Even in this difficult market you have performed. What is your hypothesis? Where does the valuation in the overall market come in your way of that performance, whether positive or negative?
Liquidity is there globally, excess liquidity.
If you look at what happened post global crisis, across the world, let's say, a decade or 15 years prior to global crisis, the earnings growth in the developed market, U.S., Europe, was in the range of 10% to 11%. It has come down by 6% to 7%. But the equity markets there also have been pretty stable and doing well.
The cost of debt has come down and implied cost of equity, the discounting factor, has come down. So, that's why excess money is chasing yield and some part of it is being going various emerging markets like India.
Domestically, the options are limited in real estate, gold. So, there is a liquidity which would come and which will be sort of maintained.
The issue from an investment manager point of view is that ultimately businesses and stocks would react to earnings.
But they are not reacting to earnings.
Sure. And that can take it up to a level. Time and again it has been shown that ultimately it will react to the earnings. So, we are going by that thesis.
There are pockets in the market purely driven by equity, the multiples have grown by say 40x to 50x. We have to draw a line. When you look at a stock - business, management and evaluation. All three are positive, all three are risky also.
Post crisis, many have not taken business risk or management risk because other pieces were not performing and probably some pockets of the market are taking valuation risk. So, it is very important to draw a line. Say our internal assessment values a business at X, maybe you can hold till 15% to 20% more because we are buying for 5 to 10 years. But if it is significantly higher than the inherent value, we have to reduce it. Typically, as a fund manager, we go underweight and if it very high, then probably sell it.
Late 90s, the largest consumer company was at a 60 P/E multiple historic, 45 forward, and that stock underperformed for 10 years. The index moved up so much, but it took 10 years for that stock to actually reach the previous high of 1999. The starting point of valuation, if it is a 40 P/E or so, we as investment managers have to see that that is also a valuation risk.
So, we try to look at risk both not only from a business management, but also on the valuation. So, that's how the portfolio is constructed. But at an overall level, I don't think that there are no opportunities where everything is expensive. Opportunities are there, maybe less.
Three years ago oil marketing companies were available despite reforms at such low valuations. When earnings came, they have become 6x and 7x multi-baggers.
When you identify a particular company or sector, how do you think about it in terms of your overall portfolio? The allocation and within that allocation how do you ensure that the risk-adjusted returns can be generated?
Our mandate is to outperform the benchmark. In a country like India when your nominal GDP is growing, earnings will be growing. If you're outperforming the benchmark, you would generate absolute returns and probably better relative returns.
We try not to significantly deviate at a sector level. We go underweight or overweight, but no sector style should be disproportionate in terms of the construct. Barring certain exceptions, we don't significantly deviate.
The IT sector has not done well over the last 12-18 months, but you still have equal weight on the sector?
No, it's not equal weight. There is an underweight case, but we will not be drastically – it will not be 40% of the weight. It will be more like 60-70% to that extent.
Take banking where we had seen various challenges. Let's say the benchmark is 25%, so either we will be 22-28%.....
So you don't deviate very large…..
We try not deviate but for certain exceptions. If you see absolute downside in the sector, then obviously there is no benchmarking to that extent. In general, that's a thought.
Within that, stock selection makes a lot of difference. Let's say banking is a large weight. When things were bad one could be more retail-oriented wherever you have seen medium-term, longer-term earning trajectory. Right now, if the view is that maybe corporate banks would probably over the next 2-3 years show a better return on asset, then you can skew from that. There idea is to control one part of risk through the sector allocation.
The alpha generation comes from stock selection within the sector and what you are buying outside from bottom-up.
What gives you that conviction to buy a particular company? And what gives you the conviction to hold it even when it goes up 5x or 10x?
There are certain cases, longer-term compounding stories where you have a view of 10 to 20 years. For example, we bought IndusInd Bank five years ago. It has done well, say 20x in 6-7 years and it will still compound, it will still chug along because private banks are taking share from public sector banks. There is a change in management. There is a long way to go in terms of getting market share.
The other examples would be where valuations are expensive so we try to look at a situation where the company is very good, but there is some problem in the company which impairs the short-term leaving the longer-term intact. So we bought Maruti when the entire labour problem was going on.
What is it you're holding today gives you that conviction that this particular theme or a sector or a company is going to grow 3 times to 5 times and these are my reasons. Say a 5-year timeframe.
The names which I've mentioned – like IndusInd Bank, those sort of names can compound very well. I mean, doubling in five years is quite sort of doable.
Can you talk about one of your successes and failures?
In terms of successes, Amara Raja Batteries was significantly lower than the leader in that industry in terms of market cap. Over 6-7 years, it has become 40x because the earnings have grown, the delta RoI has increased, delta earnings have increased and market has rewarded. It's one of the few cases where the second guy or the challenger has actually became leader in terms of the market capitalization and also literally on size of the profit side.
In terms of failures, clearly, as I said, the biggest risk comes when choosing a not so good management. We erred with one such company in financials. While we do a lot of due diligence in terms of past track record, capital allocation, dividend history, all sort of things, after buying it and after meeting the management, if there are certain decisions which the management makes…
So, what did you learn from your success and failure?
Much more due diligence is required.
Any new stock or any new offbeat stock should be bought gradually, so that you see few quarters of the sort of earnings and how the management sort of view it. Only then you take it to the top 20 or 30.
And it is all bottom-up. You have to meet the management regularly and the market is all about incremental RoI, incremental changes, incremental capital allocation, incremental growth.
The learning is that you have to be on the ground, you have to do a lot of primary research and that's when you can identify the opportunities or disconnect. Sometimes a market – in a situation like this where a challenger or the second player becomes much aggressive, is creates good opportunity.
(None of the mentioned stocks are recommendations, just illustrations of the fund manager's investing philosophy.)
Neelesh Surana is the CIO of Equities at Mirae Asset Global Investments (India). He was among the top 10 managers in the ET Wealth Morningstar Fund Managers rankings in 2015 and 2016.
He manages Mirae Asset Emerging Bluechip, winner of the Morningstar India Fund Award 2017 in the 'Equity: Small and Mid Cap' category.