Franklin Templeton equity funds go up when things are down. Here's why

Janakiraman R, Senior VP and Portfolio Manager, Emerging Markets Equity - India, Franklin Templeton

Franklin Templeton Mutual Fund manages Rs 66,507 crore of investor money (as of April-end, 2023) across its equity, debt, and hybrid schemes. The Franklin India Flexi Cap Fund, the fund house’s largest scheme in terms of assets managed, is, however, far from being a category topper. Its returns record puts it just about in the middle of the category – ranked 15 out of 35 flexi-cap funds.

But the scheme has beaten its benchmark, the Nifty 500 TRI (total return index), in 1-year, 3-year, and 10-year returns. On a 5-year return basis, the scheme just about matches the index performance.

This is broadly in line with what Janakiraman R, Senior VP and Portfolio Manager, Emerging Markets Equity - India, Franklin Templeton, says is their approach to managing the scheme.

“Our product philosophy is not to aim for the stars in terms of portfolio construction, but to consistently deliver 50-100 basis points (bps) alpha over the index.” Alpha is the excess return relative to a market benchmark for a given amount of risk taken by a scheme.

The scheme is managed by three fund managers, Anand Radhakrishnan (since 2007), Janakiraman (since 2011), and Sandeep Manam (for investments in foreign securities).

Janakiraman spoke with Moneycontrol’s Maulik and Dhuraivel Gunasekaran on the performance of funds managed by him, his small and mid-cap stock selection strategy, and what he thinks of active large-cap funds.

Keep it steady

Commenting on the flexi-cap fund, Janakiraman says, “Typically, the portfolio will have about 70 percent exposure to large-caps, and the balance 30 percent will come from a combination of mid and small-caps. The approach is to deliver an index-plus return on a reasonably consistent basis. I don't want a fund that gives significant alpha in some phases, followed by very poor performance.”

Talking about the 40 quarters ending March 2023, Janakiraman says that the scheme has given positive alpha vis-à-vis the index in 20 quarters and negative alpha in 20 quarters, which means there has been a small alpha on average.

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On the fund’s future prospects, Janakiraman says, “This performance has been in a liquidity-driven market. A common thread across all our products is that they tend to do better when there is uncertainty and volatility in the market. So if you have a combination of upcycles and downcycles, our ranking will go up.” According to him, this is because the fund is good at containing downsides.

Small and mid-cap performance

Janakiraman has been at the helm of both Franklin India Prima Fund (mid-cap fund) and Franklin India Smaller Companies Fund since February 2008. Asked why the funds have been lagging in performance since 2016, Janakiraman says he had a really tough time in 2020 and the two years thereafter, largely due to the dramatic liquidity-driven rally, as their funds normally underperform in such a phase.

“After such a phase, there is a consolidation, and that is when our funds tend to bounce back,” says Janakiraman.

He added that both in 2007 and 2017, once the bull phase got over, they undid their relative underperformance in the next 1-1.5 years.

“This time the bull market was from March 2020 to the end of 2021, almost 21 months. So it will take us some time to claw back in mid-caps. In small-caps, we've come back meaningfully,” adds Janakiraman. In the last one year, Franklin India Prima Fund and Franklin India Smaller Companies Fund have delivered 19.8 percent returns (versus 19.5 percent for the Nifty Midcap 150 TRI) and 29 percent (versus 15.5 percent for the Nifty Smallcap 250 TRI), respectively.

Janakiraman says that the two sectors that really did very well in 2020 and 2021 were IT and mid-cap pharma. “In both cases, there was a massive rise in valuations, especially in IT. We were a bit underweight on the sectors, so missed out on the rally. For us, the lesson from this experience was that at least in a bull market, don't take extreme calls versus the index,” adds Janakiraman.

Selecting the right stocks

He also touched upon how their stock selection process has become more data-oriented, especially in the small and mid-cap space. “I think now we spend more time on data like earnings upgrades, downgrades,  trends, etc.

He emphasised that they have a fundamentals-driven investment approach, but while earlier it was largely business-level data, now they are adding a layer of market-level data too.

Elaborating on their small and mid cap stock selection strategy, Janakiraman said the idea was to invest in quality businesses. “We look for a combination of free cash flow, return on capital, and growth. Three simple metrics, but very difficult-to-deliver metrics. So, if you look for a combination of this, the universe is not very large. Apart from this we follow a buy and hold approach. The churn in the Prima fund is about 25 percent, and in the Smaller Companies fund it's about 20 percent,” explained Janakiraman.

Talking about portfolio concentration, he mentioned that the top stock positions in the small cap fund are well over 2 percent “They have gone there just by appreciation. They were not so big at the time of investment. We consolidate during downcycles, when quality businesses are available at a relatively fair valuation,” said Janakiraman.

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Liquidity-driven rally helped passive funds

On whether the days of active large-cap funds are over, he said one has to look at this from two angles: one, the market phase, and two, the market-cap.

“If you have a market which is very liquidity-driven, then a large part of the returns will come through P/E expansion. That means, market returns will be more than earnings growth. In such a market, active managers will tend to struggle,” explained Janakiraman.

He pointed out that in the last 10 years, there has been a high degree of liquidity in the markets and investors have not seen any meaningful downcycles, except for event-driven crises such as Covid or the Taper Tantrum, that did not last long. “For active funds to deliver alpha, you need a combination of an upcycle and a downcycle.

“Typically, most active managers tend to be value investors. That means, in a market which is moving towards higher valuations, an active fund manager will not be comfortable adding such high-valuation stocks to the portfolio (and hence miss out on the upside, unlike a passive fund).”

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On the market cap front, he said that large-cap investing has become much more competitive. “The probability of generating alpha in a pure large-cap product will be lower than in a mid-cap product, which will be lower than a small-cap product.  There's not much to argue against that thesis,” added Janakiraman.