Which market segment are you more comfortable with at the moment?
In the last 5-7 years, we have been in a very different environment. If I look at how funds have performed, stock picking has made a bigger difference to the outcomes in this period rather than sector selection. You would argue that stock selection is always important, but 2003-08—just to take another period—was all about sector selection.
The current trend will continue. But when the market gets manic depressive about certain areas, it tends to throw up opportunities, simply because valuations start to look attractive. Metals is a classic reflector; it looked down in late 2015 and early 2016, but recovered later. Recently, only 2-3 segments have demonstrated that kind of impact—IT, pharma and corporate lenders. Another segment is companies in the utility space.
Rather than looking at it from a sector perspective, I try to consider whether valuations are telling you that the market is being so pessimistic that there could be opportunities to change. Beyond that, there are many areas where growth is there and one can look for opportunities.
Is it worth investing in the corporate lending sector, especially public sector banks?
Is corporate lending an area where you can make money? I would say you can. In any financial business, you look for strong liability franchise, healthy capital adequacy and someone with a decent customer acquisition engine, corporate or retail. Some private sector lenders have all these characteristics even though their corporate lending book may not be so high. The opportunity there is that as and when things stabilise and start improving, their growth rate will start to lift and they will not be constrained by capital or their ability to grow.
The challenge faced by PSUs is that they have low capital adequacy. While we don’t have a view on this, we don’t have too much exposure to PSU banks. That’s also because historically they haven’t demonstrated strong RoE (return on equity), which underpins a lot of our thought process when selecting stocks.
How does your investment process work? How do you filter individual stocks into specific scheme portfolios?
In our investment process, we emphasize on two factors—operating cash flow and return on capital (RoC). The two factors combine to create the magic of compounding. We now have a framework where companies are rated based on consistency of operating cash flows and average RoC over the previous five-year period.
Based on that, the analyst can focus on factors that might cause the metrics to change. This also establishes a baseline estimate for whether performances are likely to sustain. How likely is a top-rated company on, say, cash flow likely to sustain that five years later? Does the rating tend to change over time, indicating a cyclical pattern? Our analysis indicates the chance for a top-rated company to remain so for five years is around 81%. For the same period, a top-rated company on RoC deteriorates to the lowest rating 20% of the time.
If you are investing in a top-rated company, what you are betting on is what has worked for it in the past and will continue to in the future. As an analyst you need to be cognizant of whether there is something that can disrupt this.
If your starting point is a middle- or low-rated company, you look for periods in the past where they demonstrated the ability to perform better and what might enable such a transition.
This thought process makes it easier for managers to choose companies that suit their mandate.
How does this translate into evaluating fund manager performance?
A quantitative method for evaluating performance designed with the help of T Rowe Price has been in place for many years. Fund managers are evaluated relative to benchmark and peer group. Both metrics are evaluated over one-, three- and five-year rolling periods over the course of the year with a higher weight for three- and five-year performances. We will consider raising the weight for longer time periods, pushing for consistency while recognising cyclicality.
The peer comparison faces a new challenge due to changes resulting from scheme categorisation. We are not sure how to look at past performance because in some cases the peers have undergone significant changes.
Will the new limits in the defined categories affect a fund manager’s ability to pick stocks, especially in the mid-cap space?
It is going to be a challenge. Till now every fund house was following its own rule on what was defined as a mid-cap. I’m hoping that at some point, as the market evolves, one may have to reconsider whether saying 101st stock to 250th stock is mid-cap, is the efficient way to do it. Any rating system will have a rigidity built into it. If you look at the Morningstar way, small, mid and large is defined as a percentage of market cap. The number of companies can increase or decrease in this method as newer companies are added.
Last year, in our mid-cap fund, there were about 100 stocks, which were brought down to around 80. A large number of stocks work for the kind of deep value investing the fund manager does. But as a result of this circular, we have already started reworking and practically there may be around 70-75 stocks.