Franklin India Prima Fund's performance over the last 4 years is what many seasoned fund managers target - healthy alpha each year and a high second quartile performance. Experienced fund managers know that by eschewing unnecessary risks and delivering a consistent high 2nd quartile Y-o-Y performance, you are setting your fund up nicely for a long term top quartile track record. Janakiraman R seems to be doing exactly this with Prima Fund. Being sharply quality focused in the midcaps segment gives him the space to cherry pick quality companies while staying away from the more frothy names. Janakiraman R is very clear that it is unreasonable to aspire for any more near term re-rating of mid and small caps. Why then should you invest in midcaps now? Read on to understand the real investment argument for small and mid caps going forward.

What do percentiles and their colours signify?

Fund performance is typically measured against benchmark (alpha) and against competition. Performance versus competition is measured through percentile scores - ie, what percentage of funds in the same category did this fund beat in the particular period?

If a fund's rank in a year was 6/25 it means that it stood 6th among a total of 25 funds in that category, in that period. This means 5 funds did better than this fund. In percentile terms, it stood at the 80th percentile - which means 20% of funds did better than this fund, in that particular period. If, in the next year, its rank was 11/26, it means 10 other funds out of a universe of 26 did better than this fund - or 38% of funds did better than this one. Its percentile score is therefore 62% - which signifies it beat 62% of competition.

Most fund managers aim to be in the top quartile (75 percentile or higher) while second quartile is also an acceptable outcome (beating 50 to 75% of competition). What is generally not acceptable is to be in the 3rd or 4th quartiles (beating less than 50% of competition). Accordingly, we have given colour codes aligned with how fund houses see their own percentile scores. Green colour signifies top quartile (percentile score of 75 and above), yellow or amber signifies second quartile (percentile scores of 50 to 74) and red signifies 3rd and 4th quartile performance. A simple visual inspection of colour codes can thus give you an idea of how often this fund has been in the top half of the table and how often it slips to the bottom half. A great fund performance is one which has only greens and yellows and no reds - admittedly a tall ask!

WF: Does Prima have a pure midcap and small cap mandate or does it have some flexibility across cap sizes?

Janakiraman: It is essentially a mid and small cap mandate. If you look at the offer document it mandates the fund to invest in small and mid caps up to 80% of the portfolio. 20%of the portfolio can be invested in large caps. So we have flexibility to invest in large cap and that is restricted to 20%.

WF: What is the current allocation across mid and small caps now in Prima and how has this changed in the last 12 months?

Janakiraman: As of now the total equity exposure - this is as of end of August - the total equity exposure of the scheme was about 92% with about 8% cash. The split of this 92% was large caps around 13%, midcaps72%, and small cap 7%. A year ago, it was 11% in large caps, 66% in midcaps and 13% in small caps. During the last year, some of our small cap exposures did very well and have now moved into the midcaps space. Prima is primarily a midcap oriented fund. For a more focused exposure on small caps, we have the Franklin India Smaller Companies Fund, which would be a more appropriate choice.

WF: The last 4 years have seen a steady performance - delivering alpha in each year and maintaining a high second quartile peer group ranking. What drives this consistency? On the flip side, what factors are coming in the way of delivering a top quartile performance?

Janakiraman: The consistency is the result of the well articulated investment strategy across all Franklin schemes. At the core of this strategy is a focus on investing in reasonably good quality businesses at fair valuations. Such businesses offer a relatively higher degree of visibility of growth and profits. We have stuck to this philosophy; adherence to this approach puts a high degree of emphasis on factors like return on capital, free cash flow, leverage risk on the balance sheet and similar issues. This is our area of competence and since we have stuck with what we know best, it has helped us in the last 4 years or so. In the mid and small caps spaces, this focus on quality in particular helps avoid the pitfalls of investing in high risk companies with less than satisfactory financials. That is the reason for this kind of consistency that we have seen in the last 3 to 4 years.

The caveat is that in very bullish times, some companies with less satisfactory financials see their day in the sun - where they outperform more pedigreed peers in the short run. This happens typically when optimism gets the better of prudence. Our adherence to our core philosophy of sticking with quality and emphasis on fundamentals means that we stay away from some of these opportunities. Our belief is however that sticking with quality pays off much better in the long run.

As you have highlighted, we have been able to deliver healthy alpha every year in the last 4 years - I think sticking to our area of competence is what has enabled us to bring this consistency in fund performance.

WF: Some experts are worried whether small and midcaps are now entering bubble zone as the valuation gap between midcaps and large caps has practically vanished. Is this fear justified? What is the core investment argument going forward for small and mid caps?

Janakiraman: This is a very interesting question that you have raised. The answer to your first question is very simple that the exuberance that we have seen that mid and small cap space over the last year or so, has clearly meant that on a relative valuations basis, mid and small caps are no longer more attractive as compared to large caps. The midcap index, which normally trades at around 20% discount to the large cap index on a one year forward PE basis, now trades at a discount of less than 10%. So, midcaps are actually more expensive now compared to historical average on a relative valuation basis.

The answer to the second question, I think that is where I would put more of my emphasis, which is the core attraction of investing in mid caps. Lower valuations are not the core attraction - the core attraction is that in a growth phase of an economy, midcaps usually deliver faster earnings growth and therefore offer attractive investment opportunities. I think this advantage will manifest itself very clearly in this current cycle also.

The thing to note is now going forward, as far as mid caps is concerned, the returns are going to be delivered more by earnings growth rather than further PE re-rating. PE re-rating part is done with - in fact given the valuation gap, one can also perhaps look at a small correction in the near term.

Investors need to be clear about their objective when investing in mid and small caps now. They have become the flavor of the market and valuations alone do not any longer make for a compelling case. Those looking for near term appreciation need to be cautious. Mid and small caps remain compelling propositions for long term investors who wish to participate in a more robust earnings driven growth over the next few years. You need to remain invested in midcaps to really get the benefits from here on. There is limited headroom for substantial near term appreciation, in my view.

If you are buying into growth of the economy, midcaps offer you an excellent growth vehicle - one that can perhaps generate faster earnings growth than large caps in the growth phase of the economic cycle.

WF: Which sectors and themes are you overweight in Prima? How have sectoral allocations changed over the last 12 months?

Janakiraman: Somewhere towards the end of 2013, when we were in the middle of the currency crisis we came to the conclusion that perhaps we were closer towards the end of the economic down cycle. Recovery was slowly becoming visible. That time the recovery was triggered initially in the export segment, which was a beneficiary of the currency depreciation. After the recovery started, we started increasing our exposure to the growth sectors towards the end of the calendar 2013. So sectors like Autos, Auto ancillaries, Cement, Industrial products - all these sectors got higher allocations in Prima's portfolio.

We see consumer discretionary sectors as the first set of beneficiaries of economic revival and have positioned our portfolio accordingly. We are seeing signs of pick up in auto sales and cement. This phase will then translate into better capacity utilization across manufacturing, which will spur industrial capex. We are therefore positioning our portfolio to benefit from these phases of expected economic growth.

At the same time, we continue to hold our convictions in high quality pharma and consumer staples, which will continue to form part of our core portfolio. So, it's a well diversified portfolio, but one that is in tune with the changing phase of the economic cycle.

One aspect we have stayed clear from is to put too much risk into the portfolio by concentrating all bets only on domestic cyclicals. Having a well balanced portfolio in our view helps deliver a superior risk adjusted return.

WF: It is said that most exciting new themes begin in the small caps space and then become mainstream over the years. What are some of the emerging themes in this context that you are bullish about?

Janakiraman: Small and mid cap space is never short of enthusiasm for emerging new themes, especially during an optimistic phase. We discover lot of new themes but if you look at the fate of those themes a decade down the line, many of these themes have kind of expired. We saw this in the 90s, as well as the last decade. This will remain an important caveat when chasing new themes.

As far as our philosophy is concerned, we prefer investing into proven business models with adequate free cash flow, available at reasonable valuations. Many new themes cannot think of free cash flows for quite some time. These kinds of companies are really outside our comfort zone - what we understand less of, we prefer not to be involved in.

I think there are enough exciting growth oriented themes one can look for in the midcaps space, without the need to go chasing a brand new theme. Auto ancillaries are a good example - you have companies that are exploiting revival in domestic growth as well as harnessing significant export opportunities. They are scaling up well and building well balanced businesses. There are really enough opportunities for us to invest, within the core philosophy we like to stick with. Emerging themes may be good for some investors, but if they are without strong financial fundamentals, I would view them cautiously.

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