When Harshad Patwardhan started off as a fund manager at JP Morgan Mutual Fund, it was in June 2007. On the back of the success of JP Morgan India Equity Fund, a mid-cap fund was launched. The fund’s first NAV came out in January 2008, and Rs 10 was reduced to Rs 2.90. It was a baptism by fire! Now, as the chief investment officer for equities at Edelweiss Asset Management, he tells Larissa Fernand about the lessons learned since then.
The past decade has been quite tumultuous. What would you say have been your biggest learnings as a fund manager?
The first is to keep an eye on top down.
I was always a bottom-up stock picker. I still am. In active fund management, stock selection is crucial. Because in any sector, in any given year, the stock return dispersion within that sector will be significant. Take Cement, which is a rather homogenous sector. Even within this, there will be a wide margin between the top and bottom performers.
But I have learned that top-down can no longer be ignored. In hindsight I can see that macro did matter in 2008-09. One cannot focus on a bottom-up strategy to the complete exclusion of top-down.
Watch for the responses of the government and regulators.
While the main event grabs everyone’s attention, one tends to overlook the policy response. In 2008, we witnessed a catastrophic event. In retrospect we can admire how actions by the central banks was such a feat in saving economies. So just looking at the event is not sufficient, one must consider the derivatives – which are responses by the policy makers, either the government or the central bank.
What you don’t own also matters.
By 2016 we had a good track record in place, but our funds underperformed that year. On doing a post mortem, we realised that what we owned did not hurt us. What hurt us was what we did not own.
Take commodity prices. By May-June 2014, the price of crude was $125/barrel. It went to below $25 by the first quarter of 2016. Not just oil, most commodities crashed. Commodity prices bottomed out in the first quarter of 2016 and then began to rally. Metal stocks did excellently that year. But we had not invested in them because such businesses are not predictable and not compounding. So not owning Metals hurt our relative performance.
Think in terms of bets, not holdings.
Most discussion happens around stock selection. And that is the place to start. But how much of a bet to take is extremely crucial and a lot of thought must go into it. At the start of my career, I did not appreciate this as much as I do now.
The last two points – what you do not own matters and the magnitude of the bet. Can you elaborate on how this impacts your investment process – your active stock selection?
Let’s say Company A comprises 5% of the fund’s benchmark index. Not owning that stock translates into a negative bet of 500bps, which is often higher than my positive bets.
Let’s say my portfolio also allocates 9% to Company B. It may appear to be a substantial position. But its holding in the benchmark is 7%. Here my positive bet is essentially only 200bps.
So I have to keep an eye on both. If I pay attention to my negative bets, I have a greater chance at consistent performance.
How do you manage a negative bet?
Take public sector banks. They do not feature as our core holdings. They are not compounding stories. They are unpredictable. Even the managements in such banks would not be sure of the future a few quarters down the road.
Now if you look at the last 2 decades, you will see that when PSU bank stocks do well, they do extremely well. For example, in December 2017 we saw that post the recapitalisation announcement.
So in the case of certain stocks like Metals or PSU banks, which are not my core holdings, I may take a defensive stance by just neutralising the position. Why keep the negative position open if there is a trigger that might lead to significant outperformance?
Explain neutralizing.
If a stock has, say, 3% exposure in the benchmark, I may take an identical exposure in my portfolio.
So the extent you differ from the benchmark contributes to alpha generation.
Yes. But I do NOT mimic the benchmark. My aim is to beat the benchmark. So to that extent I have to keep an eye on it.
What sort of stocks form your core holdings?
Compounding stories from any sector. When I say compounding, I mean in earnings. I look for stocks where the Return on Equity is greater than the Cost of Equity. There may be companies that are growing rapidly but not beating the Cost of Equity. Such companies are not adding value, they are destroying value.
Compounding stories are HDFC Bank, IndusInd Bank, Asian Paints?
I would not like to comment on individual stocks.
You spoke of ‘negative’ bets and core holdings. Is that how you compartmentalize your portfolio?
Yes.
My core holdings are more or less a buy-and-hold kind of stock. This would be a compounding business with a proven track record of strong growth over long periods of time. It is often a structural growth story with a high-quality business and management.
Then I mentioned the stocks in which I take a defensive posture.
Third would be a business offering potentially large scale-up opportunity but without a sufficient track record. This would have a higher degree of risk.
The fourth are tactical bets which are typically on businesses in a cyclical industry which is well levered to the upturn. These stocks are bought and sold depending on the phase of the cycle and valuations.
What tactical bets are you looking at now?
I believe that the Indian economy is expected to significantly pick up in terms of nominal GDP growth resulting in faster corporate earnings growth. There are many stocks which are not of high quality in terms of business or management, but very levered to growth.
Take Construction, for instance. EPC contractors are not of the highest quality and are prone to shocks. But when looking at a period of strong upturn in the economy, they could be multi-baggers.
Note, they are not trading stocks. I won’t jump in and out. I will hold them for maybe 2 or 3 years.
Thank you.
