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Interview: Married To Long-Term Prospects

Principal PNB is not known as an AMC that boasts of trail-blazing or great performing funds. Over here, Shyam Bhat, AVP-Investments, discusses the philosophy and investment strategy of the company

Principal PNB is not known as an AMC that boasts of trail-blazing or great performing funds. Over here, Shyam Bhat, AVP-Investments, discusses the philosophy and investment strategy of the company

Your portfolios have a number of stocks which tend to be interpreted as lack of conviction. Why such diversification?
Generally, in our open-ended diversified equity funds, we refrain from taking very heavy bets. Primarily because there could always be some factors that can go against you. Such as adverse domestic or global developments in that industry, government measures etc. Take the case of sugar. A year ago, this industry was being viewed quite favourably. Globally, the scenario was being viewed positively due to factors such as easing out of subsidies for exporters from the European Union, diversion of sugarcane into ethanol manufacturing, etc. But within a year, the scenario has changed totally, with bumper crops and a sharp fall in sugar prices. More recently, we have the example of oil marketing companies.

There was an expectation that oil prices at the retail level will not be cut till the price of crude falls to $52 per barrel. But we saw them being cut even when crude was at much higher levels. Our diversification philosophy has nothing to do with confidence or conviction. Irrespective of my conviction, certain parameters have to be followed.

The largest stock will be just 5 per cent of the net assets. In top-down, sector-specific funds, it can go up to 7 per cent. This is below the regulatory stock-specific upper limit of 10 per cent. The sector limit is 20 per cent but can go up to 25-30 per cent in certain funds like the Focussed Advantage Fund. We generally don't go beyond 4 per cent of the equity of any company. Though we are permitted to go up to 10 per cent and inform the company and the stock exchange when it touches 5 per cent. Consequently, the number of stocks in many of our portfolios remain between 40 and 50.

Don't you feel over diversification puts pressure on returns?
Who is to say what number of stocks makes a portfolio over diversified? There are fund managers who go with more stocks while some stick to around 25. It is a very subjective call. Having a very concentrated portfolio can give you great returns if the calls pay off. If they do not, it can set you back significantly. We prefer playing it safe by being amply diversified. We do not believe in the high-risk, high-return strategy. This could be due to the pension fund background that Principal has. We would rather give a medium-return with a medium-risk. We are not willing to take a higher risk just to be in the top rankings. We prefer delivering consistent returns over the longer-term and avoid taking undue risk for achieving that extra return.

Is this the reason why the returns of your funds are not outstanding?
One of the reasons, though admittedly, we could have done better. Our flagship fund, Principal Growth, has done reasonably well in the past three years. Others, such as Principal Large Cap Fund and Principal Tax Savings Fund, have delivered substantial returns over the past one year. Different funds have performed in a different manner over various time frames. When the calls pay off, the fund does extremely well, be it short-term or long-term. For example, Principal Growth was among the best performing funds in calendar 2004. But that was not by design. Not by taking a higher risk. It's just that our investment calls delivered earlier than we anticipated. An investor in our funds needs to have a long-term view and not expect super-normal returns because we do not take the risk required to obtain such returns. My portfolio will not attempt to be an “in-line-with-your-peer-group” type of portfolio. We are not momentum-driven investors. We have several contrarian calls in our portfolios. Contrarian calls take time to perform. The challenge is to stick to your beliefs if you are confident of them. Since our outlook is long-term, we do not hesitate in taking contrarian bets and sticking to them.

Do you take contrarian bets in every fund?
The strategy will vary from scheme to scheme. The close-ended funds, such as the tax-saving funds and the Child Benefit Fund, would have a relatively larger number of contrarian calls. The growth fund, which is a blend of large- and mid-caps with a large-cap bias, would also have a few contrarian bets. The number of contrarian calls may be relatively lesser in our large-cap fund, since the portfolio has a greater correlation with the benchmark Nifty.

Principal has not come out with an equity product for a while. Are you looking at changes in your current basket of funds?
We already have 13 equity products, including two balanced funds. The last equity fund that we had launched was the Principal Infrastructure & Services Fund in February 2006. We will be launching another fund in the near future.

We merged Principal Equity Fund into Principal Dividend Yield fund. We have two tax-saving funds, the second being the Personal Tax Saver Fund which we acquired from Sun F&C in 2004. Due to the nature of such funds that have a three-year lock-in period, we were not able to merge the two because we cannot give investors an exit option before the three-year lock-in. We re-launched Principal Global Opportunities Fund, the only fund in the industry that invests exclusively in overseas equities. It was a small fund till August 2006, under Rs 20 crore. It had a very narrow universe of around 40-50 stocks as per the earlier guidelines. SEBI came out with new guidelines last year and we repositioned the fund. Initially, it was more like a developed markets fund. Now it is a feeder fund into an Emerging Market Fund managed by Principal Global Investors. Today it is a Rs 430-crore fund.

Principal Focussed Advantage and Principal Infrastructure & Services Industries Fund appear to have identical sectors in their portfolios. Any reason?
In the Focussed Advantage Fund, the fund manager can invest in a minimum of four sectors and a maximum of six, at any given point in time. There is a cap of 25 per cent per sector. But the sectors are not predefined. Though this fund is about 22 months old, we have only made one sectoral change, replacing metals with consumer goods. The balance five sectors have remained unchanged since inception. We replace a sector only if it appears relatively unattractive on a longer-term basis. So this is not like an 'opportunities fund' where the fund manager moves between sectors frequently. In fact, we have no fund that falls into the opportunities category. In the Infrastructure & Services Fund, the sectors are predefined. For example, capital goods, cement, construction, IT, banking and telecom are examples of sectors that qualify. Consumer goods, textiles, pharma etc would not qualify for investment in this fund. It is purely coincidental that the sectors in these two portfolios have overlapped.

Briefly tell us about your stock picking process.
We have an investment universe of 150-200 stocks. We have a seven-member equity investment team consisting of a chief investment officer, head of research, two portfolio managers, two analysts and one dealer. Everyone, excluding the dealer, tracks a sector. Our fund managers also act as analysts. We have bi-weekly meetings to formally exchange information and views and arrive at investment decisions. Inclusion of stocks in different portfolios would depend upon the objective and strategy of each fund.We look for the ability of a stock to surpass investor expectations over the long-run. We look for companies where the fundamentals are improving. A company making a loss last year may begin making profits this year. So the PE may appear very expensive but it is a change in the fundamentals of the company that is important.

Different sectors will have different valuation parameters. Price earnings to growth would be an important valuation parameter in IT and Telecom. Order book to sales would be one of the parameters in capital goods and construction companies. Price to adjusted book value would be an important parameter in banking stocks. Discounted cash flows, EV/EBITDA, etc would be relevant parameters in other sectors. The management bandwidth is something we give a lot of importance to. The scalability of the model is another important factor, especially in the light of the growth we have been witnessing in the past few years. Companies have been growing and the question is not the strength of corporate India but the sustainability of the earnings growth momentum. So scalability within the management and within the growth model too is crucial.

Which sectors are you bullish on for 2007? Which one are you avoiding?
We cannot really comment on what sector I will avoid this year, since industry factors and valuations change from time-to-time. So what may be unattractive now may be very attractive a few months down the line. At this point of time, we are bullish on capital goods, IT, banking, FMCG, auto and construction.We are underweight on real estate, media, metals and textiles. Admittedly, we have missed the rally in real estate and media stocks and now valuations are high. Unless there is more clarity and the valuations are more realistic in these sectors, we won't be looking at them.

Do you feel the days of super returns in the market are over?
Logically, looking at the returns the market has delivered over the past three years, we have already reached the stage where the PE re-rating is clearly over. We are slightly above the average PE multiple the Indian equity market has been quoted at. We are also in line with the earnings growth which corporate India has.

One main reason for the rally was the PE re- rating because it was at a sharp discount to the earnings growth a couple of years ago. The PE multiple was 10 or 11 while corporate India was growing at 15 per cent. Secondly, the earnings growth had a momentum that was more than expected.

Extremely strong FII flows was simply a fall out of the PE re-rating and the momentum of earnings growth. These two factors have been broadly addressed in the rally that followed. From here on, the growth in individual share prices is likely to track the respective earnings growth. Difficult to quote a figure for market returns, since stock specific returns could differ considerably. Some corporates could still deliver 25-30 per cent over the next few years while others might deliver 12-15 per cent. At every level there are opportunities in the market. The number of such opportunities may shrink, but they generally exist. Till the May 2006 meltdown, the rally was broad based but the rally since July last year has been more concentrated. The importance of stock selection is thus likely to be increase.