‘Actively managed funds should not be written off’

Despite these schemes struggling to beat their benchmarks, the sources of alpha are definitely there: UTI AMC Executive VP

“I wouldn’t paint a very rosy picture (of the markets) because, when you look at valuations, they are at the higher end of the fair-value zone, even if you take one-year forward earnings. So, I think earnings delivery continues to be the most important variable to look for,” says Swati Kulkarni, Executive Vice-President and Equity Fund Manager at UTI Mutual Fund. Excerpts from an interview with BusinessLine:

What is the process you follow for stock selection?

We do an internal rating of companies based on the past five years’ audited/reported numbers. We rate them on two important parameters — operating cash flow (OCF) and return on capital employed (ROCE). If in all of the five years, the operating cash flow has been positive, the company get a C1 rating; if it is positive for at least three years, it gets a C2 rating, and less than that is a C3 rating.

Similarly, we look at the average ROCE over five years and give ratings based on that. So, more than 18 per cent ROC gets R1; 10-18 per cent gets R2, and less than 10 per cent gets R3.

For the financial sector we use the Return on Assets and Leverage to rate the companies. In our analysis of close to 1,300 companies over 22 years, we have observed that companies with consistent OCF and high ROCE (C1,R1 companies) have a high probability of sustaining the same in future, and they also tend to outperform the market.

Also, the companies that migrate upwards from a lower rating of R2/R3 to R1 tend to generate far superior returns; however, the probability of the migration is low. This is the basic framework.

This framework will then help our research analysts build a rationale on the possibility of sustenance of strong return ratios or cash-flow generation by analysing macro and company-specific factors such as the business environment, demand expectations, quality of management, growth potential, etc.

Fund managers will then choose stocks with varied proportion of R1, R2, R3 based on the investment mandate and the style that she/he follows.

With fund sizes getting bigger and the universe of listed companies remaining somewhat stagnant, are there significant opportunities yet to be discovered in the market?

For some funds that are growing larger, perhaps, some market-cap segments may not be addressable. But for fund sizes of, let’s say, even up to ₹10,000 crore, I don’t think a market-cap of ₹2,000-3,000 crore is a limitation.

Cyclicality of businesses also provide opportunities. For instance, we have had corporate banks that had been going through a lean phase and being quoted at distressed valuations.

But they still had inherent advantages of their own in terms of the liability side of the franchises and capital adequacy. So, there will be opportunities even within the discovered names where market may be ignoring these.

IT is another classic example. In 2016, they (IT stocks) were available at very cheap valuations with strong ROCE and cash flow.

And now, if you look at the past one year, it’s the second best performing sector. Besides, there will be a situation where the market price is below the intrinsic value of the business.

The job of investment professionals is to discover such opportunities .

The election uncertainty is over, but the GDP numbers and the corporate earnings picture are not looking good. What’s the outlook for the market?

One good thing about the election (outcome) is that there will be continuity on decision-making as well as the reforms, which were initiated in the earlier term of this government. That is definitely a positive for the market.

Yes, corporate earnings have been sluggish. This time, the expectations are more towards a performance recovery in banks, with asset-quality problems and inflated credit costs becoming a thing of the past. There could be support on the treasury side as the interest rates have come off from what they were on an average last year. Some benefit could also be coming out of the other sectors — which are of course small, but then they will continue to contribute. I think that we could make a case for double-digit growth for earnings as far as the large indices are concerned. I wouldn’t paint a very rosy picture because when you look at valuations, they are at the higher end of the fair-value zone, even if you take one-year forward earnings. So, I think earnings delivery continues to be the most important variable to look for.

How should investors approach MNC stocks?

The quality of MNCs come from their net cash balance sheets and high ROCE business. You would see that most MNCs have absolutely zero or low leverage and also very high ROCE. If you look at UTI MNC (fund), we manage it based on the wide economic moat concept. We look for companies that have strong entry barriers and that typically tend to do well when there is a slowdown. Also, when it comes to growth phase, because of the advantages they have — be in terms of distribution, brand, technology or operational efficiencies — these companies are in a better shape to take on growth as well. Now, the question comes about on how much of it is already discounted in the prices, ie, valuation support. I think that the valuation re-rating has happened for these (MNC stocks) as the markets have realised the importance of quality. Today, on a PE (price-to-earnings) multiple basis, the PE for MNC stocks is at a premium to domestic peers.

So, I will not build a case saying that investors can give a further premium from these valuations, but I will certainly build a long growth runway for this as a theme.

Passive and passive-plus strategies are getting popular, thanks to the narrowing differential in returns compared with large-cap funds…

It’s not large-cap alone. Even versus multi-, mid-, and large- and mid-cap categories, over one and three years, actively managed funds have been struggling to beat the benchmark.

So, in this scenario, a passive fund will compete. But I don’t think active funds can be written off. Because, the sources of alpha are definitely there. For example, the investment process will identify a mis-pricing that is prevalent in the market. Whenever the market chases certain momentum stocks, you will see that their valuations might get quite rich and you could have an opportunity to book profits, lowering your downside if it corrects.

The other thing is, whenever some sectors go out of favour, you will find them at attractive prices as the market tends to ignore certain stocks that are not doing well. Yes, passive strategy gives you a proposition of having no fund manager-related risk and a lower expense ratio; but at the same time, there are opportunities in active funds also.

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