Prashant Jain on when to sell an underperforming fund

By Morningstar |  25-11-16 | 

Prashant Jain, ED and CIO at HDFC Mutual Fund, was a panelist at the Morningstar Investment Conference held last month in Mumbai. Here is an excerpt from the panel discussion moderated by Morningstar's director of fund research Kaustubh Belapurkar.

What are the market trends you have observed over the last few years?

These markets are in transition for the last 5-7 years.

We saw an economy where the CapEx cycle was extremely weak. Interest rates and inflation was quite high and the currency depreciated very sharply by almost 50%. This supported the growth in consumer staples, pharmaceuticals and IT. Growth was scarce in other sectors.

Things are changing. There is low inflation, low interest rates, lower fiscal deficit, very low current account deficit, stable currency and CapEx is slowly reviving. I believe the asset quality pressures in banks - the peak, appears to be behind us. I also think over the next few years the leadership will change and we should see new leaders emerge within corporate banks, consumer discretionary or engineering and capital expenditure.

You've been one of the early movers into the PSU bank space and you've seen a fair bit of pain on that front. Tell us your thoughts on that process.

As I said, these markets are in transition. In my career, I have seen three such transitions. The leadership change from technology to old economy and commodities in 1999; 2007 we moved from infra CapEx to consumer pharma; and I think last year will mark the transition once again back to CapEx, corporate banks. Corporate banks is a better term to use than public banks because the pain is equal in public and private corporate banks.

I have seen that it is always advantageous to be better in a cycle than be late, because it's on the way down that you can get lots of volumes, it's on the way down that impact costs are less. And on the way up, look at what has happened to, for example, an ICICI Bank in two days. So, now, if you start buying and large funds want to start investing in that space, it becomes more challenging. So, transition years always have been painful for us, 1999, 2007, 2015, but I think there is now reasonable indication that things are falling in place and this leadership transition - I think we're well on course in that.

What sort of sectors or themes are you currently focusing on?

If you look at the margins of corporate India as a whole, we are sitting nearly at close to two decade lows.

The sectors which have dragged down the profitability of corporate India are basically metals, corporate banks and engineering. Now there are reasonable indications that these three sectors are recovering.

We know what is happening to metal prices both ferrous and nonferrous. The provisioning costs of banks have clearly peaked out and I think every passing year we should see an improvement in profitability. In my opinion, by fiscal 2019, we should see very normalized profitability and normalized ROEs for the corporate banks. In the engineering and construction space, we can see that working capital cycles are beginning to moderate, interest costs starting to come down and the margins are holding steady or moving up.

It is these three spaces which I really like. Even consumer discretionary looks quite good to me.

What are some of the risks that investors should be aware of that could potentially destabilize our markets in the coming years?

The economy fairly well set. All macroeconomic parameters - fiscal deficit, current account, inflation, interest rates, seem to be falling in place. GDP growth should continue to accelerate with every passing year. Profit growth, which has been missing, should come back very strongly.

A look at the breakup of profitability of different sectors in the Sensex or Nifty shows that it is basically three sectors where profits have become virtually half of what they were three years back - corporate banks, metals, and engineering and construction. I am confident these will do a complete reversal in the next two years. Other sectors like consumer, automobiles, IT and pharma have been growing at a reasonably steady pace.

India's market cap to GDP is now sitting at 10-year lows. Nominal GDP may not grow at 14% for the next two years, but even 12% nominal GDP growth, with the improving margin with coming off of interest rates, can lead to 20% type of profit growth.

But equities are a volatile asset class and it's very hard to forecast over short to medium periods, more so in this global environment which is not very positive. But if you look at last 5-10 years, any correction in the local market, which is sentiment driven because something negative is happening outside India, has have provided great entry opportunities into the market. Be it tapering, the Lehman crises, 9/11, the European crisis, Brexit - whatever.

Volatility may be induced by global events, but I don't think there is anything material to worry about if you have a medium to long-term view.

Let’s say a fund is struggling because a fund manager still believes that the sector he's relying on might do well. As an investor, how long should I wait to see that the call materialize - 2 years, 3 years? How do I decide when to exit?

I would suggest a book to those of you who are interested in the real answer to this question. It is called Common Sense on Mutual Funds by John C. Bogle. If you read the first three chapters, you will get a very good answer. Equity is a long-term asset class. And equities in India have tended to move in cycles. By and large, a cycle has lasted for 3, 5, 8 years. So, I think a 5-7 year period is a proper cycle time to assess the performance of a mutual fund.

This approach is similar to how you assess a good batsman. Sachin was a good batsman because he had a good batting average. It does not mean that in every single match he scored the highest runs. One year for a mutual fund is like one match. Don't get swayed by 1-year performance. Look for 3-5 year performances and when that starts underperforming, do a serious analysis.

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