“Stick to the golden middle”

It is not easy to stick to the middle path, when everyone around you is risking a scrape or two chasing high profit. But Janakiraman Rengaraju stays sane and steady through all the hullaballoo. The vice president and portfolio manager — Emerging markets equity, Franklin Templeton India, believes in remaining true to conviction, diversifying a portfolio and betting on companies in which promoters have skin in the game. In the mid-cap segment, in which he operates, Rengaraju has had to constantly strike a balance between quality and valuation. It is not easy math but he bets on long-term even if there is pain to be borne in the immediate future.

Over the past ten years, how has your investment style evolved and how has it changed?

There is definitely the benefit of hindsight. Over the past ten years, I have realised that it is better to stick to the middle path. If you limit the number of mistakes, there is more additive value than trying new things. This may not work in all phases of the market. Convictions are definitely tested during the high beta phases and, if you ride out these phases simply by sticking to your middle path, you can generate a higher alpha. My middle path is to buy good quality compounders and, during bullish phases, this approach may not be the best one — it could land me in third or fourth quartile for a while. For instance, in 2007, Franklin Prima was up only 45% while the mid-cap was up by nearly 75%. Everyone was writing our epitaph. So, we cracked and, towards the end of 2007, we bought into small-cap commodity and infrastructure companies. I remember I bought a leveraged power company for Rs.72 and exited at a loss in 2010. These were momentum trades. The companies were performing well at that time and the beauty of our markets is that you could have justified those trades at that time using some very sane explanations. But, it was clear that our ability to stick to our convictions was not very high in 2007.

Jeremy Grantham said eight out of ten times you come to office, drink coffee, meet people and go away. It is during the balance two times, during market extremes, that your behavior has a disproportionate influence on the long-term return. That is absolutely true. You need a bit of maturity to act as per your convictions during the phases. Especially in a market such as India where it is 20-30 year growth market, which provides a lot of data points to back your investment decisions if you want to take some bolder calls at those times.

The attribution analysis showed us that in mid and small-cap companies if you eliminate the mistakes, you have a good chance of getting into Q2 (second quartile), and consistent Q2 is my aspiration. Post 2007, this has been the focus. It is bit easier said than done because, in mid-caps, you are expected to take some risks. Then you realise you are comfortable with certain risks. For instance, I am not at all comfortable with balance sheet risk. Given a choice between balance sheet risk and a slightly higher valuation risk, I would rather go with the latter. With the lessons learnt from 2007, we were able to build a reasonably good portfolio with decent valuations during the weakness that markets saw during 2012-2013.

So what were some of the calls that worked well during that period?

It wasn’t sector specific. My portfolio is a diversified one where the top 10 would make up 30% and 40% of the portfolio. While this is not an exhaustive list, stocks such as Mindtree, Kansai Nerolac Paints, Torrent Pharmaceuticals, Voltas, Schaeffler and even Finolex Cables, though it is down about 35% in the past one year, have done well for us from a five-year perspective.

There is no one silver bullet when it comes to investing in these companies. These were steadily run businesses with reasonably consistent execution. The promoters had a very high skin in the game. For most of these companies, the size of the growth opportunity was much larger compared with their size, which meant, without doing anything spectacularly different, they can grow for an extended duration. The growth equation is the same for Mindtree and, say, TCS. Of course there is significant difference in their bandwidth, but Mindtree can focus on a niche opportunity and grow at 15% for a slightly longer time. If you have a combination of proven management, who has executed consistently over the past five years, and a mid-cap opportunity, it is a nice one to have across the sectors. In the periods of sedate growth such as the one we are having, companies that execute well have a better advantage. When the tide is high, it lifts all boats but, when it is a reasonably low tide, companies that are more efficient executors tend to do reasonably better.

The range of quality in mid-cap stocks is very wide. So when valuations run-up like they did in 2017, what trade-offs do you have to make between quality and valuation?

Towards the end of 2017, the mid-cap valuations were at its peak and the so-called quality stocks within mid-caps were very expensive. It was tough for people like me, since that was when there were a lot of inflows, so we were forced to commit capital and preferred stocks were expensive. So one had to adapt and make a trade-off between quality and valuation. There are certain aspects of quality that I don’t compromise on, such as the ability to generate positive free cash flow and efficient working capital management. Within that spectrum, there maybe companies that are generating positive cash flow but not a very high return on capital employed. For instance, the return on capital employed (ROCE) is around 15% rather than 20%, so you look at companies with a slightly lower ROCE. All parameters remaining the same, if you have one company where growth is coming from reasonably mature products so sustainability of growth is always a question mark and the other is seeing growth from relatively younger product categories, which means the runway for growth is much longer, you want to invest in the second. But if the valuation gap is very large, you go with the first. Those are the tactical compromises you make. Many of the good quality companies have taken a hit on their margins because of high oil prices leading to meaningful erosion in valuation. For me these are nice opportunities. So for instance, there are reasonably good quality paint companies that have seen an erosion of 20-30% in prices because of higher oil prices. The next two quarters, things are looking a little cloudy and the margins are not going anywhere but, since these are 20-year growth stories, I am willing to bear the potential pain for another couple of quarters.

We run a lot of filters regularly using parameters such as ROCE, Debt/Ebitda and cash tax rates. I am a bit more sceptical about companies whose cash tax ratio is low because, if you see their cash flows, you will make out that most of them are deferred taxes. 

Over the past one year, the outperformance of the mid-caps has come off a bit, which has helped bring down the valuation excess. The small companies fund’s portfolio valuation has come down from 27x in December 2017 to 17x in December 2018 and the valuation of the Prima portfolio valuation has come down from 28x to 21x during the same period so there has been a significant reduction in valuation and there is a lot more comfort that there are now quality stocks available at fair prices.

What are the broad themes that you are betting on for the next four to five years and that you hope continue to generate the much-needed alpha?

At the basic level, based on what has played out in other economies, one secular trend that we have seen is that when the per capita income crosses beyond a threshold level, there is a definite bump in discretionary spending. While there is scientific reason attributed to that number, that level is around $1,500-2,000. We are somewhere thereabouts. So for the next two decades, the consumer discretionary category will grow faster than broad economy. Within that theme, I see a lot of spending happening on tourism, both domestic and international. Healthcare, media and education spending will go up. So, at the base you have this one powerful growth driver but there will be different themes such as auto, healthcare, education, tourism, media and entertainment that will emerge from there. However, not all of these areas will be easily available to be played from a capital markets perspective. While education has been a good theme, finding good alpha ideas in education has been painful.

What were some of the bets that haven’t met your expectations and what has been your learning from them?

Two that come to mind are telecom and Tata Motors. As far as telecom was concerned, I think we got in a bit early. Since the new entrant was already a year into its launch and had gained reasonable market share, we expected the company’s behaviour will be a bit more rational and won’t be as disruptive as when it entered the market. That was the investment thesis and we had been a bit too early in coming to this conclusion. One of the tnife in many cases. Eventually we will make some return in such cases but the point is that you will see some serious erosion before it tends to bounce back. One could play a bit more of a waiting game because it seems to be too early to take risks. Typically we look at our mistakes and see if there is some systematic behavior and the idea to correct that behavior.

With Tata Motors, the primary trigger was a fall in valuation that was deemed adequate to cover for the risk in the business. There were some risks beyond our control such as the Brexit and UK demand going weak. But I don’t think we estimated well the resources required to change from a heavily diesel intensive portfolio which is the big reason they are saying now the R&D costs are going to be higher for the next two to three years and, in each of these years, there will be likely negative cash flows. It was not only for JLR but also the case with the likes of Daimler. The level of resources required has spooked the market. While we felt that the valuation was attractive, we underestimated the R&D spend.

What is your market outlook for 2019? Being an election year, how you do build a portfolio that can weather the expected volatility?

It is very difficult to predict how the markets will react to electoral disappointments. For instance when the election results came out in the beginning of a week, in December 2018, I expected the markets to fall, but it continued to do well for the next three to four days. In 2004, when the National Democratic Alliance (NDA) lost, the market fell but continued to do well for the next three to four years. Similarly when United Progressive Alliance (UPA) came back with a thumping majority, the markets rose sharply up 20% in one month but went into a slump the next couple of years. So the immediate reaction to an election has never been a good indicator of things to come. 

Globally growth is slowing down and interest rates are moving up. The easy liquidity that we have seen in the past couple of years has also started to tighten, so the external environment is less conducive for growth than what it was in 2017-18. That said, the internal metrics are starting to look better. Over the past couple of years, we had two experiments that derailed the growth momentum but now the growth is recovering. So though it is not a great global environment, an improving domestic scenario should translate to better earnings growth. Next year, we expect the earnings growth to be in the mid-teens, primarily driven by domestic growth. 

There can’t be an actual comparison because, as far as the index is concerned, much of that earnings growth will come from banks. Over the past couple of years, earnings growth for banks has been weak due to on-performing asset provisions. So, the banks will see significant earnings growth in the next one year due to the write-backs. In ex-financials too, we are likely to see some growth coming back in consumer discretionary and pharma. The capex cycle is still a bit cold. If you go back to 2007, the capex cycle at that time was driven by energy, commodities and infrastructure. Infrastructure is back, even if it is on government spending. Whether its NDA or UPA, they have realised that they need infrastructure to use the slack capacity in the economy to produce growth and, more importantly, the infrastructure is a much more electorally winning approach. 

As far as commodities go, the glass is half full. For one, the commodity cycle has been meaningfully better in 2017-2018. Balance sheets of commodity companies such as Tata Steel, JSW, Vedanta or Sterlite are better. All of them are working at near peak capacity utilisation. I guess all of them were waiting for National Company Law Tribunal resolutions to be reached before they could move on to their capacity expansion. Now that most of the resolutions have been reached, barring Essar Steel, companies are starting to expand their overall capacity. So, things are improving for commodities. Energy is cold because we still have a large excess capacity, while a lot of capex is flowing into renewable. It is not helping us because bulk of it is imports. The missing link in the capex cycle is construction, which is very weak, especially private residential construction. In commercial real estate, numbers have been strong with record absorption rates. The thumb rule is for one foot of commercial space you need five foot of residential space, but unfortunately a lot of these thumb rules are not playing out. The restrictions on use of cash did hurt a bit but the market has adapted to that level of transparency. It is primed for a recovery that had been expected in 2018 but did not happen. While capex cycle looks poised for recovery in 2019, it won’t be a needle-moving growth without construction picking up.