Markets may do well even while there are challenges and by the time all challenges are resolved, there may be little juice left.

When a fund house manages to multiply your money nine-fold in 10 years, it draws in even the most sceptical of investors. That is what HDFC Mutual Fund has done. The fund has been remarkably consistent too, a sign of the level-headedness with which Prashant Jain, the fund’s Executive Director and Chief Investment Officer, approaches the often whimsical business of stock market investing.

Is the fund’s past a hard act to live up to? And are high stock returns in India a thing of the past? Business Line spoke to India’s most respected fund manager, to get his views.

Four of your equity funds have managed returns of 25 per cent or more in the last ten years, with HDFC Top 200 proving very consistent across market cycles. Can you tell us what made this track record possible? One competing fund told me it must be due to a quant-based model!!

Let me first clarify that there is no quant-based model at work — in fact, I have never used one. My approach to investments has been pretty simple. Buy sustainable businesses that are managed by good managers, at or below fair values, maintain reasonable diversification and have patience.

I think it is also fair to say that while the performance of HDFC Top 200 over medium to long periods has generally been good, there have been short periods when the performance was average. In 2007, for example, when the rally was mainly led by stocks in real estate, NBFCs and power utilities, the fund did not do well. The fund stayed away from these sectors as, in our opinion, these stocks had issues of either quality or valuation or both. Whereas this hurt short-term performance, it helped performance when the markets finally corrected the excesses.

A key feature of the investment strategy has been to invest in good quality, sustainable businesses that are available at reasonable valuations. It is essential to maintain this discipline in tough times and not to succumb to pressure, in order to control risk. Risk control is as important to wealth creation as is generating returns. An investor who generates moderate returns fairly consistently with limited downside risk is likely to do better when compared with another investor who sometimes achieves spectacular returns but makes occasional considerable losses. A 16 per cent return over a decade is more than 20 per cent returns over nine years followed by a 15 per cent loss in the tenth!

Investor faith in equities is at a low ebb today, with the Sensex return over five years at barely 3 per cent, while gold has managed 25 per cent. Can past returns be replicated over the next 10 years?

Even 10 years ago, one had neither expected nor targeted 30 per cent returns. It is, therefore, hard to say how the next 10 years will be, but the guiding principles should stay the same.

It needs to be noted that a significant portion of the total returns of a fund over long periods comes from market itself. Despite the pessimism in the markets and the challenges in the economy, in my opinion, unless we really mismanage, the economy should, in the current decade, grow faster than in the last decade.

The markets should also, over the medium to long term, do well, given the prevailing below average price-earnings (PE) multiples and the likely fall in interest rates. Thus, in addition to earnings growth, returns should be aided by expansion in PE multiples.

Another source of returns for an actively managed fund is the out-performance. HDFC Top 200 has outperformed the benchmark by a handsome margin over long periods. We will endeavour to continue this. But most out-performance is achieved due to market excesses and is, therefore, typically lumpy.

HDFC Top 200 and HDFC Equity are today among the biggest equity funds in the industry, each managing over Rs 10,000 crore in assets. At what point does size become an impediment to performance?

It is true that these funds are larger than other funds. But the size of these funds and in fact, of all mutual funds put together, is small compared with the Indian markets. The largest fund is just about 0.2 per cent of the market capitalisation. There is thus little risk of being crowded out.

Fund sizes are not close to a point where they start impacting performance, particularly against the benchmarks, in my opinion. I did a small study of performance of funds larger than Rs 1,500 crore and smaller than Rs 1,500 crore against their benchmarks.

The proportion of out-performing funds in both categories is nearly the same. Over longer periods, larger funds have, in fact, fared better.

We often cite HDFC funds as an illustration of how well active investing works in India. But with fewer active funds out-performing the indices in recent years, would you still advocate active investing?

I am a believer in active investing. By and large, nearly all HDFC funds have added value over benchmarks over medium to long periods. Yes, there is an increasing tendency to index globally. But as Warren Buffett observed — “in any sort of a contest — financial, mental or physical — it’s an enormous advantage to have opponents who have been taught that it’s useless to even try”.

The market has rallied 20 per cent this year. There are worries that this is not backed by fundamentals. Is this the time for retail investors to buy stocks or should they take profits where they are available?

Despite the up-move in the markets, PEs are below long-term averages and interest rates are likely to fall over time.

In my view, over time, there is room for markets to do well and apart from earnings growth there is room for multiples to expand too.

I am not saying that there are no challenges or that everything is great. However, please remember that markets know as much as you and I. Markets discount both bad and good news fairly quickly. Thus, markets may do well even while there are challenges and by the time all challenges are resolved, there may be little juice left in the markets.

Past experience suggests that PEs tend to move 10-12 times at the lower end and 20-25 times at the upper end. The journey from bottom to peak and back takes considerable time and investor patience at lower PEs is well rewarded over time.

Every market cycle usually has new lessons for investors. What should we learn from the most recent one?

In the 20 years that I have been with the markets, I have experienced three major cycles and in each one of these a vast majority of investors have mistimed their investments. This is disturbing but unfortunately true.

Consider the accompanying data. As the Sensex went up from 3000 levels in 2003 to a peak of above 21000 in January 2008 before ending close to 15600 levels in March 2008, net sales of equity mutual funds increased from just Rs 118 crore in 2002-03 to Rs 53,000 crore in 2007-08. Since then, in down markets and at lower PE multiples over the years from 2009 to 2012, equity funds have seen outflows of Rs 6,000 crore. In simple terms, when PEs were high, more than Rs 50,000 crore worth of equity funds were purchased in one year in FY08 and when PEs were lower, nearly Rs 6,000 crore worth of equity funds were sold by investors over four years.

This is so because investors wrongly base their investments on past returns and on news flow and not on PE multiples.

Investors should simply practise low PE investing. Low PEs are typically available only when the news flow is bad, when market sentiment is weak and when the markets have not been doing well.

Presently, though the markets are up 20 per cent, PEs are below long-term averages. Further, interest rates are likely to move lower. Investors, in my opinion, should maintain or increase allocation to equities in line with their risk appetite and with a long-term view.

Going by the lack of flows in equity funds for last several quarters and in fact some redemptions, history may repeat itself.

As long as this behaviour of investing disproportionately large amounts after strong past returns and investing close to nothing after poor market returns continues, in my opinion, investors will continue to gain less from equities and several may continue to feel dissatisfied.

As Einstein said, “Insanity is doing the same thing, over and over again, but expecting different results.”

(This article was published on November 24, 2012)
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