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Expectations Are Realistic

Anand Shah, Vice-President (Equity), Kotak Mutual Fund, says this time around, the difference is that it's on the back of strong earnings growth

Anand Shah completed his engineering from REC Surat, in Electronics in 1996. Subsequently, he worked with Kirolskar Oil Engines for two years and then did MBA from IIM, Lucknow, with specialisation in finance. He passed out from there in 2000. Since then he is with Kotak. Shah joined Kotak as a buy side analyst and for three years did research on various sectors and companies after which he moved on to fund management.

Do current levels of markets bother you?
This time around the difference is that it's on the back of strong earnings growth. If you look at the last three years the returns delivered by the Sensex and the Nifty have also been supported by the growth in earnings. The rate of growth of indices is matched by the growth of the earnings of the index companies. So the PE has not grown out of proportions. In the past when the index moved significantly up, the Sensex PE went up to about 30 plus in 1992 and 25 plus in 2000, and the leaders of the rally were trading at very high valuations, specially the IT companies. So there were a lot of expectations that were built in both the times. This is not the case this time around and such expectations are not built in. Our expectation from the economy at this juncture also is for the GDP to grow at 7-8 per cent, which is not unrealistic. In the last three years we have been witnessing such growth rates. So there are no huge expectations and we are still trading at a PEG (price-earnings growth multiple) of 1. If we are able to maintain the growth at this rate because of the sustenance of the economic growth rate, I don't think there is a lot to worry on the markets. What worries me is the pace at which the markets have gone up and the liquidity which might lead to a little higher volatility.

Which are the pockets of the market which you think are way beyond their valuations?
Well, the rally has been broad-based. Each and every sector has been doing well, unlike in the past when only a particular sector was pulling up the market. Today, the capital goods sector can be one case, which has moved significantly faster than others and seems to be factoring in the valuations of 2008 also, but then they have the best visibility also. So overall, given the kind of growth that we are seeing in each sector, the valuations don't seem to be euphoric, except for a few sectors which are very small and insignificant-like retailing which is at a very significant premium or probably sugar stocks which have been doing exceedingly well. But as I said, they are very small sectors. If we see on the macro side, the likes of auto or metals or FMCGs-none of these larger sectors have ran up significantly.

Any particular stocks or sectors where you think there is a lot of steam left even at this level?
I continue to like metals as a sector where we are contrarian to others. The market doesn't like commodities and specially metals. But we significantly bet on metals and specifically the ferrous metals where we think there is a lot of value even at these levels. Apart from that, engineering sector continues to be our largest holding across the funds though they have run-up significantly as they have been the biggest beneficiaries of the entire capex cycle and investments in power-be it generation, distribution or transmission. Third will be the banking sector. I think a lot has been talked about rising interest rates. We believe the banks, which have a very low cost of funds, are the ones we would like to focus upon as they would continue to do well in the rising interest rate scenario as well.

Tell us about your stock selection process
We have a very simple stock selection process. We follow the bottom-up stock picking approach. Every stock we buy in our funds is there on its own merit and not because of it being a part of any particular index. Within each stock we look at three parameters-how is the business, then its management, and thirdly its valuation. We call it the BMV (Business Management Valuation) Model. Let me explain each of these three parameters. While analyzing a business, there are three-four parameters, which we look at to decide whether we want to own that business or not. We look at factors like what kind of pricing power the business has- whether it's a commoditised business or is it a business which has a lot of franchise, whether it's a very capital-intensive business or a business which throws up a lot of cash, and lastly how do we see the overall growth of that sector. Once we decide that we want to own this business, then we go deeper into the management bandwidth to gauge the management ability and going forward what we expect. We look at the management's performance record and financial efficiency in terms of factors like cost cutting and cost control, how the ROE (return on equity) has moved. Last but not the least, what is the value which we are ready to pay for that business and that management. The important part is that we buy a business at a price where we can make money for our investors.

How do you decide about the valuation of a stock?
I think you can't measure all the sectors and all the companies on the same valuation strip. PE can't be a simple answer to the valuation. If you ask me, the best model that we use for a business evaluation is the DCF (discounted cash flow model), because it mostly captures all the parameters, be it pricing power, be it how much cash that business throws and be it capital efficiency of management. But even DCF may not work for all the sectors. So there are various other things like PE ratio, price to book, price to sales etc that we may use.

Tell us about your research team.
In the buy side we have a very lean organisation-we are six of us, three being the portfolio managers and three people in research. And we have one member in the dealing team. However, we have a lot of research support from the various brokerage houses also.

To be specific about the Kotak Midcap fund that you manage, how challenging is it to scout for future winners in the mid-cap and the small-cap space?

I think the first and foremost thing about Kotak Midcap one needs to know is that businesses that we are buying today in our mid cap fund are all potentially large companies of tomorrow.

Every mid-cap stock that we buy, we buy it on a single hypothesis that the business opportunity and the management capability has to be so huge that it can eventually become a large cap. Then in terms of stock-picking, again we follow the same business management and valuation model. Then to answer your question of do we find it difficult to find such stocks at this point of time, I'll say it has become more challenging to find out a winner after the market has rallied so much and so many stocks doing so well. But I think one comfort is that every time we have bought a stock we have looked at the longevity of the idea. As I said we have bought every mid-cap with a vision that it will become a large-cap, so we don't have to churn frequently and we have more or less maintained the portfolio. Today's portfolio would be almost similar to what it was six months back. So we don't have to scout for new ideas at such a rate and thus the new additions to the fund are fewer.

But what about the liquidity that the mid-caps would offer?
I think liquidity in a stock is a function of how fair is the valuation because if you see, a stock is illiquid when it is significantly undervalued. But as and when it reaches nearer to its fair value and if the business has potential, the liquidity comes in the stock. We have seen umpteen number of times that at the time we have bought a stock, it was not liquid enough but once it reaches a decent valuation, the stock price starts to appreciate and liquidity improves. So we are not significantly bothered about the liquidity. In our portfolio, we have a fair mix of liquid and illiquid stocks, where the number of liquid stocks would be much higher.

How do you manage risk?
The broader parameters in terms of sectors, market caps of companies etc are determined by the scheme specific features which are there in the offer document. After that how much should we diversify is a function of how do we see the markets going forward and how much comfort do we have on the individual stocks. Apart from that, things are more qualitative in the sense that how good are the companies we have picked. The risk comes when you have bought into a wrong company. To take care of that we have frequent management interactions and also there is a regular check-up on all the stocks we own on a quarterly basis to see if there is any change in the business, its fundamentals or its management and whether that is taken care of in the valuation.

As you said a little earlier that the markets can be a little more volatile going on from here. So are there any defensive strategies that you have in place if the markets tank? How do you plan to defend returns?
Equity as an asset class is volatile and you can't get away from that. So the markets, and the fund NAVs will remain volatile. But you have to differentiate between volatility and risk. Volatility is the nature of equities and one need not get worried about it. What we are are talking about is the risk-which is that, are we getting into a wrong company? Or are we getting into companies at wrong valuations? These are the key things to be worried about. This brings us back to the point that do we have very stringent parameters set to ensure that we are in the right companies, right managements at the right valuations? Therefore, the responsibility of the fund manager is to manage the long-term risk. Short term volatility is a part of equity and I don't think there is much to be done about that.

You manage an opportunities fund and a contra fund. Where would you draw the line between an opportunistic stock and a contrarian bet?
I think there is a key difference between the two. For that let me take you to what contra is all about. Contra investment is about buying into pessimism. It's about buying the company whose chips are down because either the fundamentals in the short-term have deteriorated or the perception of company or the business is bad, but which is far from reality. Whereas opportunity is all about buying into optimism, buying into businesses which are doing well and are expected to do better over the next three to four quarters This is in contrast to buying in contra where the businesses are not expected to do well over the next three to four quarters.

Tell us about the positioning of your funds.
Kotak 30 is a large-cap fund, Kotak Opportunities is a multi-cap fund where it spreads the portfolio among large-caps and mid-caps and even invests in small-caps, and we have a mid-cap fund which invests predominantly into mid-caps. Somebody who doesn't like volatility or is a low risk equity investor should look at Kotak 30, whereas somebody who has an appetite for risk, appetite for long term investment should look at either Kotak Opportunities or Kotak Midcap. Then we have a balanced fund, which is very strictly managed in a manner that you buy stocks at a significant discount to the intrinsic value so that the downside to the portfolio is minimal. Therefore, a very conservative investor who wants to invest in equities should look at the balanced fund of Kotak. Then we have Kotak Global India Fund-here we are looking at companies which are not only looking at domestic market but are also eyeing the overseas opportunities. These are the companies that are taking risk of going outside India, creating marketing and distribution set-up, and will be the big beneficiaries of eventual growth. It is a concentrated bet on the new confident India. Then we have a Contra fund, which has a completely different style of investing into contrarian bets, going against the herd and therefore, it will be a longer term investment.