PE multiples can’t expand; earnings growth needs to pick up

By Morningstar |  08-08-18 | 

Prashasta Seth, chief investment officer at IIFL Mutual Fund, talks to Ravi Samalad about his investing style and why he believes large caps will remain popular this year.

IIFL Focused Equity Fund invested in Reliance Nippon Life AMC. Did you subscribe to the HDFC IPO as well?

We exited Reliance Nippon Life AMC because we subscribed to HDFC AMC. Post listing, HDFC AMC will constitute close to 10% weightage of the fund’s weightage. So we didn’t want more than 10% exposure to AMC business in this fund.

How do you see the prospects of the asset management industry given that its fortunes are directly tied to markets?

In asset management, there are fixed costs and the operating leverage is very high. For instance, if you are managing a Rs 10,000 crore fund, you would need 2 fund managers and 5 analysts. If the AUM increases to Rs 1 lakh crore, you can still manage with perhaps 3 fund managers and increase the analyst team to 10.

The other challenge in the industry is distribution commissions. Factors like capping of commission payout, improving operating leverage, wider participation of households in financial assets will bode well for asset management companies.

Do you think profitability of AMCs will go up with the popularity of direct plans?

Ideally, the difference between the total expense ratio of regular and direct plan should be the commission payout to distributors. But industry data suggests that the commission payout is higher than the difference in TERs of direct and regular plans. I believe increasing share of direct assets will improve profitability. The only challenge is that not all investors are ready to pay a fee to distributors/advisers who recommend direct plans. So how do you incentivize distributors recommending direct plans?

What is the strategy of managing a focused fund as compared to a fund which holds wider number of stocks?

You need to have strong conviction in your ideas. A fund which holds 50-60 stocks can take minimal weightage to each stock. On the other hand, in a focused fund, the minimum weightage to a stock could be 2-3% which can go as high as 10%. Besides, the amount of due diligence is higher since we tend to go overweight on stocks vis-à-vis benchmark. Since we hold a concentrated portfolio, we tend to avoid cyclical stocks. If you buy in the wrong cycle, the pain it can give will be substantially higher in a focused fund because of the concentrated holding. Thus, we invest in high conviction secular growth stories which could play out in 2-3 years.

The fund is currently overweight vis-à-vis the index in Healthcare, Technology and Utilities. What makes you bullish on these sectors?

We wanted to position our portfolio a bit defensive. Both Healthcare and IT will benefit from rupee depreciation. IT had underperformed for a large period of time till January 2018 and valuations too were compelling. We felt that reasonable valuations and demand pick up would help this sector.

As far as Healthcare is concerned, most issues related to the U.S. is priced in. The situation should only improve from here. Also, rupee depreciation will help the Healthcare sector.

In Utilities, we have focused on specific opportunities. It is not a theme or sectoral allocation. It’s an independent call on a stock. We have 6% weightage in Calcutta Electric Supply Corporation or CESC Ltd. If this company gets approval for demerger there will be a lot of value unlocking.

Why does the fund does not have any exposure to Energy and Communication Services?

We have been looking at oil marketing companies, but we still haven’t been to take a final call on this sector. We are waiting for a right opportunity to enter.

In Communication, it is still unclear on which way the industry is headed. The profitability is reducing. We are unsure when the sector will bounce back and command pricing power. We have to see how long Reliance JIO continues to keep the prices low.

The current rally is only due to a handful of large-cap stocks. When do you think there will be a wider rally in next rung of stocks?

Our thesis this year is that we don’t expect to see a broad-based rally with participation from all stocks. Keeping this in mind, we have launched a fund called IIFL Capital Enhancer Fund where we are taking exposure to large cap stocks which are expected to lead the economic growth. It aims to protect the downside by investing in a put option. We believe large caps will outperform mid and small caps this year. This is because we are in hardening interest rate environment, the currency is depreciating, and liquidity is drying up in global markets. I think mid-caps can play catch up for a large part of this year. But we don’t see them outperforming the broader indices by year end. I would recommend investors to stick to large cap funds having focused strategies this year.

Some reports are predicting a correction in market. What is your sense?

Logically, there should be a correction, but the domestic liquidity is abundant. We are entering a phase where fundamentals are deteriorating.

For the last five years, the macro situation was improving even if micro situation wasn’t so well. Today, you are in a situation where macros are worsening but the micros are improving, as far as the latest quarter earnings is anything to go by. We have to wait to see the numbers for 2-3 quarters.

I think what is very clear from here is that PE multiples can’t expand. It’s the earnings growth that has to drive the markets. The earnings season this quarter has been exceptionally strong. Whether this is one quarter phenomenon exemplified by what happened in base quarter which was weak or is it something that will persist needs to be watched out.

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