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SanjayChawla

Are midcaps still overvalued or now at long term average?

Sanjay Chawla

CIO

Baroda Pioneer MF

Midcaps are trading at 61% premium on trailing PE basis to broad market post correction against long term average of 26%. That makes them significantly overvalued. But the same midcaps are now trading at 16% premium to broad market on 1 yr forward earnings basis against long term average of 17% - which means they are not overvalued. So are midcaps overvalued now or not? Sanjay Chawla highlights the weight of expectations on earnings growth in midcaps and warns that its time expectations get moderated. All the more reason to remain sharply focused on sector agnostic bottom up stories, which is what he is doing to drive performance of the Baroda Pioneer Midcap Fund which changed avatar from a PSU oriented fund almost 2 years ago.

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WF: The fund was trailing category averages but has recently caught up, perhaps because it held up better than others in the correction seen in 1HY2018. What has enabled you to protect capital better on the downside and what strategy are you putting in place to fully capture the next upside?

Sanjay: Baroda Pioneer Midcap fund came in to existence from Oct 2016, post conversion of the erstwhile Baroda Pioneer PSU Equity Fund. Consequently, 1 or 2 years will be a right time frame for performance analysis in this category. The AMC did not have a product in the Midcap space and considered it appropriate to convert PSU Equity Fund to Midcap Fund which offered a wider basket of products to investors.

The fund follows the sector agnostic strategy. The Bottom up approach is implemented by taking concentrated bets and focusing on growth-oriented stocks. Our investment philosophy is GARP- Growth at Reasonable Price. This is also visible from earnings growth for the portfolio stocks which is higher than benchmark.

High visibility of earnings growth, good management and less volatile stocks has helped the fund performance post its conversion. This investment strategy has been fruitful and will be continued in the future.

WF: You are considerably under-weight on financials and the dominant sectors in your portfolio include consumer durables, services and technology. What is the rationale for these under and overweight stances?

Sanjay: The fund follows the sector agnostic strategy; hence the focus is on selecting high earnings growth stock. In financials, positioning of the fund is skewed in favor of non-banking financial companies and retail oriented private banks. For eg. in financial services, the portfolio includes stocks of companies which are one of the largest NBFCs focused on rural and semi urban market. They are among the largest Indian tractor financiers or light commercial vehicle financiers. These are companies where there could be strong penetration opportunities and good pricing power.

In technology the focus was on turnaround stories. Companies whose turnover have crossed a billion dollars and have the right portfolio of service. The rationale was that there would be improved valuations led by improving earnings growth for these stocks.

WF: You hold ~11% in cash / cash equivalents, do you see an opportunity for investing at lower valuations in the near future?

Sanjay: At Baroda Pioneer AMC, for all our funds, our cash holdings are in the range of 2-4% to meet redemption and for tactical opportunities. However, given the weak market conditions we had increased our cash position to 4-6%.

In case of Baroda Pioneer Midcap Fund, 11% cash holding is a month-end phenomenon and does not necessarily reflect our underlying view about the markets. We believe our cash position in Baroda Pioneer Midcap fund on a monthly average basis is currently consistent with the overall cash holding and is not high.

WF: How do you see midcap valuations post the recent correction? Has value now emerged or do you see scope for more downside before these stocks become attractive again?

Sanjay: Midcap index has corrected by around 11% YTD. One can attribute multiple reasons for this i.e. earnings not coming through, scheme rationalization by funds and FPI outflows over the last 6-7 months. Over the last 12-15 months there have been two significant events 1) demonetization and 2) GST implementation. Both did impact consumption spending across various product categories, thereby impacting earnings. Recent regulation requiring rationalization of schemes based on market capitalization also impacted flows in midcap.

Valuations need to be looked from multiple angles. On trailing PE basis Midcap index is still trading at 61% premium to broader markets. As seen from chart below, on a trailing basis Midcap is trading at 61% premium vs 10-year average of 26% premium. This is despite the recent correction.

Chart : Midcap trading at 61% premium to NIFTY on trailing basis

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Source: Bloomberg

However, on one year forward basis midcap index is trading at only 16% premium to broader markets. This compares to 10-year average of 17%. However, one needs to factor that earnings growth expectation are high for midcap stocks and these expectations will moderate going forward.

Chart: Midcap premium 16% to NIFTY on one year forward basis

pic07082018

Source: Bloomberg

Even on trailing price to book basis midcaps are trading at discount to broader markets, this remains a key indicator of opportunity within this space. However, while there is an opportunity one has to be cognizant of the risks midcaps generally carry.

WF: What in your view are the major market / macro challenges and opportunities over the next 12 months, that will influence the course of your fund’s performance?

Sanjay: There are couple of macro challenges that may impact performance. Global trade war is something to be watched out for. This may not impact fund performance, but it is sentimentally negative for stocks in general. Increase in crude prices and consequent higher inflation and increase in interest rates, clearly will be negative for midcap stocks in general. We are also entering the election year which will have a bearing on stock markets in general.

Disclaimer : Mutual fund investments are subject to market risks, read all scheme related documents carefully.

The above article only seeks to provide information to readers and does not in any way seek to solicit or advise readers to invest in any scheme of Baroda Pioneer Mutual Fund. Past performance and any forecast is not necessarily indicative of the future or likely performance of any scheme of Baroda Pioneer Mutual Fund. Opinions expressed herein are subject to change without notice. Baroda Pioneer Asset Management Company Ltd., Baroda Pioneer Mutual Fund and/or its sponsors are not liable for any loss caused to any investor due to reliance on the above article. Readers are advised to consult their investment advisers / tax consultants on the implications of investing in mutual funds.

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