Successfully navigating midcap volatility
Sr VP & Fund Manager
Motilal Oswal MF
WF: Your fund’s performance has improved sharply in the last 1 year – it looks like you have been able to protect on the downside better than your peers. Did you consciously adopt a more defensive strategy? What did you change at the margin over the last 12 months to enhance fund performance?
Akash: We had become cautious on mid and small caps in January 2018 as valuations reflected froth in many of these companies. We reduced our small cap exposure substantially and moved into large caps. Further, we churned few mid cap stocks where earnings growth was lagging and bought high quality mid cap companies with robust earnings growth potential. In the past five reported quarters, the weighted average earnings growth of the portfolio has been 31%. During the same period, mid-cap 100 index reported earnings decline of 14%. The portfolio has a return on capital employed (ex-financials) of 32% and the debt equity ratio (ex-financials) is 0.04 with 80% of companies having net cash in their balance sheet. The valuation premium of a high quality and high growth portfolio like our fund which normally trades at a decent premium has now gone into a discount compared to the mid-cap 100 index, largely led by delivery in earnings growth.
WF: A plain reading of your fund’s performance seems to suggest that you have been better at protecting capital on the downside compared to capturing the upside of the bull phase. Is this a fair comment?
Akash: Mid-caps have corrected 20% in the last one year and with the above changes we have been successful in protecting the downside. High return ratios and low leverage of the portfolio helped to achieve this. However, it is important to note that the earnings delivery is strong and relative valuation of the portfolio compared to the mid cap index is cheap. Hence, in our view, the portfolio is well – positioned to ride a rally in the mid-cap space as and when it happens.
WF: Some experts believe that even after the steep correction, midcaps have only come back from premium valuations over large caps to neutral and are not exactly cheap. How do you read valuations in the midcaps space?
Akash: Valuations for mid-caps (at 35x trailing multiples, 20x one year consensus forward multiples) are still at a premium compared to large caps or their own longer term trading history. The key lies in estimating the future earnings growth. Instead of estimated earnings growth of 30% in FY18, mid-cap earnings de-grew by 15%. In CY19, the street is building a whopping 80% earnings growth. We believe the earnings growth for FY19 would be 10% and CY19 would be 20%, which is much lower compared to the street estimates. In our view, valuations in the mid-cap space are still expensive, though the froth is gone.
WF: What are your key over and underweight sectors and why?
Akash: Consumption sector including housing and consumer discretionary remains a perpetual strong theme to invest. Companies in this space would continue to enjoy higher and longer earnings growth as they are more structural in nature. They exhibit higher stability and consistency in growth as well as lower volatility in business performance. Retail oriented banking and finance companies which fund consumption expenditure should also benefit.
We are under weight on telecom, utilities, capital goods and infrastructure sector. Competitive issues in the telecom sector and delay in pick-up in investment cycle has marred the earnings growth of companies in utilities, capital goods and infrastructure sector. Companies in these sectors are suffering from high leverage as well. We think it will take some more time before growth recovers for this sector.
WF: Which sectors do you see creating significant wealth over the next 3 years?
Akash: We are more positive on consumer staples, consumer discretionary and retail oriented banks and finance companies which lend for consumption activity as we believe consumption is a secular growth story for India given its demographics and income levels. The valuations for most of these companies is fair and we expect them to be steady compounders creating wealth in the long term based on their earnings growth trajectory.
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