Fund managers' mantra: How should you build a portfolio?

The Indian market has had a good 2012. However, it has been very volatile over the last few sessions. How should you build your portfolio? Should you use top-down or bottom-up approach? Fund managers help you build your portfolio.

Speaking at Morningstar conference, Sunil Singhania, head-equities of Reliance Cap AMC says India is a very interesting place. "We have a large number of entrepreneurs, large number of companies. We have companies that are of global standards in terms of scale, perception and operations. We also have a lot of upcoming sectors. While not undermining the importance of sector allocation and top-down, I think we cannot ignore bottom-up stock picking because a lot of sectors are new to India. We would definitely focus on new sectors and new companies," he adds. Meanwhile, S Naren, CIO-equity, ICICI Prudential MF says till 2007, he was very bottom-up oriented and 2008 changed quite a few things. "We did become a good mixture of top-down and bottom-up. That mixture has been continuing. While we are all used to a more bottom-up environment, we have seen that the world has become more top-down. So, I think that transition has happened," he asserts. Also read: Mother-of-bull markets is ahead of us: Jhunjhunwala From a strategy point of view, Naren says, India is perceived as a growth market. "The way the industry evolved between 2004 and 2007 was that a number of products came up. So, to differentiate product, we have a separate product strategy. So, if you have a value fund, it would be a value strategy. If you had a concentrated fund, it would be a concentrated strategy. If you had a defensive fund, it would be a defensive strategy. Post 2007, we have had a tough time to collect inflows. So, these strategies were no longer in those old days where we used to get a lot of money and new schemes. So, we have now stabilised investment processes," he adds. Prashant Jain, executive director and CIO, HDFC MF says think investment approach is mix of bottom-up and top-down, more bottom-up with some input from top-down views. "We focus on sustainable businesses that have good comparative advantages. We have focused yet diversified portfolio. So, we do put reasonable money behind high conviction ideas," he adds. Kenneth Andrade, equity fund manager, IDFC MF says "To be bottom-up, we effectively try and look at opportunities which are scalable. We try to polarise capital into the strength of the entire economy. If you go by historical trends in the Indian market and also globally, I think some of the biggest money has been made when capital actually gets polarised around certain environment of the entire market. So, in year 2000, we had technology part of the market. In 2007, we had the investment economy that drove capital markets worldwide. That’s where alphas effectively got created. So, the planning in terms of creating portfolio is to try and identify and be ahead of the entire curve in terms of putting capital to work there So, we are concentrated to an extent, but we run our diversifications across that entire category of industry or sector." Below is the edited transcript of the interview on CNBC-TV18. Q: You are a little more balanced between top-down and bottoms-up. I think from a professional’s perspective, but even at the individual level, keeping tabs on what is happening in the macro environment around the world is extremely challenging, if not impossible in some cases. Given that, what is maybe one macro event globally that you think investors or people in the audience should try to get their head around to help them in their Indian investment? Singhania: I think we have tried a lot of time, but frankly macro economy is something, which we have failed miserably in predicting. We continue to try. We have a three member macroeconomic team. I would say there are very important two things from India’s perspective. One is a sharp surge or a sharp fall in oil prices. It definitely has a major impact on India’s P&L and balance sheet as a country. The second thing, which has become the most important, is liquidity in the global markets because that is a reflection of even pain being mitigated and vice versa. So, I think global liquidity and oil prices, atleast from an India perspective, would be two things which we would recommend. We have a close eye on them. Naren: We have always believed that oil prices are single-most biggest economic variable. The second one, which particularly we look at between July and September, is monsoon. Both these are essentially unpredictable. We react to what happens rather than trying to predict what will happen to a monsoon or an oil price. I think while valuation is not a macroeconomic variable, what we have seen is that valuations are a very good macro economic variable from the point of view of asset allocators. My experience has been that when valuations are extremely cheap, it is time to invest. While that is not a macro economic variable, people need to focus on that. Do you use valuations only in the form of price to earnings? May not be. But, internally, we look at price to earnings, price to book and marketcap to GDP. We have seen that a composite looking at these three variables, which are not macro economic, but valuation orientation, would be very useful for investors. Somehow when valuations become extremely low, people tend to be more cautious. We have seen this in almost all parts of the world also, not just n India. Q: You focus more on the bottoms-up. How important are competitive advantages to your analysis? Jain: I think it is quite important for us. We invest with a long-term view. Right now, our portfolio turnover is 20 percent, which means average holding, right now, for last two years, has been about five years. So, I think it is extremely important. Some of the mistakes that we have made is either these businesses did not have competitive advantages or we assess them wrongly. So, I would say it is extremely important. Andrade: I think any stock that come on to the portfolio has to survive the next cycle. So, what we essentially look for in terms of creating a portfolio is to look at market leadership and what are the qualities that drive market leadership in its particular category. So, it is increasingly critical as to every time you need to make a portfolio scalable, that you get the right kind of companies on your book. So, you have to have leadership skills or you have to have a cost basis, which will help them survive the next cycle, in an economic rundown. So, both these put together, it is increasing necessity to have this in terms of building it on to your portfolio. Q: What sort of time horizon do you guys work with? Singhania: Last four-five years have been very tough for investors. Very miniscule returns have been made from the equity markets. But I think we have to look at it from a perspective that we were coming off from a very high base. So, 2003 to 2007 we were growing at 50% CAGR, year after year, as far as equity returns are concerned. Second, we have had a lot of one in a century events over the last three-four years in terms of the financial crisis, even the storm, which has hit US, is like one in a century kind of a thing. So, from an investor’s perspective, if we tell investors that three-four years should be a good enough time, there we can get reasonable returns the question is that we have not got it in the last three-four years. But having said that, if we see the rolling returns over the last fifteen years, even from a three years perspective or a five years perspective, I think equity markets have given reasonable returns. While saying that one should be invested as long as the growth profile of the economy and the growth profile of the companies which form the markets remain strong, I think from an investor’s perspective, the investors should definitely have a timeframe of atleast three-five years. It is very easy for us to say that stay invested forever. But three-five years should be a reasonable timeframe where investors give time for their investments to start to fructify. But probably the last three-four years have been an exception. Q: What is the largest risk to Indian equities right now?

Naren: I have noticed since 2011, people have lost enthusiasm for equity. That worries me the most, because when I look at the data, people have almost a trillion dollars of gold. But, they have only about USD 30 billion of equity mutual funds and maybe USD 10 trillion of real estate in India.
Equities have become a very small part of the asset class. Most of the people today are using all the rallies to only cut their allocations and forget about it. My experience in equities has been that if you have invested in equities, in an environment when everything is bad, you have made money.
Right now, India seems to have a gold real estate culture. We worry that the equity culture which possibly started in the 90s and went on till 2007, it is moving people away from an equity culture. The Indian government has created a good trading system, a good mutual fund system, a good settlement system. The demat system is completely computerized, the income tax laws are reasonably clear but despite all that, the quantum of money that people are looking at in equity, has become very small. While it may not worry me in the near-term, but in the long run, it is essential that people look at equities as well. Q: What changes that sentiment when you are speaking to your clients and investors? When you give them that message, what sort of change does that send broadly in the market? Naren: What we have done within our firm, is that we have come up with products, which are possibly better equipped for a lower return world.  So, we worked on creating these products in 2009, because it was very clear after 2007 to 2009, that we were in a new world and the world that existed between 1991-1992 and 2007 does not exist any longer. We worked on creating products, which would deliver better returns in a lower return situation.
Also, we continuously communicate with investors. We have broadened our range of fixed income products as such. So these are the things we have done as a firm. Q: Sort of kind of find that comfort space I guess and give them the products that they need? Naren: Yes. Q:  What do you see as the biggest risk in the Indian market?

Jain: It is one way to say that I’m worrying about investors not investing. But I think, that is how investors have behaved worldover, that money rarely comes in when P/E multiples are low. Ninety percent or more of money comes in at close to very expensive valuations. It is unfortunate but it is true. I personally, do not see it changing. So yes, one may worry about it, we may do whatever we can about it, but still I do not see it changing.
I think what material is or what is worrisome for Indian markets, is a hike in oil prices. Today, we do not have any buffers either on current account or on fiscal account. So, I think, if oil prices spike from here, it would have a detrimental impact on both the economy and the markets. On the other hand, if oil prices come off, it would have a positive impact.
Another worrying issue is if we fail to reign in our fiscal deficit. Most of the problems that we are facing are internal problems. They are self inflicted issues and I think the solution also lies within us. So, if we do not manage to curtail our fiscal deficit, I think we will not realize the growth that this country is capable of. Q: Some of the reforms that are being debated, that are put in place. Sunil and Kenneth do you mind maybe speaking to reforms or regulatory changes that are sort of on your radar that could potentially impact equity markets here? Kenneth: When it comes to the regulatory issues I think we have been caught up with number of regulatory issues virtually in every industry for the last two or three years. Our own regulatory issues are at its peak at this point in time. The regulator, till date has concentrated on regulating profits and not contributing in growing the entire business and you would tend to see a very mark shift in the way they would approach the industry going into next couple of years. So, our sense is that, as far as the regulatory risks are there we are peaking out.
For corporate index, it has basically acted the reverse way around. It has to a very large extent, contained the number of new players who could incrementally come into the entire business. So, in a sense, it’s helping the business actually consolidate itself and over a period of time get profitable. I see a sense of the change happening.
Whether it is regulatory issues, or businesses not making profits or too many entrants into the entire business, all this should contribute into a very self sustaining eco-system in their respective industries going into the next couple of years. So, profitability based because of regulation should improve much more dramatically going into the future. Q: What industry do you think in India is particularly plush with competitive advantages If you had to put capital in an industry today and you couldn’t touch it for 5 years, what industry would that be? Singhania: India definitely scores in knowledge based industries. We have seen the benefit of IT flowing through the economy over the last 20 years, not only in terms of reining in our dollar deficit, but also in providing a lot of fillip to employment and development of real estate and so on.
I think a similar industry which is looking very good is on the pharmaceutical side. The advantage of that sector is that there is huge potential domestically. The total domestic pharma industry is roughly only USD 12-13 trillion and Pfizer’s one drug, Lipitor used to sell more than that globally.
So, I think that is a scale of opportunity domestically. The second opportunity also comes from generalisation of a lot of drugs which a lot of countries and their governments are forcing upon their healthcare system, because ultimately the governments have to bear the burden of it.
In this respect also, the Indian companies are there, The companies have a cost advantage because of the huge knowledge pool we have. So, one industry where we think that we will have lot of advantage for 5-10 years to come is pharma.