‘We find more value in large-caps today’

If large-caps don’t do well, mid-caps and small-caps cannot move up relentlessly

Portfolio Management Services (PMS) have soared in popularity in this bull market, with seasoned ones like the Motilal Oswal’s Portfolio Management Services attracting a lot of HNI interest. So how does the portfolio manager select stocks? Why did it recently shutter its popular fund to new money?

What are the most risky segments of the market? Manish Sonthalia, CIO, Director and Head-Equities for PMS, Motilal Oswal AMC takes a few questions from BusinessLine, in a telecon.

Motilal Oswal offers three different strategies under its Portfolio Management Service. How have they fared and how should investors choose between the strategies?

The Value strategy is our oldest offering, a large-cap strategy, and if you see the returns since inception in 2003, it has delivered good CAGR returns of 25.31 per cent. The Next Trillion Dollar Opportunity is the multi-cap strategy that started in 2007 and has delivered CAGR returns of 19.49 per cent and the India Opportunities portfolio, which is a relatively recent mid-cap strategy, has delivered returns of 18.37 per cent since inception.

However, in terms of our investing style, all our funds use the QGLP (margin of safety approach in a growth investing framework) to select stocks. Essentially, we filter stocks for quality, growth, longevity of that growth and price.

Currently, we feel investors should commit more money to the Value strategy which is a large-cap portfolio. We are somewhat cautious on the mid or small-cap exposures, given the valuations. But we are finding it hard to convince investors as they are quite enamoured by the returns in mid and small-caps over the last three to four years.

Investors are forgetting the fact that about 50 per cent of the earnings for India Inc come from the Nifty or Sensex companies and if the large-caps don’t do well, mid-caps and small-caps cannot continue to move up relentlessly.

This is why we have stopped accepting fresh money in the Next Trillion Dollar Opportunity portfolio after it hit a size of ₹5,300 crore. In short, we unequivocally find more value in large-cap stocks today, than in mid or small-cap stocks.

Do you hold cash positions in your portfolios to sit out periods of expensive valuation?

No, we take the view that human beings are not wired to time the markets perfectly. In long-term investing, it really doesn’t make too much of a difference whether one buys 5 per cent higher or lower and, hence, we do not take cash calls.

We own concentrated portfolios with 20 or 25 stocks and believe that over-diversification over-dilutes returns and not risks. The way we look at our PMS is that we are not beta seekers (who earn returns from market moves) but alpha-seekers (who earn returns from superior stock selection). We aim for good absolute returns.

So you are essentially growth style investors and don’t prefer the value style?

Yes, in our view, a pure value investing approach does not work in India. Only the growth style works. Pure value investing is about buying companies that trade at a fraction of their intrinsic worth.

Essentially, you should be buying assets worth ₹10 at ₹2. In India, those kind of situations are typically value ‘traps’ and not really long-term buying opportunities. This is because a large number of businesses in India do not even earn a return on capital employed above their cost of capital.

Therefore by looking for these bargains, you will end up owning businesses with very low return on equity.

Instead, what we look to do, is to buy companies with an intrinsic value of ₹10 at, say, ₹6, 7 or ₹8, but are somewhat confident that this ₹10 is going to become ₹100 sometime in future.

But aren’t such quality stocks also quite expensive?

If you look back on the top wealth creators of the past two decades, say an Asian Paints or HDFC Bank, you will find that what seemed like a high valuation 20 years ago was really quite an attractive valuation, once you factor in the earnings growth they have delivered over the years. In 1997, HDFC Bank earned ₹40 crore in net profits and traded at a market cap of ₹1,000 crore.

Today, the bank’s profits are at over ₹14,000 crore and the market cap is ₹4.5 lakh crore. If you backwork today, you could have paid a PE of 150 times for the stock in 1997 and still earned CAGR returns of 25 per cent on your capital invested. It is very hard to foresee the kind of wealth an earnings compounder can create over the long term.

Do current market conditions remind you of 2003, when the bull run had just getting started, or 2008 which signalled a peak?

Definitely, the situation is closer to what we saw in 2008, particularly in small-caps. Of course, the long-term trajectory on Indian markets remains perfectly intact. But it can’t move up one way without corrections.

There is a lot of euphoria in the markets in the extreme short run. For the last three years, we have been hoping for an earnings recovery in the Sensex and Nifty companies, but that has not been coming through. Nifty earnings growth is stuck at low single-digits. If earnings growth does not catch up, the risk of a correction will remain elevated.

How do PMS compete with active mutual funds? And do investors prefer fixed fees or variable fee based on profit sharing?

This is a very competitive business and I would say the fees are quite comparable to mutual funds for a customised portfolio. In fact, the competition is so high that no manager can charge even ₹1 extra.

But most investors prefer fixed fees in a bull market. Today, hardly 10 per cent of our clients would be in a variable fee structure. We offer either fixed fees or charge 10 per cent of the profits on the portfolio, calculated on the high watermark principle. We also allow investors to switch between fixed and variable fees once a year.

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