Overvalued high-growth, high-quality stocks still correcting: Anand Radhakrishnan of Franklin Templeton MF

Over the last year, our performance has been improving across fund categories. A year ago, we were doing well only in flexi-cap and focused equity. Some value categories have started joining it. We are also seeing improvement in small- and mid-cap. In hybrid and large-cap, it is still work in progress. Yeah, the fixed income issue happened at an unfortunate time when our performance was also bad.  Prior to that, investors were worried about our performance, but they were still hopeful that things were going to get better. But post that, people had one more reason to redeem money from our funds.

As far as winning the confidence back in terms of more consistent performance goes, a substantial part is done. Of course, some of it must show up in a commercial sense in our numbers. Today, there are some 35 different distribution firms who have reboarded our funds after taking us out. So, that is the visibility that things are improving.

Three things matter for performance — whether your investment strategies are aligned to the market cycle, whether you are correctly positioned in terms of ideas, and whether you have less share of mistakes. Take the current market situation — global growth is weak, domestic growth is strong; broad improvements are there in financials and capital goods while there are headwinds in IT. If you are appropriately positioned, you will not have massive challenges. In this situation, if I am overweight in IT or metals and underweight in financials and capital goods – maybe there are good companies, but they will still underperform. This was the situation we were in, in 2018-19.

Secondly, the portfolio should reflect the best conviction ideas.  At times, the degrees of freedom the fund managers take are very high. Sometimes, we purposefully keep it low. While the research funnel gives you the ideas, how well the manager aligns to those ideas is the internal process. Here, we have made some tightening, some better alignment. Thirdly, there are two kinds of mistakes — errors of omission and commission. We had errors of commission — which means wrong ideas over-represented and right ideas under-represented. We took a conscious step to avoid this. Occasionally, in a fund house’s journey, this mis-positioning happens. How well you correct and realign is important.

Broadly, we acknowledge the fact that post demonetisation, post GST and post Covid, there has been a general push-up in the valuation of most stocks. Pre-Covid, we were of the view that India has structurally moved to a lower inflation, lower interest rate regime and that justifies a slightly higher valuation as valuation is also a function of rates. Covid came and distorted that view temporarily. But if I wear my pre-Covid hat now, to an extent, high inflation and the need to raise rates is somewhat behind us. If that is the view, then you can tolerate a bit of overvaluation.

May be we are 1 PE higher than ideal situation from a Nifty perspective. However, as an active investor, you can leave out some stocks which are pulling the index valuation up and look at the rest of the index. That said, if I look at my value strategy, it is 3 or 4 PE less than the Nifty. But then, it comes with lesser implicit growth. The conundrum comes when people do these trade-offs – do I pay less or do I pay for growth?

But there are times when market overpays for growth – that is getting corrected. We are still in the correction phase – high growth, high-quality companies which were overvalued, which were skewing the index’s valuations, are still correcting. Finally, the growth vs valuation paradigm must align and you must have a robust theoretical framework construct to look at companies and tell you if you have gone from one end to another here.

There was a time when wherever demand was created, capacity was created in China. Now, wherever demand is getting created, capacities are getting created around that demand. So countries have now realised during moments of disruption that we saw, that if you want to protect your economic interest, it is better to have supply chains that are aligned to your national interest. This is where the concept of self-reliance, Atmanirbhar, all comes in. So, people need to put money on setting up capacities. Luckily, people have the money. Balance sheets are clean. Banks are willing to lend. I will lend lot of credibility to the story that this is the revival of manufacturing, revival of DIY rather than outsource in many sectors – can be medical equipment, defence, solar, electronics, speciality chemicals. This will gather momentum.

Portfolios should adequately reflect this economic reality. If you still orient yourself to hyper consumption stories which are at very high valuations and don’t look at good manufacturing ideas, you will be shutting yourself off from good returns. Such cycles, when they happen, they run long. How long? There are many kinds of cycles. Some are shallow cycles, some are deep cycles. Rise and cuts in IT spends is a shallow cycle; the auto sales cycle is not very deep; but metals and capital goods have deep cycles – when they go down, they go down a lot and for long. When they go up, they go up a lot and for long.

If you only look at existing names, choices may be limited or may look slightly overvalued. But unlisted companies in this space may already be existing. It is just a question of getting listed. When cycles run for a long period of time, existing and new set of ideas will come. Post big 4 in IT, many other small companies got listed and people made money. Similarly, you will have companies for every ABB, L&T and Siemens of the world.

When economic cycle coincides with the market cycle, then you are doubly impacted, positively as well as negatively. For example, the economic cycle of 2003-2007 was very expansionary, both globally and locally; In markets too, globally, there was a lot of pumping of money post the tech-crash and this fuelled a big boom, which culminated in the global financial crisis (GFC). There you saw that, economically, there was a period of substandard growth and the market cycle also aligned, at least for 2/3 years. It took many markets a decade to come back to the pre-GFC level. In dollar terms, many of them have still not crossed the GFC peak. Now, is that a deep cycle or a shallow cycle?

In India, we were slightly luckier. Our economic growth pulled us above the GFC peak and we touched a new peak both in rupee and in dollar terms. India is one of the few countries among emerging markets, which in dollar terms, is higher than GFC peak. So, the cycles are working. It is just that the currency you are using to measure that is masking it. Most of the local currencies have depreciated against the dollar. Rupee has moved from 45 to 80 over the period.

In a nominal sense, it looks like the markets have given great returns. But in a real sense, measured from the perspective of a more stable currency, the returns are normal.

The second point is that, if the economic cycle itself is shallow, markets cannot have deep cycles. Third is the active role of policy makers in the last decade or so. Central banks around the world didn’t want a reverse wealth effect. In many markets wealth is linked to consumption and growth. If wealth collapses, economy collapses. So that is why they wanted to protect asset prices. Protecting asset prices means keeping the interest rate low, which implies keeping the bond prices, equity and home prices high. Because of policymakers’ sleight of hand, the tolerance to having a deeper cycle has come down.

Conceptually, if the investor wants a low-cost fund but is willing to pay for (out)performance, we can create a performance-fee based share class, just like there is a direct and regular share class. Here, instead of charging, say, 1 per cent AMC fee, you say you charge 0.5 per cent. If the fund beats the benchmark by 1 per cent, for example, you can charge additional 10 bps, for a 2 per cent outperformance you can charge 25 bps – basically, some carry.

At an individual investor level, implementation is not insurmountable. Management fee is charged on a daily basis. Say that I keep monitoring my daily rolling 1-year relative performance; whoever enters at any point, based on the last 1-year rolling performance (or whatever is the performance measurement period which we have agreed to), I can say that XX per cent is our current carry on outperformance which we will be charging. For example, you enter when I am charging 0.7 per cent and then, one year later, my performance has improved, I am charging 1.1 per cent. On average, you would have paid something between 0.7 and 1.1 per cent and you would have captured the in-between period’s return.

AUMs naturally gravitate towards better performers. Hence, with or without performance fee, industry is already aligned to deliver better performance to investors. Secondly, suppose because of outperformance, the fund gets more AUMs, then the expense ratio falls when the fund moves to the next AUM slab. And that adds more outperformance. Then, you are foregoing fees for creating performance whereas, conceptually, if you are outperforming, fees should go up. At the one end while there is a call for size-linked TER, at the other, there is a performance-linked TER. But size is linked to performance, which is somewhat conflicting.

People are moving, isn’t that so? If a large-cap fund is beating the index, money will come back. So, it puts pressure on the large-cap fund managers. Market votes with its feet. Agree, money will not flow out overnight. Some funds/fund managers will be given a longer rope because of historical track record. In some cases, the vote will be immediate. If investors are willing to give a long rope to the fund manager, then we should let the market forces play themselves instead of taking a very prescriptive view about it. Competition and customer satisfaction are invisible and unwritten forces that shape any industry. Regulations that nudge the industry towards right practices have always been welcomed.