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WF: Congratulations on your flagship Equity Fund's completion of 15 years of wealth creation. What would you say have been the biggest milestones and moments in this eventful journey?
Neelotpal: These 15 years have indeed been long and eventful. There have been many milestones and memorable moments. Let me start with a recent milestone. Last month, our fund's NAV touched Rs 200 for the first time ^. That number speaks volumes about the long term wealth creation that this fund has delivered over the last 15 years. Around the same time, I received a call from an investor. He said he had invested some money in the fund during its NFO 15 years ago, which has now increased significantly. With this money, he said he will now be able to fund his son's overseas education, which otherwise would have been a challenge for him. That was quite a moment. As fund managers, we think of NAVs and CAGRs and alphas - but to know how all of these have translated into making a difference in the life of an investor, is a truly humbling feeling for all of us.
The other big takeaway from these 15 years is a lesson on markets. During this period, we have seen 3 big events - each of which looked like almost an insurmountable problem. We had the 2008 financial meltdown, then we had the European crisis in 2011 and then we had the current account deficit issue that led to a currency crisis in India in 2013. These events came in thick and fast and looked like capable of causing lasting damage to capital markets. However, the markets came out stronger after each event, so did our fund when coming out of these challenges. These incidents have strengthened long term equity investors' conviction in staying invested in our fund, in markets, over market cycles to reap the kind of long term wealth creation that the fund has delivered in these past 15 years.
WF: Your fund's long term alpha - at 7.6% in the large caps space, is truly commendable. Looking ahead however, many observers believe that with SEBI's new guidelines on composition of large cap funds, with the introduction of TRI and with huge ETF flows buying the large cap index, the scope for alpha generation in large caps will diminish considerably. What is your view on the role of active strategies in India's large caps space?
Neelotpal: I think this is a very relevant question. Let me answer it at two levels. Firstly, bulk of the fund's alpha has come from stock selection, and not from sector selection or theme selection - and our stock selection as you are aware follows our globally adopted PB/RoE framework (Read more about the framework here). This automatically instils a discipline of buying good stocks at a reasonable valuation - which is the starting point for the quest towards alpha.
Coming to SEBI's classification guidelines - we welcome them as our Equity Fund has always remained a true to label largecap fund, while some of the peers took on a broader mandate at times. This will allow us to compete on a level playing field in our bid to produce alpha and healthy performance vs peers. As far as TRI is concerned, yes it can shave off some 1.3% to 1.4% from alpha when you take into account dividend plough-back, but that again applies to all funds in the same measure. So, while overall alpha can reduce, relative performance of funds vs each other will not get impacted by TRI.
Money flowing into index ETFs won't impact alpha potential since money is getting invested in proportion to the index weights in the index constituents. We are anyway competing with the index for alpha - so index ETFs don't in any way hinder or aid our process of alpha generation which is through bottom up stock picking.
WF: Debt markets seem to be worried about oil prices, about inflation and about fiscal slippages and have consequently reacted adversely with yields hardening. Equity markets seem to have shrugged off all these concerns, including rising interest rates. How do we reconcile these two positions?
Neelotpal: Again, a very relevant question, which we in the equity market should think about. But let's keep one thing in perspective. For debt markets, deterioration in fiscal deficit means near term increase in Government borrowing, which immediately upsets the demand-supply equilibrium, which consequently results in an increase in yields. So, the impact of deterioration in the country's macros is immediately felt in the debt markets. Equity markets on the other hand are more dependent on earnings growth and factors that influence it either way - and macros tend to have an impact on earnings with a lag, and on an uneven basis across companies. If there is input cost inflation which a company is able to pass on through an increase in its selling price to protect margins, there should be no impact on its share price. If cost of borrowings increase and a company makes changes in its capital structure to nullify the impact, there again should be no impact on its share price. So, there are a number of steps that companies at an individual level can take to mitigate adverse impact of macros. Stock prices therefore tend to move at a more company specific level and not across the board in response to a change in the macro situation.
We have to also keep in mind that while macros have deteriorated from the position 6 months ago, they are vastly better than where we were 3 years ago. To that extent, impact on equity markets will be felt only when there is a perception that macros will perhaps continue deteriorating to a level that will materially impact corporate earnings.
WF: There is some excitement about the Q3 earnings numbers, though some caution that it is more of a low base effect playing out. How do you read Q3 earnings growth and what lies ahead for our much awaited earnings revival?
Neelotpal: Yes indeed there is excitement - after all, we are seeing double digit earnings growth after 13 quarters! Having said that, we have to recognize that we are benefiting from a low base effect - the 1 year ago data now represents the demonetization quarter. Next couple of quarters too will benefit from low base effect - which means optically earnings growth will remain relatively strong - in the mid to high-teens. This should set a good base for a more sustained earnings momentum in FY 19 and beyond.
When we look at earnings numbers, we need to weed out one-offs and extraordinary items to look at what really constitutes core earnings growth. If we look at the current numbers, a high-teens number at a total level will come down to mid-teens after removing one-offs.
In terms of what to watch out for in earnings growth, sustainability of growth numbers will need all performing sectors to continue their existing earnings momentum. Any negative surprises in some sectors can impact the aggregate numbers.
WF: Which sectors do you continue to see value despite stretched valuations?
Neelotpal: As you know, we focus more on individual stocks and are guided primarily by our PB/RoE framework. If we look at our stocks, they are in select financials, industrials and global cyclicals. In terms of sectors wherein we don't have much of ownership in, they are consumer and pharma, where we are concerned about valuations.
WF: What do you see as the key risks to this bull market?
Neelotpal: At times, the biggest trend drivers are a cause of worry. In our case, strong domestic flows is one of the biggest drivers of this bull market. So naturally, one would want to consider whether there are any factors on the horizon that can cause flows into the market to reduce. While we can't see at this moment any reasons for domestic savings to stop flowing into capital markets, one worry is diversion to primary markets. The volume of IPOs and QIPs is growing strongly, sucking up incremental liquidity quite rapidly. What we need to track is liquidity coming into the secondary market - which is now competing with a vibrant primary market.
^ HSBC Equity Fund - Growth option data as on 31 Dec 2017
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