Markets have got polarized very sharply in recent times, leading to significant distortions in value across large segments of the market, says Sailesh. While most open ended equity funds are constrained to remain benchmark focused in a competitive market, there is an opportunity to create a closed ended product, which will have time on its hands to seek out these value buys which are currently ignored, but may well become heroes of the next bull market. Read on as Sailesh takes us through what the new Reliance Closed Ended Equity Fund - Series A is all about.

Reliance Closed Ended Equity Fund - Series A

WF: In your new Closed Ended Equity Fund - Series A, you say that you will adopt a more "absolute return" focus. Can you please explain how this will be different from the way you will manage an open ended equity fund?

Sailesh: The real way of investing is to effectively value business from an absolute basis. Given where the market is today and what has happened over the last few years, the market has become distorted in terms of concentration on certain sectors. People are focused on getting relative returns against a benchmark that is being influenced only by a few stocks and sectors. The benchmark has become even more important as a sizeable amount of the FII money coming in is index based ETFs. This causes market attention to get more polarized.

Due to this distortion in the market, we have businesses which have been created 15-20 years ago with long history, sizable scale and distribution, available on absolute valuation basis which are very low. You will find one third of BSE 500 companies nearly available at valuations which are below book value of one.

If you look through the filters of absolute value and buy them as businesses rather than buying them as stocks, you have the potential to create significant long term value. This is because the delta in earnings of many of these companies will be high over the next 3-5 because their high operating leverage and their strong balance sheet and weakening competition are not factored into prices today.

So one critical thing this fund will focus on is rather than having a benchmark and be aligned to the benchmark, it will create a portfolio that is more focused on absolute value rather than relative value to benchmark. In that sense, it is a go anywhere product participating significantly where absolute value is much higher than what the current market prices indicate.

WF: What is your stock selection strategy for this fund and how would it be different from a typical multi cap open ended equity fund?

Sailesh: We have kept the multicap mandate because of the way the markets are positioned. Across the market - across cap sizes, 60%-70% of the index valuations in one or two sectors are much lower than what they were in the peak in 2007 and at least 25%-30% of the market is below the 2009 lows. So this kind of a structure allows you to create a diversified fund across 5-6 sectors and across market caps.

The essence is there is significant value and growth. This fund will focus both on value and growth in investing and selecting stocks. If we see significant value and growth available in mid cap space, we may have 70%-80% of the money invested in midcap space -scalable businesses which are in those 3, 4 important areas because of growth, businesses with high operating leverage and businesses operating on track record. We will be able to create a portfolio in a diversified way. The option of having a flexible cap is even when you have phases in the market place like midcaps gets overvalued or some other event, you can move a good portion of the money if required and hence with low risk, a high quality portfolio can be created in both the spaces.

WF: Is it fair to say that the extreme polarization in the market and the focus on near term performance is currently coming in the way of true bottom-up stock picking in open ended equity funds? Would this be one of the drivers to launch a closed-ended product?

Sailesh: Yes, it gets marginalized in the existing diversified products. It is significantly benchmark oriented. To some degree, it is evaluated on a regular basis. More importantly a lot of people take a tracking error from the benchmark when they create portfolios. In this case also they will be taking the tracking error. If you take 5-7 of the top performing sectors in the NIFTY stocks, they would have possibly delivered all the returns in the period of time. This kind of extreme distortion does not happen in the market at every period of time. It is available today for you to capture. In 2007 for example, the pharmaceuticals and FMCG sectors were completely ignored. Nobody wanted to own them and most funds were into capex or infrastructure oriented stories as they were the best opportunities at that particular time.

WF: Given that the market is now at a lifetime high, what gives you the confidence to launch a 5-year closed ended equity fund?

Sailesh: Markets at a lifetime high is a misnomer if you look at the current number. This level was reached 6 years back so by any metric India even at its lower growth rate of GDP and companies with growth rates coming down, but the sizes of profits are up by 50%- 70% in the last 6 years since we touched the high last time. So in that sense the valuations of the markets are low.

There has been a big churn in the market place. The weightages of the consumer stocks and the pharmaceutical stocks which were around 3% in index in 2007 are today about 15% for each of these sectors. So there is a sector churn, the earnings have grown and the overall PE multiples at that point of time when the index was at this level, had been in excess of 23-25 and now are in the range of 15 to 18. So there is a difference and basically it is a misnomer to believe that the markets are at a lifetime high. It is just that the number is being touched now after 6 years of consolidation in the market place. If you see the consolidation of the market for a period of 5 years, the next 5 years tend to be much better than the last 5 years as cumulative returns of the last 5 years actually impute and come into the valuations and then the valuations are disproportionately cheaper than what the reality is on the ground.

WF: What would be some of the sectors or themes that you currently find very interesting which might find the way into this portfolio?

Sailesh: There are 3 to 4 important areas that we are focusing our concentration on especially on many companies which have inbuilt operating leverage. As the headline number is not very high, the operating leverage for these companies is not playing out. So whenever these companies see a bit of rebound in growth or a reasonable comeback in growth, you will have substantial growth in earnings for these companies and these are companies that have strong balance sheets today. They are generating cash even in these environments and they are seeing the competition weakening. It is just that the revenue growth has not started to come back because we are in an economic cycle that is tighter.

These companies are present in every sector like auto, auto ancillaries, engineering and others that are connected to industrial activity. These companies are working at utilization of 60%-65% and we are finding substantial operating leverage in them. Growth is the challenge. There is a shift in the market place in the last six months due to the depreciation of currency. Import substitution is becoming an important opportunity. No new significant capacity is coming in, the existing capacity will be a substantial beneficiary in terms of profit structure and growth which is today not implied in the valuations of these companies.

Engineering companies today have cash in their balance sheets. If you look at the last 10 years, all these companies were leveraged. They had financial costs hurting them badly. These are strong companies suffering from a weak economic environment today. So operating leverage is one important thing. Recovery in international demand because of stability in certain international markets like a reasonable growth in the US will benefit exports. Recovery will lead to export growth and this will benefit engineering, IT services, auto exports and other businesses. So that will again flow in and positively impact the earning of these companies.

WF: Some investors are wary about closed ended structures, as their returns are critically dependent on the state of the market during the month in which the fund gets redeemed. In what ways can this risk be mitigated? In what ways can an element of profit booking take place, when situations warrant, within the 5-year period?

Sailesh: A flexi cap fund allows you to have the opportunity where you can book profits and move to where value exists in the market. The focus is on buying on absolute valuations basis so the profile of the product will technically be slightly different from what the market momentum sectors are at that point of time. This automatically creates a defensive portfolio in excessively bullish markets. So the level of risk is reasonable and not excessive.

We also have a dividend option in this product, which allows the investors to come in via the dividend plan. Whenever there are opportunities where you have exuberance in the market or in a segment of the market, we can book profits and pay out dividends to investors. Whenever the market has 2-3 good phases and we get opportunities to book profits as per regulations, we will work towards the dividend strategy.

Share this article