Key Factors To Quant-Based Investing — NJ Asset Management's CEO Explains
It is a myth that there are no quality stocks in small and mid caps, and the fund's model helps in removing this bias, Shastri said.
NJ Asset Management's fund performance varies widely from the index, as the approach to allocating funds is quant-based instead of the traditional sectoral or capitalisation-based allocation, according to Director Rajiv Shastri.
"Our investment approach is what is called factor-based investment, or quant investment," Shastri, who is also chief executive officer of the fund, told NDTV Profit’s Sajeet Manghat on The Portfolio Manager show.
The basic thesis behind it is using past data to identify desirable characteristics in stocks and aiming to benefit from the characteristics, he said.
Quality, value, momentum, and low volatility are the desirable characteristics, according to the fund manager. "We don't really go in for sectoral allocation in the traditional sense."
The fund starts with the 300 largest stocks by free-float market capitalisation and then filters it down based on various quality factors, he said. "We are completely agnostic to all sectoral allocation and that is why our performance will vary widely from the index, both positively and negatively."
The fund also does not look at expected returns while allocating funds, rather the quant-based models have proven to be robust, he said.
The fund has a very reasonable mix of stocks, while following its investment model. It is a myth that there are no quality stocks in small and mid-cap space, and the fund's model helps in removing this bias, Shastri said.
The NJ Bluechip Portfolio has 39.53% allocation in large caps, while the mid and small caps have an allocation of 48.75% and 10.97%, respectively. NJ Multicap Portfolio has 46.67% in large caps, 32.12% in mid-cap stocks and 20.48% in small caps, as of Jan. 31.
The fund manager's blue chip fund is quality-based, while their multicap fund is momentum-based, where quality is also filtered in. The four fundamental factors they look at are return on equity, return on equity consistency, debt to equity ratio and dividend payout, Shastri said.
"When we rebalance, we will identify the stocks that show the best momentum at that point in time. We never decide what to sell, but rather determine what we want to own," he said.
Shastri is positive on financial stocks. "The fact that the financials are in the portfolio means that we feel that the rules that we apply tell that it will continue to move positively for a few more months," he said.
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Watch the full interview here:
Edited excerpts from the interview:
What is the kind of approach that you are looking at with respect to investments? How do you go about selecting your sectors?
Rajiv Shastri: Our approach to investment is what is called factor-based investment, or quant-based investment, or rule-based investment.
But the basic thesis behind it is that we peruse past data and are able to use that to identify certain desirable characteristics in stocks and use rules developed on the basis of identification to select stocks. Then those stocks should reflect the performance of those desirable characteristics. So, you know, these characteristics are popularly known as factors. Basically, there are four that are applicable in India, which are quality, value, momentum and low volatility. So, we use these factors to identify our stocks and then invest in those that our models identify. So, we don't really go in for sector allocation in the traditional sense, because we are identifying stocks based on the presence of certain characteristics, the factors that we're looking at, and aim to benefit from the performance of these characteristics rather than the sectors or any such capitalisation or any such slice of the market.
If you're looking at factor-based investing or quant-based investing, how do you determine what kind of return that you're expecting and at what time you select? Is it based on data that you exit stocks as well?
Rajiv Shastri: We do practise our models but it is not from the perspective of what kind of returns to expect but rather whether these models have proven themselves to be robust. Robustness has many implications. Robustness means that we use parameters to identify these factors. So these parameters have to basically show that the top slice, the best companies based on these parameters are able to perform better than the second or the third slice.
So, basically we are trying to see whether these parameters are able to generate better performance than the stocks which we would not have selected based on these parameters. Now, there is a commonsensical approach based on these factors. The factors that I said like quality. When we say quality factor, the thesis behind it is that high quality companies should outperform average companies or those with lower or pure quality. So that thesis is perfectly sound. What we're trying to do is, try to find a database way of implementing that thesis on to the existing stocks.
How do you break up your portfolio into allocations like extra large cap or mid cap or small cap? If you look at quality, many of the large caps will be part of it, but mid caps and small caps may fall short on that criteria of yours. So, how do you look at allocation of your money across these three asset classes?
Rajiv Shastri: Firstly, I think it's a normal belief that large caps are higher quality than mid caps and small caps, but what we've seen in our portfolio—when we identify quality stocks based on data—is that there is a very reasonable mix of mid-cap and small-cap stocks. So it's kind of a myth that there are no small-cap stocks that are high quality or no mid-cap stocks that are high quality. We do find high quality mid-cap and small-cap stocks.
So, we don't have any bias. We don't have any sectoral bias. We don't have any capitalisation bias. Our only bias is the factor that we're seeking to identify.
We have two stock-based portfolios—blue-chip and multi-cap. Our blue-chip portfolio is quality-based, our multi-cap portfolio is momentum-based. But quality is the underlying thesis of all our portfolios. So even in our momentum portfolio, we do apply quality filters just to ensure that on the basis of momentum, we don't get stocks that are extremely low quality, which does happen in many, many bull runs.
Once you do a bottoms-up approach, you select the stocks. Is it then, after that, that you bifurcate them into sectors to see what is the sector allocation, or do you look at some of the sectors which are running up and then invest in them?
Rajiv Shastri: We do look at the sector allocation post facto, purely from an academic point of view to understand what kind of sector allocation is resulting from it, what kind of capitalisation allocation is resulting from it. But, if we are following an underlying factor thesis, let's say, quality, for example and if I were to say that I will always have a 10% allocation to lending companies, now, if I'm selecting companies based on quality, it is possible that I don't see any lending companies in the top 20-25 companies that I want to buy. So if I want to buy lending companies specifically because I have put that condition, I might have to go down the quality ladder to identify those companies. So I might just take the best lending company which might be at 70th in number and the second-best lending company might be 120th in number.
So instead of buying the top 25 companies by quality, I end up compromising the quality of my portfolio by putting restrictions—either capitalisation-based or sector-based. So, our focus is on identifying the factor that we are looking at and not looking at trying to achieve a certain allocation, as far as sectors are concerned or as far as capitalisation is concerned.
I can see from your allocation that you have financials in multi-cap which is basically 20% odd, industrials which is nearly 19.5%, I.T. is 12.4%. You've seen financial run-up happening quite a bit now. About 12-18 month run-up has happened. PSUs have been leading the pack, the private sector has been a little sluggish. How do you see financials going forward?
Rajiv Shastri: It's very difficult for me to kind of form an opinion on the sectors that we are in, on the sector strategy, or the sector allocation that results because that is not the goal. All I can say is that in our multi-cap portfolio, which is a momentum-based portfolio, momentum doesn't have much persistence. So, in the sense that, you have to rebalance it far more frequently. Then, you have to rebalance a quality portfolio, which is far more persistent. Quality is a far more persistent factor. It doesn't change over short periods of time, whereas momentum can change over reasonably short periods of time.
So what we do is that we rebalance the multi-cap portfolio more often, whereas we rebalance the blue-chip portfolio once in a year only. So when we do the next rebalancing, what will happen is that we will identify the stocks that show the best momentum at that point of time—obviously, stocks which are filtered on quality first, which show the best momentum at that point of time.
Answering another question that you asked earlier—do we use a database approach to push to move into a sell? If you look at our approach technically, we never decide what to sell in a predetermined frequency. We determine what we want to buy and what we want to own. If that's already present in our portfolio, well and good. If it's not present in our portfolio, then we have to buy it. And stocks that we already own and which are not coming in the new portfolio we have to sell them to buy the new stocks that are coming into the portfolio. So the sell decision is somewhat automatic, based on what we would like to own, which comes from a periodic rebalancing.
How do you look at the sector—financials—as a whole?
Rajiv Shastri: Financials is a very important sector in the economy. How it performs and how it will be performing over the next three months or six months, honestly, I don't have a clue. The fact that it is part of my multi-cap portfolio means that it is moving robustly in a positive direction and we would like to benefit from that movement. We assume that it will continue for a while, and we'd like to benefit from that movement. So, that is the reason why they're there in the portfolio. So the fact that, you know, financials are in the portfolio means that we feel—at least the rules that we apply, believe that the financials will continue moving positively for a few more months.
When you apply such rules, do you also look at how the sector is performing as a whole?
Rajiv Shastri: Well, not at all. In fact, we apply the rules to a wide universe of stocks. I'll give you an example of a typical portfolio that we construct. So we start with about 300 stocks, larger stocks by three broad market capitalisations. And then, we whittle it down based on various quality factors to arrive at a reasonable universe where we apply our prime factor that we wish to apply, which is in certain cases, momentum and in certain cases, we continue with quality. So we're not really looking at a sector allocation, or achieving a desired sector allocation, or even looking at a sector allocation vis-a-vis the index that we are benchmarked to. We are totally agnostic to it. That’s why, our performance may vary very widely from the index, both positively and negatively. So it's not necessary that our portfolio overlaps are very, very small.
So, if you see our portfolio overlap with the Nifty 50, you'll see it either in single digits or very low double digits. Our portfolio overlap is going to be very, very small. So, the idea behind it is to actually, genuinely bring the underlying benefits of true active investing to our investors, where we are not bound by the index, we are not bound by any sector or capitalisation allocations. All we are looking at is benefiting from the factors that we want to benefit from.
In your blue-chip portfolio, you have the top guys. One of the stocks that's mirroring both your blue chip and the multi cap is HAL. How do you decide on that? Do you look at the fundamentals of the companies as well? From a fundamental point of view, how do you look at these stocks?
Rajiv Shastri: Okay. Of all the factors that I spoke about, quality is almost entirely dependent on fundamentals. So what is the company P&L and balance sheet characteristics. Value is a combination of fundamentals and market characteristics because the price element comes in, while the intrinsic value or the value of a company can be decided based on fundamentals. But the market is valuing it differently and we get a price for the company from the market. So, value is a combination of fundamentals and market information, market data. Momentum and low volatility are almost entirely based on market data. So, momentum is basically the directional movement, whether it's positive, negative and how strongly positive or negative and volatility is basically the standard deviation of the daily movement and how volatile that stock is, as it moves either positively or negatively. So, as far as quality is concerned, it's almost entirely a fundamental factor and our definition of quality is based on data. And to surmise it into one sentence, we think that quality companies are those which earn a high level of profit consistently, with low levels of debt and distribute these profits to the shareholders.
So the four fundamental parameters that we look at are—ROE, which is profitability; ROE consistency, which is consistency in profitability across time; debt-to-equity ratio, as we call it, equity to total capital; and dividend payout.
Dividend payout is not the same as dividend yield. We are not comparing the dividend to the prevailing price in the market. What we are saying is, if you want Rs 100, how much do you pay out? What is the percentage that you are paying out? So we select stocks based on these four characteristics and we shortlist them based on these four characteristics and these are the stocks which we say are high quality stocks.
Then, towards the end, we may use various other factors to decide on weightage or to decide on the final shortlist of 20 or 30. But the fact of the matter is that the quality factor is predominant as far as blue-chip is concerned, and it's almost entirely based on fundamentals.
In your top five sector allocations, you have I.T. which is at 24.2% in the blue-chip fund. So, it's safe to assume they are all the top three or five I.T. companies which have good profitability as well as have a good dividend payout ratio. They have a capital allocation policy in place, which allows profit to be given back to the shareholders.
Rajiv Shastri: Out of the four parameters that I laid out, if a company goes through the first three layers, which is consistent ROE and debt-to-equity, you will notice that most I.T. companies do actually have higher ROEs and they are fairly consistent as far as the ROEs are concerned. We also look at this data over a period of time. It's not just the last available data, but obviously we look at it over a period of time and the final factor that we use, the final parameter that we use is dividend payout. Now there might be in our portfolio, certain companies that don't pay dividend at all, but they have been very, very strongly positioned as far as the first three factors are concerned—first three parameters are concerned. So therefore, they continue to be a part of the last portfolio. The fact of the matter is that it's possible that the dividend payout is zero.
Can you give names of such companies which tick mark all others, except for dividend in large caps, and you are part of it, because the factors are saying that it gives you good returns?
Rajiv Shastri: Off hand, I don't have the data because it's a small group of 20 stocks in the blue-chip portfolio. So I don't know which of these companies don't pay a dividend at all, but since it's just 20 companies, I assume that all of them would be paying dividends.
We have a larger portfolio that we do on a mutual fund side, which is a 50-stock portfolio, where it's possible that you might get a couple of companies which don't pay dividends. Mostly, in these companies, we would assume that they would all be paying dividends.
If investors are looking at your fund, what should they be looking at? In a normal PMS point of view, they have the other approach, which is look at the sectors, look at fundamentals but you have a bottoms up approach. So, it becomes a little tough for some of them to understand how exactly you are making your portfolio.
Rajiv Shastri: It's extremely important that people do understand the philosophy that we're pursuing because it will give them an idea about what to expect from the portfolio.
In a very short manner, if I were to describe it, if you look at our portfolio, our goal is to make sure that you don't feel uncomfortable with any of the companies that are there in the blue-chip portfolio. You look at the companies and you look at the names and you say these are good quality companies, I don't mind owning them. If you don't mind owning companies, then the market volatility whether the price goes up or down becomes a secondary factor because you're convinced about the quality of the company itself. The price might go down, but then you'll know that if it's a high quality company, it's a temporary phenomenon and the price will go up eventually, if I continue holding on to it. So this is the basic thesis that we intend to follow. The basic thesis is that we want to own high quality stocks. Now, if you look at our portfolio and you see high quality stocks and you look at the company names and you say, I don't have a problem with these companies, all of them are high quality companies, then at least you will have the comfort of knowing that we have bought companies that are good.
Over a long period of time it has been demonstrated across the world that higher quality companies outperform benchmarks. So if I own these for a long period of time, I am confident that these companies will outperform. Over short periods of time, there may be periods of underperformance, there may be periods of ridiculous outperformance. We have seen both of them in the past. But my basic goal of owning high quality companies and being secure about the fact that my companies are not questionable in any nature, is being met.
What is the average holding period for you in large caps because you said in a multi cap it could be as low as quarterly rejig which can happen?
Rajiv Shastri: In the blue-chip portfolio, we rebalance it once a year. We try to ensure that all the profits, we generate, all the gains that we generate are long-term capital gains. There is no interim churn in the portfolio, because quality is a very persistent factor.
So you can't have a company which is high quality for 10 years, and then, suddenly the next year it becomes low quality. That's not the way it works. So quality is extremely persistent. If a company is high quality, it continues to remain high quality for reasonably long periods of time. We rebalance the portfolio every year. But that doesn't mean that the entire portfolio changes every year. So there is a remarkable level of consistency and persistence in our portfolio as well. About 20% to 30% of the portfolio changes on an annual basis, but 60% to 70% remains the same.
So if you look at that churn, our average holding period ideally would be between, three to four years for each stock that we own. There are some stocks that will last only for the year but then there are some stocks which will last for more than four years.
Have you made the most of the PSU rally in this market?
Rajiv Shastri: I think it has contributed, but it has contributed more on the momentum side than on the quality side. So, while HAL has been a kind of company which has both shown momentum and quality, other PSUs may not have shown the high degree of quality that we experience in … and other companies that are there.
