strategy. None of this would be possible if we were not blessed with a strong and diverse team in the first place. It is my belief that in my role as the head of the team, my agenda is to manage process, people, and culture; performance is an outcome.

Based on the stock-holding patterns of your funds, we observe a strong buy-and-hold strategy in practice at UTI. What are the key tenets that you look for in a stock to form conviction? Do you go by quant-like metrics or by qualitative factors? Can you describe the triggers for you to completely exit a particular stock?

Our philosophy is to think long term and that is reflected in our low portfolio turnover. That said, we do not operate with a target for portfolio turnover and there is a range of outcomes across strategies. The investment process and the strategy guard rail act as a deterrent from chasing market seasons and fads, thereby keeping the turnover lower.

Our selling discipline is primarily guided by when there is deterioration in fundamentals, particularly in our research pillars of cash flow and return on capital. Further selling decisions could be driven by when better alternative opportunities are available. Strategies which are guided by margin-of-safety consideration tend to be more valuation conscious and could rely significantly on the latter. Corporate governance, including accounting issues and capital allocation decisions, could drive a complete exit from a stock. I would say that all investing decisions are a combination of metrics and qualitative factors.

Currently, there is a great mismatch between the earnings and how the markets are behaving or have recovered after the crash. Do you feel the earnings could catch up with the market prices or does the gap between the two seem to be unreasonable to you? How concerning is it as a fund manager?

Earnings did remarkably well with the Nifty EPS climbing nearly 15 per cent YoY in FY21. The divergence is between GDP, which declined in FY21 as per preliminary estimates, and the reported growth in earnings of the Nifty 50. The Bloomberg consensus forecast is for nearly 37 per cent earnings growth in FY22. Valuations are elevated even after considering this growth in earnings, leave alone the risk of an earnings miss. More than the risk to FY22 earnings, if for whatever reason confidence in the medium-term economic cycle were to fade, then the valuations would weigh heavily on forward returns. Market valuations and their divergence from the mean/median are a measure for risk and can be used as a tool for asset allocation by investors. Our focus is on stock picking and keeping our portfolios aligned with the strategy and mandate with the objective of creating alpha.

We see that your flexi-cap fund is slightly underweight on the financial sector as compared to the rest of your equity funds. What is the sectoral allocation strategy across your equity portfolios? Is there any built-in flexibility that fund managers have to get such variations with their portfolios at UTI?

As I mentioned earlier, we do not have a one-size-fits-all approach at UTI for our equity funds. There is variation in sector allocation and portfolio attributes - types of companies and portfolio aggregate valuations across strategies. Each fund has a distinct set of parameters by which it operates. UTI Flexicap fund has a framework that emphasises quality and growth. Very few lenders currently qualify in terms of a track record of navigating consistently through credit cycles while maintaining superior growth; we have high exposure in such stocks. The strategy does not look for turnaround bets and hence many stocks in the lending space don't fit in its strategy.

Technology and pharma stocks have a run-up quite a bit over the last year. How long do you foresee the rally to continue?

The technology and pharmaceutical sectors in India earn a high proportion of their revenue from exports, which is a function of their global competitive advantage. They have demonstrated their competitiveness over cycles and thus there are always likely to be attractive bottom-up opportunities in these two sectors. The pharmaceutical sector or the healthcare sector has a significant domestic growth opportunity as well. Rising incomes and increasing insurance penetration increase the demand for healthcare products and services. The combination of increased pollution and stress levels leads to the rise of lifestyle conditions. Such chronic ailments require long periods of treatment, if not lifelong treatment, unlike anti infective products. This makes the domestic healthcare market a potential high growth area.

The IT sector is trading at valuations which are near their highest in a decade, perhaps reflecting its strong growth outlook but also making risk-reward slightly less favourable. In healthcare and pharmaceuticals, business models are varied and valuations have a wider spread. We still find attractive opportunities in this sector.

What factors have contributed to the recent performance of value funds? How long is it likely to last?

Favourable initial conditions have contributed to this outcome. Historically, when the market trades considerably below the long-term average valuations, it bodes well for the value theme to outperform growth. In March 2020, the P/B on the Nifty 50 was nearly two standard deviations below the long-term average. Added to the conducive initial conditions, you have easy liquidity, low rates, a quicker-than-expected recovery in growth, rapid vaccination development and rollout, and a spike in commodity prices. Put together, these have contributed to the strong performance from many of the cyclical areas that dominate the value approach and may be absent from growth strategies.

Another important contributor to value performance is the broad-basing of performance across market capitalisation. The period from early 2018 to mid-2020 was a period where a narrow set of heavyweights with strong earnings growth dominated the broader markets. Now we are witnessing an environment in which small and mid caps have outperformed the heavyweights.

The market has cycles in terms of performance across approaches and market cap. When it comes to growth vs value, we suggest that investors use it as a diversification tool rather than a timing or rotation strategy. Investors should also note that eventually, it is the quality of the stock picking that creates the alpha rather than just the label.