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Betting on Bottom-Up Ideas

Anil Sarin, Co-Head -Equities, Pru ICICI AMC, says fund managers are under pressure to perform. "But within those constraints, the he has to manage his likes and dislikes"

Anil Sarin comes to fund management from an interesting discipline. Coming from an armed forces family background, joining the Indian Army's Officers' Training School (now the Officers' Training Academy) was a straight career path. After five years in the Infantry, Sarin realised that he was happier doing analytical work. He chose to opt out and joined IMT, Ghaziabad, to pursue business management in 1992. He joined SBI Mutual Fund in 1994 and quit in late 1995. He then moved to Birla Mutual Fund, where he worked as an analyst and fund manager till September 2003. After a five-month stint in Kotak Securities' portfolio management business, he joined Prudential ICICI in April 2004. Excerpts from an interview:

Can you tell us about each of the funds you manage?
I have managed Prudential ICICI Dynamic Fund for the longest period of time. In this fund, we try to keep over half of the corpus in large-caps and 30-35 per cent in mid-caps. The remaining money is in cash or in a few new companies to bring some novelty by exercising our stock-picking skills. We try to identify some stocks that are not well-understood by the market but have good potential to appreciate. This strategy has helped us so far, though in recent times, we have been caught on the wrong foot sometimes because mid-cap stocks have started falling well before large-caps fell. Though the recent trend has not been good, it does not invalidate the approach.

In Prudential ICICI Dynamic Fund, you have the ability to go up to 50 per cent in debt or cash. What is the reason for having this provision? Have you used it so far?
The Dynamic Fund was launched in the aftermath of the technology meltdown. At that time investors had a feeling that fund managers had let them down. This was because the lay investor had made an implicit assumption that we would reduce equity exposure and increase debt holdings, when the markets were falling. When we went back to investors and told them that they had given us a mandate to stay invested even during the fall, we did not get a favourable response. So this product was born. At that time, the fund had a mandate to go 100 per cent in cash. We reduced the cash limit to 50 per cent, when the tax regulations changed. Practically, we have never been able to touch this higher limit.

How is Prudential ICICI Emerging STAR different?
It's a mid-cap fund, which invests in companies having a market capitalisation of as low as Rs 100 crore and as high as Rs 3,500 crore. What one attempts to do to a small extent in the Dynamic Fund, we attempt for the entire fund in case of Emerging STAR. We try to identify companies that have good growth potential, attractive valuations and are not so risky that they become write-offs.

Since it is a mid-cap fund, it has inherently high volatility. Also, you are paid to experiment in this fund, so you cannot wait till a company achieves stability or gains a certain size. This fund started well, had a period of under-performance, followed by a good period of out-performance. At present mid-caps are going through their own share of pain, and this fund is very much a part of it.

I am optimistic about the potential of this fund. A few months back, there was an accusation that mid-caps were trading at very high multiples. Today, for whatever reasons, valuations are quite reasonable. There are some midcap businesses that are not so dependent on factors like tariff or fuel prices and yet are going at valuations of 6-7 times.

How do you pick stocks?
We choose companies that have high return on capital and generate free cash flows as far as possible. If there is issuance, it should be for higher incremental return on investment (ROI), so that shareholder wealth is created, and not destroyed.

Since there is a preference for companies that create shareholder value, I naturally like to go towards information technology, pharmaceuticals and media companies. For the same reason, one would avoid commodity companies, where the capital output ratios are poor and profitability is cyclical. The only deviation is a few construction companies, which are cash consumers and do not have free cash flows. But these are the stocks that have gone up 8-10 times because it is expected that the infrastructure cycle has just about begun in India, and there is a lot of growth. So if the margins, which are 5-7 per cent, become 8-10 per cent, the incremental ROI from here onwards is high.

At the same time, I pay special attention to valuation. Because of the focus on valuation, you tend to miss out on some retail stocks, which always appear expensive, and you are not able to cross your heart and say I want to buy that stock come what may. So, I like companies that generate free cash flow, and I believe that if you overpay for a stock, sooner or later, you will have to face the consequences of that action. During a bull market, like we have been in, these things don't matter and there are cases where companies have run up far ahead of their fundamentals.

How do you reconcile with the fact that you will be missing some stocks?
It is hard. If you try to change your strategy, the results are confusing. You tend to change your strategy just when the trend is about to change, and you would be left holding high-priced inventory in a falling price scenario. You didn't participate in the upside, and you are part of the downfall.

You have to draw a line somewhere. I do admit that there are pressures to perform, or you lose out on the one-month, three-months and one-year rankings. There is an imperative to keep the performance going, but within those constraints, the fund manager has to manage his likes and dislikes.

How do you include companies in your universe of stocks to invest in?
IPOs are one of the ways by which companies enter the universe of stocks. If a sector becomes attractive, it expands your universe. The third path is through broker research.

What are the factors that you look at while buying stocks?
I do quantitative analysis before buying, which takes into account the historical performance, historical valuation and the changes that are taking place in the industry or the company. I try to see how the company was perceived by the investing public in the past and what it is doing now and how the perceived value will change after the changes in the company. "Perceived value" is ascertained from the price-earnings multiple. We also look at EV/EBITDA (Enterprise value/earnings before interest, tax, depreciation and amortisation), how the working capital has changed, how the tax structure has changed, etc.

We also try to view a company from the picture of free cash flow. Typically, in commodity businesses or highly indebted businesses, the P/E remains constant, but under the surface debt repayments keep happening, which you can catch through cash flow but not through accounting. So the cash EPS and the declared EPS will be different.

Among the qualitative factors, I lay a lot of emphasis on the changes that are occurring. In the past, I bought a textile company at a time when people thought textiles was a bad industry. But after looking at the cash flow, interviewing the management and visiting the plant, I saw that it was building sheds that were much bigger than the existing ones. Obviously, more machines were going to come and good things were happening at that company. If you understand these changes a little before and a little better, you will be richly rewarded.

I also look at what the business should be worth without looking at the stock price. If the business has barriers to entry, good return ratios, replacement cost, brand, etc, then the investment can be rewarding. It also gives a lot of professional satisfaction that you are not getting affected by what the market is thinking, but you arrived at your own conclusion, which worked out well. I also think about how companies use the free cash flow. Capital allocation is important.

Also, the research-led approach has its benefits and costs. If you try to do everything yourself and you try to uncover relationships between ratios, then you will require a lot of time. In most companies, you will have to sit with the management and make multiple visits before you can fully understand. Only after visiting NDTV repeatedly was I able to understand the charm of the industry. By the time this knowledge about a company becomes common, the super-profits are behind you.

The size of the market plays an important role. If you are in a saturated field, for example, like fertilisers, apparent cheapness is not an attractive enough reason for you to be buying. My preference is in areas where there is a long way to go, and sectors like technology, pharmaceuticals, media, etc. fulfil those requirements. If it is a capital-intensive business then the valuation has to be very cheap and the potential must be high. The textile sector is an example of a capital-intensive business with good potential. Though the valuations are not as cheap as they could have been in relation to the earnings, but they have now come off quite a bit on a relative basis. It is an inferior business, but because of the brute growth-you put more capital and you get better numbers. One is tempted to participate. On the other hand, the demand is not there for steel, at least in the short term, and the price is falling. Sugar is another industry, which in spite of being a commodity industry, is interesting due to special circumstances. It has always been under government control and is politically sensitive. In the short-term, sugar became attractive as the production was low last year. The longer-term changes in the industry will be the reduction in the subsidies and a structural change in the pricing of sugar. Yet another factor is that crude oil prices are high and so there will be diversion of sugarcane into ethanol. These special circumstances make sugar an attractive industry.

How do you decide when to sell a stock?
I tend to buy growth businesses and stick with them unless the valuation goes completely out of whack. There is not that much of a focus on when to sell; the focus is more on identifying stocks and if they fall, you buy more. If you see the record of successful investors, you will note that longer-term money has been made in businesses that compound. Trading results can sometimes go against you; at least, some of us don't have that well developed instincts.