Interview with Aniruddha Naha, Head-Equities, PGIM India Mutual Fund | Value Research Aniruddha Naha, Head - Equities, PGIM India Mutual Fund, talks about the challenges of mid-cap investing, how to identify potential wealth destroyers, and his advice to stock investors

'Volatility is part and parcel of mid-cap investing'

Aniruddha Naha, Head - Equities, PGIM India Mutual Fund, talks about the challenges of mid-cap investing, how to identify potential wealth destroyers, and his advice to stock investors

Mid-cap investing has its own set of challenges. We speak with Aniruddha Naha of PGIM India Mutual Fund about them and how he manages PGIM India Midcap Opportunities Fund. This fund has been rated five stars by Value Research and has been among one of the best performers over the last year.

How do you pick stocks for your Midcap Opportunities Fund? When do you exit a stock?
The stock-selection process is objectively defined in terms of companies' cash flows and debt levels. Any company with positive operating cash flows 70 per cent of the time in the history of its business, a manageable debt-to-equity ratio and no major corporate-governance issues flows into the universe. From within the universe, we look for businesses with good growth potential available at a reasonable valuation; our valuation framework being growth at a reasonable price (GARP). Hence, a combination of historical cash flows, balance-sheet debt levels, corporate governance and valuations all tie into buying a business.

The exit of stocks happens either:

  • When our assumptions regarding the business are violated, which could be a result of the industry evolving, business dynamics changing or simply a mistake in our assumptions; or
  • When the valuation framework in terms of PEG is violated and hence the stock doesn't fit into our growth at a reasonable price valuation framework.

Which sectors are you overweight and underweight in and why?
We continue to favour IT and industrials, while we have been underweight in financials and consumer staples.

We have a decent exposure to IT and industrials. We have been overweight IT consistently for the last two years, as we clearly saw the cloud and digital technologies adoption by businesses in the western world. Once a business adopts new technologies, it kicks off a wave of implementation of these technologies across the organisation, which is where Indian IT companies step in. We continue to like the sector, as we believe this trend will continue for the next six to eight quarters. Also, in an uncertain macro environment, the stability and visibility of the business and earnings of the sector give us a lot of comfort.

We like industrials, as corporate India has a clean balance sheet across market capitalisation. Also, capacity utilisations are moving up, which will require increased capital expenditure to expand. In this situation, corporate India, with a clean balance sheet, will have the capacity to expand. We are already seeing some amount of capex resurgence, which should be beneficial for industrial demand.

We have maintained underweight on financials and consumer staples. Though a large part of the asset-quality issues has been resolved, the financial industry has seen an incredible increase in competitive intensity, with new players coming in during the last five years, the latest being the fintechs. With credit growth remaining tepid and the balance sheet of corporate India being strong on cash flows, financials will continue to see lower lending options, which could lead to higher competition and lower margins and profitability.

We have stayed away from consumer staples primarily due to the expectations of inflationary pressure on raw materials, slower growth and higher valuations, which don't fit our growth at a reasonable price (GARP) model.

How should a stock investor approach mid caps? What should be their positioning in one's portfolio vis-à-vis large and small caps?
Mid caps come with higher return expectations and higher volatility vis-à-vis large caps over a longer period. Investors looking to invest in mid caps should take a longer time perspective and expect deeper drawdowns than large caps. Over a longer period, a well-constructed mid-cap portfolio should be able to generate a better return profile.

The positioning of mid caps vs large caps and small caps in one's portfolio should be determined by an individual investor based on their risk-return expectations over time and the time frame that the investor wishes to stay invested. Frankly, there is no single formula that determines asset allocation.

A major challenge with investing in mid and small caps is containing volatility, especially in uncertain times like the present ones. How do you contain volatility in your portfolio, and what would be your advice to a stock investor?
Volatility is part and parcel of mid, and small-cap investing. Investors need to keep in mind that volatility is different from risk, and as long as volatility isn't creating risk, they should stay true to their objectives and absorb volatility as a part of their investing journey. Returns are a combination of earnings and P/E expansions in a stock. An analyst or fund manager has no control over whether the stock will enjoy a P/E expansion or compression, so it's futile to predict that. What an investor can do is try and predict earnings based on the business models, interactions with industry experts and managements, and channel checks. The only way one can try and contain volatility is by investing in good businesses and trying to predict their earnings. As long as one can do that, even if there is volatility, the strength in earnings should keep the business in good stead.

Another challenge with them is a rapid deterioration in business fundamentals, especially during tough economic times. How do you safeguard your portfolio against this? What are your criteria to identify potential wealth destroyers?
Our stock-selection process clearly looks into the history of each business, and we try and see how it has managed operating cash flows at the troughs of business cycles. In case it has been able to manage operating cash flows well through tough business cycles, it clearly indicates that it has the DNA to survive challenging times and the likelihood that it will be able to withstand a downcycle going ahead. Hence, a study of operating cash flows vis-à-vis business-cycle troughs gives us a good insight into stable businesses. We also look to invest in businesses with low financial leverage, which again helps in tough economic times.

Any company which hasn't been able to manage its operating cash flows well or has higher leverage, or both, is a potential wealth destroyer, and we have stayed away from such businesses.

What have been your most precious investing lessons?

  • The top line is vanity, the bottom line is sanity, but cash flow is reality.
  • The maximum returns are made when you buy a business at a point where there is strong earnings support and the chance of a P/E expansion happening. It happens when there is a chance of ROCE and ROE expansion happening in the business over time. A business bought at a point where ROCE and ROE expansions have already played out is a well-discovered business, and the chances of a P/E expansion happening are limited.

This interview was conducted in March 2022.

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