PGIM India MF's CIO explains the underperformance in some equity funds

Vinay Paharia, chief investment officer (CIO) at PGIM India Mutual Fund, has been in the mutual fund industry for 17 years. He manages assets worth Rs 20,300 crore across nine equity and hybrid schemes at the fund house.

Among the equity schemes he oversees, PGIM India Small Cap Fund and PGIM India Midcap Opportunities Fund have faced challenges, ranking at the bottom among 31 small-cap and 38 mid-cap funds over the last one year.

In this interview, he shares the changes he has made at the fund management level, the key learnings from the bull and bear markets, and the reasons for the funds' underperformance. Here is the edited transcript of the interview.

You've been in the finance industry for over two decades. What sparked your interest in equity investing?
Since childhood, I have heard discussions in my family about investing and the ups and downs of the markets. But I never thought that I could make a career out of it. While pursuing my Master of Business Administration (MBA), I realised that there is a career associated with stock markets. Until the first year of my MBA, I had no clear goal for which stream I would choose. During one of the summer interviews, I informed my interviewer that I was interested in the equity markets. So, he recommended Peter Lynch's 'One Up on Wall Street'. I was deeply interested in what was written in the book. It opened my eyes to what investment was all about and what caused stocks to go up and down. Later, I also discovered Warren Buffett's and Joel Greenblatt's writings. But I think the trigger was what Lynch said in his book.

Starting in 2002, you've weathered bull markets and global crises early on (started managing the funds in 2007). What key insights did those experiences leave you with?
Whether it's a bull market or a bear market, both are associated with very different emotions and bring in different types of learning and understanding. The bull market symbolises raw greed. I discovered that in a bull market, the experience becomes baggage; it becomes your enemy. The less experience you have, the better your performance is because you don't look at a manager's quality, company or business quality. You only focus on the future. And hence, one of the lessons is to ensure that you reduce your biases and increase your due diligence. In a bull market, you keep dropping your guard regarding due diligence since everything keeps making good returns. I think that is a very big mistake.

Another lesson is to not extrapolate your near-term trends, which become visible. For example, during the early infrastructure boom or the power boom (of 2006-08), most people extrapolated very strong power demand for thermal energy. Similarly, in the IT boom, people extrapolated 100 per cent growth in the software business. We have to remember that trees cannot reach the sky. I think those were some of the key learnings during the bull market phase.

The bear markets, of course, bring their own set of challenges and opportunities, and I think it's an opportunity for investors. But there, the challenge is more on the emotional side because when you're dealing with your hard-earned savings being marked down by the market every day, it is a very, very tough sight to visualise. But those are the markets where you actually get most of the investing opportunities because people tend to ignore the valuations of companies and the fair value of stocks. In those times when market inefficiency comes to the fore, whatever the price, people just want to get out because it's a very emotionally challenging phase. If I were in an investor's shoes, I would definitely be doing the same thing, maybe driven by fear. But I think, as professional investors, we are trained to ignore most of this noise. And I think that's what we learn through bear markets.

How would you describe your investing style? Are there specific types of stocks or situations that catch your eye?
I would first answer the second question. The bear markets are more exciting because you always get whatever you like, which has a high potential to go up. So, bear markets are an absolute delight for an investor. But, I think, as we discussed, they have their own challenges. In terms of my philosophy, it's a work in progress, as always; you keep learning and reshaping your philosophies. For example, currently, we have adopted a very straightforward, simple philosophy, which is also evident from a very long-term study of the Indian markets. We have done a long-term study of 20-25 years of Indian markets to determine what durable factors have delivered superior returns. And these factors cannot change from time to time or cycle to cycle. These are durable things that an investor can adopt and create portfolios of. So, we've discovered through research that companies with stronger or higher than average growth and higher than average quality (return on equity) have performed much better than the market over a longer period (a three- to five-year period).

That, in summary, encapsulates how our philosophy is shaped. Additionally, we want to ensure that we diversify and hold companies for a longer period of time.

Further, we just don't look at simple P/E multiples because a P/E multiple is an outcome of four factors: forward earnings growth, forward returns on equity, interest rates, and the riskiness of the underlying business. All of these four factors together create a unique multiple for each company; it's like the fingerprint of a human being. Everyone has a unique fingerprint. So, similarly, every business at a particular point in time will have a unique fair multiple. So, our objective is to buy companies that are available at a price that may be slightly lower than the underlying fair value, which presents a greater potential upside over a five-year period. We have about 180 companies in our fund house universe that possess this characteristic, which means they are having better than average earnings growth and better than average returns on equity. So, of these 180 companies, we have fair values for all of them right now. Depending on the market price, we look at the potential upside. We hold on to these companies over a five-year period where fair value is lower than the current market price and exit where fair value is above the market price.

You've been with PGIM Mutual Fund for about a year now. Have you made any major changes to the research or stock selection process?
PGIM has been a fund house that has followed the growth at reasonable price (GARP) philosophy ever since it started its operations in India. My objective when I joined was to ensure that I sharpened this investment process further, bring more evidence-based investing, and infuse more science into this art. I also added a filter on quality. While it is growth at a reasonable price, we made it quality growth at a reasonable price. So that important quality filter got incorporated, and we also incorporated the fair value framework for each and every company in the universe. This means instead of looking just at the P/E multiple for that reasonable price, we look at fair values for each company for that reasonable price. So, I think all of that process tightening is what I've been doing and spending most of my time on.

Some of your equity funds have seen performance dips recently. How are you planning to steer them back to prominence?
I think our performance has been weak, especially this financial year. This year has actually been unprecedented in a trend where lower-than-average growth and lower-than-average quality companies have significantly outperformed companies that have better-than-average growth and quality.

We did the same study for NSE 500 companies, and we looked at the median returns of companies that had better than average growth and quality versus companies that had lower than average growth and quality. So weaker companies have delivered 65 per cent returns, compared to 35 per cent returns for good-quality companies; the gap is a massive 30 per cent. This is unprecedented because never in history have we seen such a huge gap open up in both of these segments of the market. In fact, there have been instances where lower-quality companies outperformed the good ones by perhaps 7-8 per cent.

The magnitude of the underperformance of good companies this year has been significantly higher. During this discussion, I've mentioned that we primarily focus our investments on high-quality and high-growth companies. Because of this, our funds have underperformed.

So, I think this has been a particularly challenging year for our investment philosophy. And there have been some other factors, like sectoral performance, that have impacted the performance. For example, we have been overweight in consumer discretionary and financials, which have not done well in the markets. On the other hand, sectors that have done well, like utilities and industrials, have been underweight. So, both kinds of positioning hit us. Now we have more or less balanced portfolios. So, sector positioning does not impact us anymore. However, stock selection is an area where we were significantly impacted this year.

I think this phenomenon cannot last long for a simple reason-stock prices are just slaves to earnings. So to give you some more data, for example, from the year 2018 to 2023, the NSE 100, which is a large-cap benchmark, delivered an earnings growth of 11 per cent, and the index also delivered an 11 per cent return. Similarly, mid and small-cap benchmarks saw earnings growth of roughly 8 and 9 per cent, and the returns were also almost in line with the earnings growth.

But what has happened this financial year? We have seen the NSE 100 deliver a 45 per cent return (April 1, 2023 - February 29, 2024), and the underlying earnings growth was just 27 per cent, a gap of roughly 20 per cent.

However, the mid-cap and small-cap indices have actually crossed all limits, meaning they have seen 25 per cent earnings growth, and the returns are 57 per cent for mid-caps and 70 per cent for small-caps. So, I think that clearly, the benchmarks will catch up; we have borrowed returns from the future. Going forward, either there will be a time correction or a price correction in many of the low-quality and low-growth small caps and mid caps. Nevertheless, high-quality and high-growth mid caps, small caps, and large caps are still available at reasonable valuations.

Do you believe there is a froth in the mid and small segments of the market?
We think micro bubbles are brewing in low-quality, low-growth, small and mid-cap stocks. Another segment is the newly listed initial public offering (IPO) companies. The third is in some of the public sector enterprises, which have actually run significantly ahead of their underlying earnings. Fourth are the real estate companies, especially the residential real estate companies. Fifth is the industrial and capital goods segment, including companies in the railway segment. Finally, the froth is in the micro-cap and small and medium (SME) enterprises. So, these are specific areas where we think there is a red flag and a potential for significant principal loss.

Also read: Interview with Ramesh Mantri, CIO, WhiteOak Capital Mutual Fund