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FUND MANAGER INSIGHT
Is this the right time to be investing in midcap funds?
Lalit Nambiar - UTI Mutual Fund
03-May-18

Markets gave an excellent opportunity to the value investors and cleared the way for them by bleeding the speculators who were dominating markets. Fall in rupee may have already absorbed some of the pain. Banking sector has big debts and NPAs. The core philosophy is to buy good businesses going through a bad phase.

Mutual Fund Live connects with Mr. Lalit Nambiar of UTIMutual Fund on the UTI Midcap Fund. Read on to know his insights on the Midcapspace and the fund.



MF Live: The markets have been volatile for a good time now. How do you see the current state of the market? Where do you anticipate them to head in the near future and over the long term?

Lalit Nambiar:
India has come out of a macro sweet spot in terms of the twin deficits. Rising crude price means that the consolidated fiscal deficit as well as current account deficit have waned but are far from disastrous or even weak. We have a healthy prognosis from various weathermen on the impending monsoon but the farm sector is supposedly in distress. However, anecdotal evidence on tractor and vehicle sales and other indicators speak otherwise. With state elections in the next few months and the general election scheduled next year, potential government largesse is making the markets nervous. Overall, it seems to be a mixed bag, which is usually the case for most periods in the stock markets. Markets seem to have digested the downsides perhaps because the fall in the rupee may have already absorbed some of the pain. In addition, there is a dearth of alternate asset classes, given realty and gold are suffering from short-term memories of an indifferent run. Upside scenarios include an early general election which could mean lesser sops and lower inflation, the banking sector imbroglio may finally, finally  be seeing a light at the end of the tunnel in terms of NCLT resolutions and senior management changes. Overall, the prognosis on the Indian markets is hardly worrisome and demographics is likely to provide a significant long-term tailwind. Predicting market levels is a mug’s game, but if it helps set a context, a scenario I have top-of-mind currently, is that the market will probably wander about a bit until general elections and crude could correct after the ~$100bn Saudi Aramco IPO, set for later this calendar year. In which case India should be able to do better than muddle through the next 1-2 years. Rising consumption expenditure over the last decade or so should result in higher capacity utilisation levels, that and a reinvigorated banking system should trigger the next investment cycle. The economy should probably have well and truly taken off by then and hopefully the equity markets would catch this trend early. 

MF Live: How are mid cap stocks valued now? Is there a potential to generate alpha in the space given the current valuations?

Lalit Nambiar:
Put another way I think the question seems to be “is this the right time to be investing in midcap funds?” Thinking fast, the lazy answer is that the large cap indices seems overvalued on a trailing basis and by that measure at least, the midcap indices are similarly looking overvalued. Thinking slowly, there is the slight danger of oversimplification in this analysis. One, Midcaps are less researched names and tend to grow faster as they are performing off a smaller base. Therefore forecasts tend to be fewer and less accurate and what may seem expensive on a trailing basis may not be so on a forward basis. Two, also unlike large cap funds, midcap funds tend to have a greater active weight through more non-index names and these names can be different for different funds. Stock picking skills therefore play a much bigger role in alpha creation in midcap funds, so I would say there is always potential to generate alpha depending on skill (and luck which is so rarely acknowledged). Three, most experts agree that it is almost impossible to time the market, so maybe we should think in terms of maintaining a judicious asset allocation based on our risk appetites rather try to time the shift between asset classes or between segments within an asset class.

MF Live: The portfolio of the stocks is diversified across various sectors. How have you positioned  the UTI Midcap Fund? 

Lalit Nambiar:
In this fund, we attempt to build a margin of safety by buying above average companies, in terms of past track record, at a weak phase in their operations. The core rationale of course is that the company’s operations would eventually revert to mean on business performance or recognition for core fundamentals. Necessary conditions or the core theses to support this rationale of improvement would include; One, change in industry conditions; Two, rejig in leadership style/business setup or market environment;; Three, a structural shift in the industry (usually regulator or environment-driven); Four, an optional upside not at all priced in to valuations or Five, something unique or under-appreciated characteristic, of the company. An expectation that in due course the company would rise to its natural level, above the trajectory presently baked into the beliefs on its long-term prospects. When internal metrics such as sales and profit growth eventually revert to mean, the improvement in trajectory tends to be extrapolated and the overall sentiment on prospects gets a boost. With earnings and sentiment (read valuations) working together, the resultant construct for stock price is usually very healthy and this is the space where the fund hopes to generate alpha. In terms of distribution, as a bottom-up fund, rather than discuss sector breakup, we prefer to slice it by the core theses I mentioned earlier. Therefore, when one looks across these theses buckets about a third of the portfolio is in names where we think the main driver of reversion is Industry Consolidation or Debt deleveraging usually due to cyclical factors. Close to about 40% is in names where the drivers are intrinsic such as a Leadership or Business or Market Model rejig. A bit more than 10% is sitting in the Structural Shift bucket mentioned earlier. The balance say about 13% of the portfolio is currently divided equally between Option Value going free and Niche/Enigmatic businesses.

MF Live: What is your approach and methodology for selecting the stocks in the portfolio?

Lalit Nambiar:
That is a key question and therefore may require a rather detailed answer. The core philosophy of the fund UTI Midcap Fund is to buy good businesses going through a bad phase. It primarily enacts this philosophy by picking stocks from a bottom-up perspective, as selection is driven more by the unique characteristics of each company and helps tune-out some of the noise around the macroeconomic scenario. We think this strategy benefits the fund as mid-sized companies usually have more room for growth given their smaller base and are typically less affected directly by broader themes. As and when the company's fortunes begin to improve, the fund attempts to capture the wealth generated during this recovery phase. That said I do look at companies in my portfolio as a business owner and so I would not rush to sell them just because their performance improves and valuations rise so long as the growth runway ahead seems sufficiently long. While we stress bottom-up, we also set some top-down baseline assumptions on the business environment within which each of these companies work as well as how their fundamentals correlate to each other under various business scenarios. This helps us understand the portfolio exposure to different macro risks. For example, if bottom-up a coal-based power generation company seems attractive, on a top-down basis one cannot ignore the fact that the alternative energy narrative may have permanently damaged the viability of its business and that of its bank. Precision in measuring these risks is difficult but a top-down overlay keeps us alert regarding the extraneous risks affecting the portfolio. Hence, when one looks at the portfolio from a sectoral perspective, it may look like we are overweight in certain sectors but that is more of an unintended outcome of the bottom-up process I spoke about earlier rather than an intentional result of a top-down investment process. 

MF Live: How do intend to position the fund in the near future? 

Lalit Nambiar:
The fund process and positioning are well established and the track record is hopefully sufficiently robust. The positioning as we see it therefore, will remain unchanged, as we expect there will always be gaps, which this fund can exploit under most market conditions.

MF Live: Is there a specific investment strategy that you always stick to- Growth, Value, Contrarian, etc?

Lalit Nambiar:
Value to me implies that the price does not fully reflect the intrinsic value of the business. Hypothetically, this could span a spectrum of stocks from those valued attractively relative to their long-term cash flows to those where the asset values are compelling relative to the price. That said, at the time of purchase I prefer to look for value propositions. Put another way, we find margin of safety in buying good companies during a transitional phase. Again, a contrarian, by definition, begins her/his search for stock ideas from a space that the market has largely ignored or trashed. Our quest for turnaround names and the bottom-up approach to identifying them usually results in stocks situated in such contra spaces and to that extent, the process would make our strategy contrarian.

MF Live: How often do you analyze the overall portfolio of the fund? 

Lalit Nambiar:
As part of the internal process, each fund is reviewed with the investment steering committee on a half-year basis and with the Head Equity at least once in two months. Portfolio weights are deliberated within the investment team each quarter while the internal research view on each stock holding get discussed at important trigger points such as news or changes in views and during quarterly results.

MF Live: Which investors should advisors recommend the fund to? What should be the time horizon and how should the fund be positioned in their client’s portfolio?

Lalit Nambiar:
Short answer is it should be recommended only to disciplined investors with a time horizon of at least 5-7 years and even then the longer the better. Positioning should be that of an extremely long-term wealth creator, which allows one to raise their lifestyle quotient whilst they are earning and helps maintain it post-retirement and then some, allowing one to perhaps leave behind legacy wealth. Long answer is, data for the last ten calendar years shows that in eight of them, midcaps outperformed large caps.  One can then interpret this to mean that fresh asset allocation to equity is essentially as an allocation to midcap equity versus say real estate or gold. The fence sitters may perhaps be more attracted to midcap stocks/funds, as the potential returns in more exuberant times seem to more than justify the risks. Extending this logic a bit further one can say that in the investor’s risk-return matrix, midcap stocks/funds are to equity what equity stocks/funds are to fixed income products/funds. But with higher return expectations, one must assume more risk which in equity is primarily liquidity risk, which one cannot exit at a time of one’s own choosing and expect to maximise return. Thus if fixed income is at one end of the spectrum of credit risk and duration, equity then is at the other end with high risk of capital loss and infinite duration with respect to interest rate change. All midcap funds, including this one, therefore will be more volatile. Only an investor who is very determined to accumulate wealth and therefore very disciplined and steadfast in their outlook can enjoy the full potential of the returns they stand to provide.

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