Sensible equity strategy in these challenging times

Neelotpal Sahai

Head of Equity


Neelotpal Sahai talks about the recent midcap correction, key risks and why multi-cap strategy is preferable for investors.

  • Midcap correction a result of high valuations, strong commodity prices and currency depreciation
  • Higher commodity prices are positive tailwind for some large caps but headwinds for small and mid caps
  • Constructive medium to long term view on India. Best way to participate is through multicap funds that have maximum flexibility to adopt bottom up stock picking strategies
  • Key risks to watch for – US-China trade war, global interest rates, crude oil prices, elections in India

WF: Investors have seen some bruising times in the recent steep correction in mid and small caps. Would you term this a correction in the longer term bull cycle in midcaps or the end of a cycle? How do you see the road ahead for mid and small caps?

Neelotpal: It is a very relevant question and it is on the top of mind for many investors. The current cycle for mid and small caps and subsequent correction are a result of two factors.

#1 the valuations had gone up ahead of actual earnings delivery

#2 and # 3 are the headwinds from strong increase in commodity and fuel prices which led to currency depreciation

#2 and # 3 are more fundamental and important to note. The last two factors are positive for some large caps but negative for mid and small caps, which is why there is differential in large cap vs the small and mid caps.

Valuations of mid and small caps at an aggregate level and at individual level have now moderated from the high premium they were commanding in October 2017 through to January 2018. Over longer term, the mid and small caps have traded at a discount to large caps, this premium was not justified to that extent. That is one of the reasons for the correction we have seen.

Higher commodity prices are positive tailwinds for large caps which deal in commodities themselves and the companies that are linked to global prices, while they become headwinds for mid and small caps who are consumers of these commodities. Our view is that commodity prices should remain at elevated levels, but not going up further from here as well.

What it means is that you are unlikely to see a further deterioration in margin levels based on commodity prices. A lot depends on the ability of businesses to pass on these cost increases to their consumers. Companies which have scalable and resilient business models, differentiated positioning are the ones that should be able to lead the recovery. This further emphasizes the need for a strong bottom up focus among mid and small caps.

WF: At a broader level, do you see macro trends in India and overseas potentially capping our market rally? How do you see the equity markets going forward over the next 12-18 months?

Neelotpal: In short to medium term, news flow does impact the market but it is important to see how the macros and micros play out. For example, the macroeconomic variables have worsened over the 6 months but it is coming after a significant improvement over the last 4-5 years. All the macros were at their worst in 2012-2013. Since then, we have seen massive improvement in inflation, fiscal deficit, even growth has picked up albeit with few hiccups.

So of late, we have seen some deterioration led by higher commodity and fuel prices. However, all is not lost. The central bank is proactively managing inflation as it was demonstrated by the recent hike in the last policy meeting.

On the global front, crude oil touched $80 but it has retreated a bit. Chances are that crude prices will soften a little bit, but not to an extent that gives us a huge relief.

US-China trade war prospects is something we have been sensitizing investors to almost a year ago. At that time, it was more rhetoric in nature but now we are beginning to see countries imposing tariffs on each other. It is a concern but it shouldn't snowball into a full blown trade war because that is not in the interest of anyone. However, I should like to put a number into picture. If all countries were to impose a 10% tariff on all goods, then it would lead to a 1% deceleration in global GDP.

While talking about the macro situation, I would like to look at where things are headed. From a medium to long term perspective, we are definitely constructive in that what has happened in India. The reforms they have been implemented augurs well. Other than GST, there are other key reforms which are less talked but are as just as important. Structural repair in the banking industry will go a long way in rebuilding trust and relief in the banking sector. The government has taken some steps to correct these structural issues and already, we are seeing some signs of the benefit. However, the full benefits will be seen medium to longer term. That’s why we remain constructive.

WF: Coming to products, pre-rationalization, we had diversified equity funds and multicap funds. Now that there is no separate category called diversified equity funds, is it correct to say that the only truly broad-based category with no theme/style restriction is the multicap category?

Neelotpal: Now multi-cap is the only category where there is no restriction as such. In a multi-cap fund, it is theoretically possible to have 0% in large cap at any possible point of time. So it has maximum flexibility for the fund manager. It also provides flexibility for the investor who just wants to get into one fund and still get exposure to the full market. Fund managers in practice may not use such a wide degree of flexibility – but the product allows for maximum flexibility compared to any other equity product category.

WF: Why do you believe that a multicap strategy is perhaps best suited for investors considering equity investments now?

Neelotpal: The multicap strategy gives fund manager flexibility to align the portfolio to market conditions. The most important thing remains bottom up stock selection and the strategy the fund manager employs. In a growing country like India, there are meaningful investment opportunities across the spectrum whether it is large cap, small or mid caps.

On one hand, large caps gives you the stability and reduction in volatiilty that naturally comes with investing in equity capital market. Large cap is less volatile but, if one wants to participate in the growth of the Indian economy, then investing in newer business models which will scale themselves into larger cap over a number of years is a must. Then, one should also have exposure to small and mid caps. This is why a combination of these two thought processes - having stability in the portfolio as well as alpha generating ideas - means that multi-cap should be the best strategy for the investor.

WF: What is the proportion of large, mid and small caps in your multicap fund now? How have these proportions moved over the last 18 months where we have seen strong rotation between cap sizes?

Neelotpal: I tend to keep large caps at somewhere between 60-75 percent and that has been the range over the last five years. There have been some instances where the large cap was down to 60-65%. One instance was in 2013 and the other instance was in second half of last year. In these small windows, my large cap exposure was down below 65%. I don't recall ever going above 75%. Currently, it is about 72%. When one needs to contain volatility in the fund, large cap goes up and when one needs to generate higher return, then mid cap goes up – that is the thought process.

WF: What are some of the sectors and themes that you are significantly overweight on in your multicap fund and why?

Neelotpal: The themes we are positive are linked to the domestic economy recovery, financialization of savings, commodity prices remaining high and shutting down capacity for metals and chemicals in China.

From a sector perspective, we are overweight on financials, discretionary consumption and materials.

Within the financial sector, the private sector which is about 1/3 of the banking industry has proved to be quite resilient and has been gaining market share consistently from the PSUs space. Our preference for this segment is based on health of balance sheet, retail focus, clarity on earnings and valuation and market share growth.

We are positive is discretionary consumption as there has been continued focus from the government to revive demand in the rural areas. The focus in this budget was on improving farmer income as well as masses in general. That should aid consumption at the bottom of the pyramid. IMD (India Meteorological Department) has forecasted a normal monsoon this year and that should aid in revival of normal consumption. Our preference for companies in this sector is within home improvement, building materials and autos.

The third sector we are positive on is materials and it is largely because of China shutting down capacity on environmental concerns. Some of these capacities are going to be major and therefore, commodity prices could remain elevated at this level. Domestic metal companies and chemical companies which sell domestically but get priced at dollar/international levels are the biggest beneficiaries.

WF: What are the key risks that you would advise investors and distributors to be watchful of now?

Neelotpal: Investing at any point in time does come up with its own risk and it keeps on changing. Now, there are risks from domestic as well as international factors.

A key global risk is whether US-China trade war will intensify. Although it does not make sense to intensify more, one does not know how much more it can go to. The second concern is with respect to central banks in developed markets raising rates more proactively to kill inflation. That might lead to a slowing down of the global growth in calendar 2019. In 2017, we had a great global growth in a benign inflation environment. Now both of these factors are changing. Inflation is slightly inching up but it is below the levels the central banks want them to be. So it is not a cause of concern. However, since central banks are proactively considering rate hikes, that could lead to a meaningful slowdown on the global economy and that will have an impact on emerging markets as well.

On the domestic market, crude oil price continues to be the most important concern. Crude oil price is currently in 74-75 region, which is about 7% lower than the peak it has touched but meaningfully higher than what it was a year or so.

The other domestic risk is not a market risk but more to do with sentiment. Over the next 12 months, we have a number of elections. Any risk to the ruling party actually becomes a kind of concern for the market although it is not a concern over the medium to long term. While elections should not impact medium to long term performance of portfolios, it will impact the market in the short term.

Please refer below the detailed performance of HSBC Muliti Cap Equity Fund and of the other funds managed by the Fund Manager.

Lump sum investment performance


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