The Outperformers 2013

“Markets are getting polarised towards large caps”

UTI Mutual Fund CIO Anoop Bhaskar believes a jittery market is relying too much on large caps

While most fund managers would venerate the Sage of Omaha, Anoop Bhaskar is clearly not one of them. His reasoning: Warren Buffett’s job is not half as tough as his. While that view might be debatable, there is no denying the pressure one has to endure while managing public money in a volatile market. The head-equity of UTI Asset Management with assets over ₹74,000 crore, personally manages UTI Equity and UTI Opportunities Fund, which is the top performing scheme in the large- and mid-cap category space, according to Value Research. The fund has managed 13% CAGR over the past five years against 4% CAGR for the Sensex. Bhaskar tells V Keshavdev that in an increasingly volatile year ahead, investors will continue to pile into large cap names, thus pushing them into bubble territory. That achieved, interest and attention will then spill over to the next tier of big market cap stocks.

If you were to look back at the past five years, why have large caps scored over mid caps?

One key difference between FY04-08 and FY09-13 is that in the former there was too much optimism on infrastructure, a preference for more risk. Investors were happy to bet on small and mid caps on the sheer promise of future cash flows. FY09-13 is based on domestic consumption, and on companies with present cash flows, not future cash flows or promises. Investors have preferred to reduce risk during this period and focus on companies with stronger cash flows, instead of those who need to raise capital frequently. FY09-13, like in every cycle, corrected the excesses of the previous cycle. In FY03-08, there were excesses in infrastructure — capital goods companies were traded at 40 times their earnings.

Similarly, in the current cycle there were periods when consumer goods were trading at 40 times their earnings growth of 12-15%. Asian Paints never used to get rated above 15 times. Now it trades at 35 times. Marico, a single-product company, never used to trade more than 14-15 times, but today it trades at 27-28 times. Godrej Consumer trades in a similar range. Investors have shown a keen preference for safety, this time around. That is part of the rhythm of a cycle: you move from one extreme to the other. 

Besides slow business growth, what is the biggest risk that outperformers could face going ahead?

If you recall, in FY03-08, much of the risk in small caps was taken by foreign investors. Many Singapore-based long-only boutiques would look for undiscovered stocks in order to buy large stakes in them. Starting FY09, those investors have been more careful and have gone to the other extreme. They have chosen to continue investing in a few favoured companies. So, if a fund was at $1 billion and had eight investments in India, at $4 billion, it still kept buying the same eight companies.

The concentration of holding of key investors is now one of the biggest factors that you have to consider, because if any of those investors face redemption you know they have only eight or 10 stocks in India. That creates its own downward pressure. Part of this was seen last month, when better quality private sector banks fell more than their public sector peers as emerging market funds faced redemptions back home.  

Will large caps continue to be outperformers because of an aversion towards mid caps?

As always, it will be a cycle. Today, there is a concentration of around 25 stocks that trade at two times standard deviation away from their last 10 years’ PE. That is where most of the flows have been. The kind of flows that come from overseas, be it ETF dominated or emerging market or global funds, are now focusing only on the larger names. The long-only boutiques of Singapore are more or less defunct. It is perceived by investors that they do not offer any protection on the downside and they play in many illiquid names, which overshoot the return in a bull market and overshoot the fall in a bear market because of lack of liquidity.

Because of the nature of flows in the past four to five years in emerging markets, flows will be primarily focused on the larger companies or the more liquid names. Local investors or funds, which have a long India presence and are comfortable owning mid-cap names, will be the ones to focus here. But then, over the past two to three years, even local investors have been less willing to back very small names where there is an issue of credibility of accounts or there is lack of cash-flow generation. 

So, I think, going forward, the top 50 Nifty stocks may lag in terms of market cap growth as they are already over-owned. Now the next 50 or 75 stocks will move up. In all, there are 150 large-cap stocks in India. So the cycle will shift from the ones that are the most valued to the ones that are less valued. Then, slowly, investors will get the confidence for the next 75 or 80 stocks. That is the universe in which we play. So we would be very keen to look at companies within the top 150. That is where most investors will also stop. 

Most investors will look at companies where the business cycle is close to bottoming out or has bottomed out and then play accordingly within the larger names in that sector in the next cycle. I think it will be more sector-specific rather than just by market cap. 

Will institutional investors continue to hold onto domestic consumption stocks for their defensive nature? 

Not all of them. As they get concerned about FMCG and slowdown in domestic consumption in India, investors have moved towards IT because the rupee has depreciated and there is slight improvement in the economic environment in the US and Europe. IT stocks are reasonably — though not attractively — priced. They will get into bubble territory when they trade at 1 to 1.5 times standard deviation from their last 10 years’ mean. But at 16-17 times, I think more and more investors will fancy IT services stocks.  

How do you find valuations today?

Valuing stocks becomes a bit of a challenge in times like these because the cost of equity as perceived by overseas investors is much lower than seen through the eyes of a local investor. Therefore, it leads to issues in pricing, which look relatively high to the local investor. For example, I am told that Hardcastle, the McDonald’s franchisee in west and south India, has placed equity with a foreign investor at a valuation of ₹5,000 crore. This is for a company that made a profit of ₹33 crore last year and expects that to rise to ₹150 crore after two years. But that investor is taking a 20-year view, whereas our investors stay in our funds for 12 months. We have to take a 12- to 14-month view. To us, that stock looks expensive but to somebody who has a 10-year view, it might not be so expensive. So, it all depends upon the kind of investors you have and the investment horizon.  

If you were to put the time horizon part aside, what do you look for in mid caps before committing capital?

Historically, in India, the profitability of smaller-cap companies has a strong correlation with the market. This might appear an empirical statement but the kind of inducement to report profits is also dependent upon what multiple the company is being traded at. That is where you have to be very careful. What we have tried to put in our fund is that we want companies that have at least ₹50-crore profitability in a year and have seen at least two business cycles. So you know how bad the business cycle can be for them. That ensures that many of these concepts stocks that have got listed in the past two to three years are not there in our portfolio or we relegate them to a very small percentage. We try to look at companies that have shown some scalability. 

Secondly, a larger promoter holding gives you comfort. That way, our interests are aligned with the minority interests. They will take more rational decisions on capital allocation because their stake is large enough for them to get impacted. Thirdly, can the promoters bring any technical strength to the business they are in, or are they just businessmen who depend upon consultants? Lastly, does the business have scalability? Can it cater to either emerging markets or neighbouring markets so that over a period of time it becomes less dependent upon the domestic market? Those are the things we look at on the mid-cap side. 

As a rule, we don’t go into companies having a market cap of less than ₹4,000 crore. We want to have the ability to exit companies. Fairly decent volumes and liquidity ensure that.  

Compared with mid caps, how different are the parameters on which you evaluate large caps?

In mid caps, it is mainly a bottom-up, company-specific approach. So you don’t look at the sector but evaluate the company. But in large caps you have to balance between the company and the sector. Let me give you an example. In January this year, very few funds would have had IT services even as the No.2 sector in their portfolio. In six-seven months’ time, it will become perhaps the largest sector across most of the diversified funds because of the view on the rupee. I think that if the rupee ever comes below 60 again, you will find IT exposure reducing very significantly. That will be the impact of the macro on a sector, irrespective of how the stock behaves. 

That is one of the challenges in large caps. You should not get overwhelmed by the macro; you need to be focused on the companies also. While the macro plays a significant part in evaluating the company, it should not become the only factor. One has to figure out which company is better placed to capitalise on the situation. That is where the marriage between the two comes in. At times, fund managers look at the broader picture and forget to look at the details. That’s fine as long as the trend is in your favour. But it is only when the wave recedes that you realise the company you backed didn’t really have the wherewithal. That is the key difference between large and mid caps.  

Which sectors are you keenly monitoring at this juncture?

In the next 12-18 months, sectors that have got large scope to play on the rural side, which have got a fair amount of export potential and are more based on the domestic consumption side, will be the ones to look at. The infrastructure and capital goods cycle requires a push from the government, and that could take another 15-18 months. 

The sector that will give a lot of heartburn to investors will be banking. It is a high beta sector. As and when the government announces measures or as and when the currency stabilises, the sector will prop up and move up very fast. 

The last phase of bottoming out will create more operational challenges for banks. It will be a fairly challenging sector for the next 12-15 months as has been the case in 2001 and 2003 when India last came out of a slowdown. At that time banks had fairly high NPAs but were helped by a sharp drop in G-sec yields and the treasury gains acted as a cushion. 

Seeing the current rate of inflation, the possibility of outsized treasury gains seems less probable. Therefore, they will have more operating challenges and for the next two to three quarters, they will have higher provisions and higher credit costs.  

What is your take on the power sector?

I think most of the investments in the power sector are based on assumptions that are fairly optimistic and which do not factor in the reality that there is only one buyer of electricity in India — the state electricity boards. They lose 50% of the power, for which they get zero. The naivete was about the solvency of a buyer who is losing money on every purchase. The industry has to sit and accept that perhaps these assets will earn much lower returns than what was earlier promised.

Already, most equity investors have seen significant erosion because they bought in at two or three times book value and now the same assets trade below book value. The adjustment with the debt holders is the next phase. That will happen over the next three to four quarters. Lenders and investors have to accept the fact that in this sector you cannot get oversized returns for a sustained period of time. Interestingly, one of the promoters of a power company said, “If I had known I will only get 12% RoCE [return on capital employed], I would have put my money in gilts and not taken the trouble of setting up a power plant.” 

How do you see fund managers repositioning themselves over the next year or so? 

The Indian economic cycle will bottom out over the next two or three quarters. In the next nine months, we will see some of the excesses getting drained out of the system, as companies sell part of their businesses. Investors will increasingly look at business cycles to check which sectors are placed for a revival. So, perhaps the first sector to revive could be automobiles. For example, commercial vehicles have reported the 17th month of y-o-y decline. The biggest previous down-cycle saw 15 months of y-o-y decline in FY01. Hence, we can’t assume that there will be another 15 months of y-o-y decline in the category. At some stage, commercial vehicles will revive and then investors will think perhaps Ashok Leyland can beat Tata Motors as it is a concentrated India commercial vehicle play. 

It will be very industry-specific and investors will bet accordingly. Those who prefer stability will prefer Tata Motors, even though the domestic business is still a very small part of the consolidated figure. Some will prefer to have a bigger bet on auto ancillaries, which is more stable and which doesn’t depend upon whether you bag Tata Motors or Ashok Leyland. Maybe you might buy a Porsche thinking it is more stable. That will depend upon each investor’s perception and what valuation they are comfortable with. But I think it will be a sector-specific function.  

What is the sense that you get from managements that you have been interacting with?

I think one of the worst sources to ascertain the state of an industry is the management. It is like asking a fund manager on where the market is headed. He can most probably never give you an unbiased view. Instead, you need to ask the right questions about why demand is down and the factors driving it down. One of the learnings of the last 12 months is that sales depend upon the environment but profits to a large extent depend upon internal events. What measures is the company undertaking to reduce costs? How are they substituting raw material? We need to focus on those things to understand if the company realises that it is in a downturn or is it still hoping that things will be good. That is what we really want to understand from management. 

Could you share some more insights?

Currently, the cycle is in favour of strong cash flows and companies with stable businesses. At some point in time, because of over-valuation, that cycle will run its phase and people will look for companies that have more promise, and investment in infrastructure and power will again come back. You are already seeing IT come back after two years of neglect. As the macro changes, investors will have to become flexible to play those. Second, rather than size, focusing on companies that are less ambitious has turned out to be a far more profitable way of investing rather than focusing on those that had oversized investment ambitions. You have to back promoters or companies who realise the outer limits within which they have to operate.

Thirdly, don’t have too much of a long-term perspective. Every 12-15 months, be open to the idea that there will be some changes. What works now might not work after 18 months and what doesn’t work today might work after 15-18 months. So, you cannot take a five-year view and instead need to be much more agile and sceptical. You have to keep rotating that five-year view to match what the underlying macro is. The 2008 slowdown was too short and it was more of a global phenomenon. So everyone became an expert on the US Fed and quantitative easing, but they have not seen the impact of a slow grind, when the economy slips from 8% to 4.5%, and what it does.