All weather theme with exciting growth prospects

Sunil Subramaniam

Managing Director

Sundaram Mutual

Sundaram Services Fund is being positioned as an all – weather fund which should find its place in every investor’s mutual fund portfolio. The fund has 3 key investment arguments – 1) Services is the fastest growing macro sector in India, 2) Vast set of stocks with ample opportunity to play risk and reward across market capitalization, 3) Services industry is on the threshold of transition, post GST - from being unorganized to organized. This would translate to more fast-growing companies being listed which will increase the universe of stocks to choose from.

WF: Your fund presentation showcases a wide array of service-oriented sectors and their exciting growth prospects. The key concern today is whether we are overpaying for growth and quality. How would you respond to this concern?

Sunil: There is no denial that there are temporary concerns especially surrounding the US elections and Indian elections contributing to the political uncertainty. Crude prices have also remained a factor contributing to the macro concerns. This has led to domestic fund managers paying a hefty valuation for quality and growth. There is a tendency for mean reversal from this status as we realize that these global factors do not have a very telling long term influence on domestic markets / macros. The micro earnings of all the sectors (in the first quarter), except the banking sector has seen an earnings growth which has doubled or tripled. These are phases in the market and there is nothing unusual about these phases. From a long-term perspective, these factors allow the fund manager to identify quality picks (where growth is not yet visible) which will provide rewards over a 3-5 year horizon.

WF: When you cast your initial portfolio, which of the several sectors highlighted by you will the fund likely be overweight on and why?

Sunil: Initially, we need to blend a long term horizon with shorter term considerations. The fund manager will be cognizant with fund allocation with a long-term perspective. He will also use the buy-hold approach keeping in mind the basic premise of buy-low; sell-high. This will provide rewards over the long haul, but this polarized approach will lead to NAV suffering on an intermediate basis. Hence, we will be blending short term opportunities (visible short-term growth). This growth and quality are currently visible in sectors like retail, retail credit, to some extent IT (especially the differential IT and not the plain vanilla outsourcing IT). About 50% would be in such opportunities, another 50% would focus on picking up long term growth stories.

WF: You have mentioned that this is a potential all weather fund. Why do you believe this can transcend from a thematic play to an all-weather core fund in an investor’s portfolio?

Sunil: There is focus on positioning this as an all – weather fund, primarily to break away from the notion of being a sector fund which offers high-risk; high-reward due to the nature of portfolio construct, which is essentially satellite holding and not a core-holding construct. From a regulatory perspective, this is seen as a thematic fund, but in reality our effort is to highlight the fact to the audience (potential investor) that services sector is a mega – sector and not a micro-sector with limited options. This sector alone contributes to ~52% of India’s GDP and holds 15 sub-sectors under its wing. Hence, the positioning of this fund as all-weather fund which should find space in the investors core mutual fund portfolio is justified.

WF: Bruising competitive forces have disrupted key service businesses including telecom and airlines, causing significant loss of market cap in these sectors. Has the service sector now become a riskier investment proposition due to these disruptive forces?

Sunil: The first part is to understand that the services sector which contributes to over 50% of India’s GDP has a wide range of opportunities (sub-sectors / stocks) within. Some of them fall under the defensive play and some under the aggressive category (basically fall on either extremes). There are sectors like telecom which are undergoing massive transformation and hence, have registered subdued performance. This blend is what is exciting. If one were to operate at one end of the spectrum, it would provide with nominal returns. The fund manager has to play both risk and rewards. When we look at the 15 sub-sectors within the services industry, there is no intention to invest in all of these sectors at any given point of time. We will evaluate each sector on the opportunities, challenges, disruptions and choose to invest or stay away from the specific sector. We then look for stocks within the specific sector where we intend to invest.

WF: How do the weakening macros (falling rupee, rising interest rates, rising CAD) impact India’s services sector?

Sunil: The falling rupee actually favors the services sector, the BPM / BPO industry which is a significant part of the services sector has accelerated the services sector’s (export) growth of India. We have seen exports grow from 31% in 2012 to 39% today. Holding stocks in this space will help counter the falling rupee scenario and will act as a natural hedge over the long haul.

There are 2 reasons for interest rate rise – first being an impact of crude rates inflation, pushing up interest rates and demand-pull inflation pushing up interest rates. Given that the current increase in interest rates is on the backdrop of rising demand where the producer sets the prices (in a falling demand scenario price is set by the consumers), since we are currently riding the increasing demand scenario, the rising interest cost will be passed on to the end customer by the producer. India is nowhere close to being in a falling demand scenario (increased supply). Hence, this factor does not seem to challenge the services sector adversely at this given point of time. On the rising CAD, we have a different perspective. We believe that the fiscal deficit and current account deficit should be viewed in the perspective of the country’s growth. It is like looking at the PEG ratio instead of looking at P/E in isolation. Citing this with an example of increased industrial activity, we can understand that there is increased demand for machinery and raw materials, which needs to be financed, this results in increased deficit but at the same time, there is increased job creation and economic value creation which enables / propels economic growth. If such growth is the reason for the increased CAD, then we believe that ultimately the taxation revenue to the Government via GST laws and Corporate taxes will more than compensate for the increase in CAD in a medium-term scenario. If growth is triggering the deficit, in the medium - long term the revenue from taxes should tune down the deficit. Hence, given that the current account deficit is primarily growth driven, we believe that the same will turn-down over the medium term.

WF: We have seen a number of recent fund launches that focus on the Indian consumption theme. To what extent is there an overlap between a consumption themed fund and a services themed fund?

Sunil: The overlap would be to the extent of 30% - 35% between consumption themed funds and Sundaram Services Fund. Consumption themed funds would play the retail sector and to some extent retail financing sector. There are many sectors like logistics and transportation, Information technology, online trading, asset / wealth management industry, media and entertainment which are within the scope of services themed funds, but not in consumption themed funds.

WF: What would you say is the key investment argument for your new fund?

Sunil: There are 3 factors which constitute the key investment argument fund –

  • Over the past 50 years, Services sector’s contribution to GDP growth has been growing on the backdrop of growth in the outsourcing industry – this is the fastest growing macro sector of the economy
  • There is a vast set of stocks (~190 stocks) which fall within the ambit of services theme – 30 largecap, 40 midcap and ~120 smallcap – this presents enough opportunities to play risk and reward across market cap
  • Arrival of GST is a preamble to this sector becoming more organized – this transition from being unorganized to becoming organized will be the biggest boost to the industry.

Like in the case of developed nations where the contribution of services sector to GDP is ~70%, we will see that Indian services sector which is currently contributing ~54% will move towards a higher number (possibly 70%). While the unorganized to organized transition happens, there is going to be a shift from unlisted to listed – this essentially means the opening up of wider opportunities for a services themed fund. Currently the market cap for services sector is merely 34%, this is likely to move towards 54% while the 54% scales up towards the intended 70%.

The fact that 51% of the FDI is routed towards services sector as of today, this will see further rise. Further, the exit route for FDIs is public listing, this emphasizes on the fact that the growth / transition in this sector will create more listed companies in this space. A pre-dominant part of the funds flowing in from foreign destination is coming into the online services segment, around 15-20 companies have managed to raise capital to the extent of Rs. 1.7 lakh crores over the past 5 years of which in the past 8 months has seen 9 companies raise Rs. 22,000 crores. All these companies (Zomato, Value Research, Paisa Bazaar, Amazon India, FlipKart etc.,) will eventually list on the domestic bourses to enable the investors to exit and take the funds back to their country. This is likely to pan out in the next 3-5 years. There will be huge addition in the listed space coming from these companies which will grow at a very rapid pace. The services fund will be ready with the necessary funds to encash this opportunity for long term value creation.

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