Large-Cap Firms Offer Superior Risk-Reward Payoff, Says PGIM MF's Vinay Paharia
We are not against investing in cycles but are against investing in companies that do not possess competitive advantage, Paharia said.
Large-cap companies offer better risk-reward payoffs in the current market due to attractive valuations, according to PGIM India Mutual Fund's Vinay Paharia.
One of the two broad aspects that the fund looks at during the construction of a portfolio is a tactical approach with respect to large and midcaps, Chief Investment Officer Paharia said at the NDTV Profit's Portfolio Manager Show.
Midcaps in general are expensive, while "large caps offer superior risk-reward payoffs because valuations are reasonably attractive and earnings growth is good," he said.
The midcaps have last year seen a material increase in their valuations, driven by higher earnings growth, he said. "This entire space (large and mid-cap) consists of a larger number of companies and hence more opportunity to pick."
"We intend to have a larger exposure to large caps, as midcaps in general are trading at an expensive valuation in the current market," he said. "We are not against investing in cycles but are against investing in companies that do not possess a competitive advantage," Paharia said.
One broad theme in 1-2 years is that quality and high-growth companies have underperformed very significantly compared to companies with poor quality and weaker growth, he said. "This is a trend that is sort of unprecedented because in the last 20 years, we have seen good-quality companies deliver good growth."
Bad track records of corporate governance, businesses that are structurally weak, and extremely leveraged businesses are the ones we will avoid, Paharia said.
Edited Excerpts From The Interview:
Vinay, what's the portfolio stance and why is this the stance for the overarching portfolio? I believe this is the stance behind your large-cap and mid-cap fund that you will be starting off.
Vinay Paharia: There are two broad aspects with which we are looking at constructing a portfolio currently. One is very tactical with respect to large caps and mid caps.
Large caps, in the current market environment, are offering superior risk-reward payoff. Simply because the valuations are reasonably attractive, the earnings growth is good. Hence, risk-reward seems to be much superior.
Whereas mid caps in general are pretty expensive and while the earnings growth is far, far higher, the valuations have also seen a material rerating in the last one year or so. Having said that, this entire space consists of a larger number of companies and hence there are more opportunities to pick from.
So, generally, we are overweight on large caps compared to mid caps in this fund, purely for valuation reasons. Second, and this is much more important and less talked about—I think one broad theme which we are seeing in the last 1-2 years is that quality companies and high growth companies have actually underperformed very significantly compared to companies, which are actually very poor quality and have weaker growth. And this is a trend which is sort of unprecedented because in the last 20 years, we have consistently seen good quality and high growth companies delivering superior returns compared to their weaker counterparts. Hence, we are capitalising on this trend today, having tilted the portfolio significantly towards good quality and high growth companies. I think these are currently out of favour and offer a significantly superior risk-reward payoff. I think that's one aspect of the portfolio construct currently.
I was looking at your market stance and one of the statements that stood out was how you probably referred to that briefly but many fast-growing, quality, large businesses are available at reasonable valuations.
Will it always be the case? Why is it that this time is different for you, to favour these kind of large caps, because some of these might be quality large businesses at reasonable valuations, but that growth may be cyclical in nature, for example, or lower relative to the growth that some of the broader end of the spectrum companies are offering?
Vinay Paharia: I think we can always consider a few cases here and there, which could exhibit this kind of opportunity. Let's say we analysed more than 500 companies and looked at the data on a quantitative basis, which removes all sorts of bias and looked at companies which have better than average sales growth and better than average returns on equity and how these companies performed relative to everyone else.
When you look at this data of such companies, it could be anywhere between 150 to 200 companies. The average median return has been significantly weak in the last one year, especially compared to any time ever in the past 20-25 years. So I think we are talking about big data numbers which are spread over a large number of companies and not biased towards a few companies.
Where it is, for example, that you will look to make exceptions? Are there some base criterias, for example, in the current market context that a company within a particular ROC or ROE or margin growth or debt levels will or will not be considered?
Vinay Paharia: One of the aspects, which is always a no-go area for us is companies where governance track record is chequered. So I think, we will never want to deliberately go in areas where there is a weaker governance track record.
Second, we would want to avoid businesses, which are structurally weak. Like for example, commodity companies, which have no sort of competitive advantage, which are purely let's say, having a good time right now because the underlying commodities are good. So I think those are the types of businesses, which we would want to avoid, of course, extremely leveraged businesses, extremely weak, sort of growth profile companies which are being disrupted. These are all examples of companies which we will want to avoid.
You miss out the cycles, then. For example, if you avoid commodity companies, and let's say if China were to go ahead and give stimulus and the kind of gains that some of these ferrous companies or non-ferrous companies, base metal companies will give, will be quite stupendous. So why avoid them at all costs?
Vinay Paharia: I think the key thing is to look at businesses within those segments, which are attractive. Like, for example, the cement sector. Not all cement companies are weak. For example, there are a few companies which, across the cycle, have earned significantly higher returns on capital compared to everyone else in the peer group because they possess some sort of competitive advantage.
So our objective is not just to avoid any particular sector or company but look at them on a bottom-up basis where those companies have some sort of a competitive advantage. If there is no competitive advantage, I would highlight that look around some of the cyclical companies, their long-term track record on a rolling 3-5 year basis is extremely weak. So when we are attracting long-term investor capital, our objective is to build wealth over a longer period of time. I think many of these can be just like noise in the overall big picture scheme of things.
Okay. Let's try and get your sector stance going and among things, you have talked about healthcare as being a space which is looking interesting. So what within this? Your stance and particularly your comments around domestic formulation companies is very, very interesting.
Vinay Paharia: I think, healthcare is a sector which we are significantly overweight on. And within that, we are overweight on domestic formulations and healthcare services, particularly hospitals.
Domestic formulation companies are more like FMCG companies. These have significantly higher returns on capital. In fact, many of them have negative working capital. They don't require too much capex to do this business. And, over a longer period of time, they have grown at a much faster pace than FMCG companies, driven by new product launches. So I think that is a very clear, interesting case for domestic formulation companies.
Secondly, the hospital services space. This is another space where penetration is growing significantly for organised healthcare providers, driven by high level of penetration for health insurance and also demand for quality health care. So I think, with all of this combined together, the impact is visible in the financials of the listed hospital chains, which are showing very high growth and higher returns on capital. And these companies are also able to deploy capital in newer territories and displaying similar return on capital on that.
So that's as far as healthcare goes. Now, lending financials. For the longest time now, people have been grappling with why private banks are not growing. May be the supply is high, what have you but we are entering a period where the margins will not be sustainable, if you will, they'll come off as well.
Do you think growth will make up and valuations are supportive enough and is the argument convincing enough for you to stay highly overweight on private banks?
Vinay Paharia: In fact, this is a good example of cyclicals. We just had a discussion some time back on cyclical. And this is an example of cyclical, where there is some sort of a competitive advantage. So once again, it highlights that we are not against cycles, but we are against heavy investing in companies which do not possess any more or competitive advantage.
Coming back to lending financials, you're right. There could be instances where the margins may be under pressure in the near term. But what you have seen is that most of the companies in this sector are able to pass on most of the cost pressures. They have grown at a better than GDP growth rate and their returns on equities are on a longer term basis, clearly higher than 15%.
So I think this is an excellent sector to capitalise on the India growth story, which is today available at a very attractive valuation by the way. So I think one of the aspects which we look out for—when investing in a company from a long range basis—are present in many companies in this space.
Okay. The other aspect in your notes is your highlights around QSRs. How do you juxtapose the valuations that they are trading at, vis-a-vis the recent growth trends shown by these companies?
Vinay Paharia: Once again, these are shallow cyclical. They are currently going through a weaker demand environment and I think that is a great opportunity to invest in many of these franchisees. Why I call them as franchisees is because these are consumer-facing businesses, that have very high returns on capital and clearly they possess very, very strong brands, in many cases.
Quick service restaurants, as a category, is growing at a very fast pace. Lot of these companies are actually adding more and more units of restaurants right now, despite market headwinds, for the simple reason that for the long term, this is a great opportunity for India. And most of the consumers are actually favouring the sector, coming out and ordering more. Hence, the business environment looks very attractive for most of the companies in this sector, over a 3-5 year period. Once again highlighted, we are not against investing in companies which are undergoing weakness in their business environment, purely on a cyclical basis. So I think, QSR is one of those examples.
However, the auto component sector is a good example of a structural growth story. Most of these companies are actually good exporters. They are developing niche capabilities in the electric mobility side and I think they are big beneficiaries of the China Plus One strategy adopted by many global OEMs. Hence, I think, this is one more sector which is very attractive within this entire consumer discretionary basket.
