Kotak Emerging Equity Fund has delivered 5 consecutive years of positive alpha, topping it with a huge 32% alpha in 2014. Its percentile scores however indicate a tendency to outperform peers in good markets and underperform them in weak markets. Pankaj explains what's driving consistent alpha generation as well as the percentile scores and the themes that he has bet on that are driving this robust performance. After the big run up in 2014, and with the current market volatility, are mid and small caps a good bet? Read on as Pankaj explains why he is very positive, not just about the long term, but also about market direction over the next 12-18 months.

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: Your fund has delivered positive alpha 5 years in a row, but 2014 was huge. What were some of the calls that came good, to enable an alpha of over 32%?

Pankaj: Our endeavour always has been to outperform the benchmark and we are happy that through our consistent investment philosophy we have been successful in outperforming the benchmark every year since last 5 years. In 2014 the outperformance was high as some of our investment themes and stock calls worked well. At the start of calendar year 2014, we tilted our portfolio towards the following themes which worked nicely for us:

1. Shift from rural India consumption to Urban India consumption

2. Shift towards infra/capital goods revival and cyclical recovery

3. Overweight on Private Bank and NBFCs:

4. Stock specific picks in export oriented sectors like Technology and Pharma.

WF: Although alpha has been positive over the last 5 years, in terms of peer group comparison, the fund has underperformed peers in weak markets (2011, 2013) and has outperformed peers in strong markets (2012, 2014). Is your portfolio strategy a higher risk one, compared to peers in the mid cap funds category?

Pankaj: The beta of the fund during most parts in the last 5 years has been in the range of 0.7-0.9 and hence the fund is not high on risk. In 2013, the portfolio was positioned for a cyclical recovery few quarters before it actually happened but unfortunately in between the crisis of June-September 2013 happened due to which portfolio positioning didn't work for that period. However subsequently our view of cyclical recovery in the economy has worked nicely and the fund has generated much better returns than most of the peers in the category.

WF: In what ways is the Kotak Emerging Equity Scheme different from Kotak MidCap Fund in terms of portfolio strategy and fund composition?

Pankaj: The main differentiation of Kotak Emerging vis-à-vis Kotak Midcap has been on market capitalisation side. Kotak Emerging as on 30th June 2015 end had average market capitalisation of 6900crs (source: valuereseachonline.com) vs. Kotak Midcap's market capitalisation of 10300crs. Also Kotak emerging has a higher weightage on small caps stocks as compared to Kotak Midcap.

WF: In 2014, the valuation gap between mid and large caps closed out, making midcaps look expensive. What is the key investment argument now for mid and small caps?

Pankaj: We agree that in the near term midcap-small cap valuations look rich and in CY14 midcaps outperformed largecaps by the highest margin in last 10 years. However we believe that over the medium to longer term, with domestic economic recovery in sight, the mid-small cap space still looks attractive and has the potential to outperform the large cap space. We are of the view that over the next few years lots of new sectors (logistics/supply chain, ecommerce etc) and some of the old sectors (roads, railways, financials, defence, auto ancillary) should gain traction which can be only be played through mid-small cap space.

WF: What are the sectors and themes you are overweight on in your Emerging Equity Scheme and why? What are your key underweights and why?

Pankaj: As mentioned above, the key themes we are positive on are:

1. Urban discretionary consumption discretionary.

2. Capex (industrials and infrastructure related)

3. NBFCs and Private sector banks

Key underweights are:-

1. Rural consumption plays

2. Metals

3. Real estate

WF: What is your overall market call for the next 12-18 months and what do you see as the key drivers going forward?

We are very positive on equity markets over the next 12-18months. We are of the view that after a long time we have a focussed, proactive and stable government at the centre and whole host of macro factors like inflation, GDP growth, current account, balance of payment and currency are looking favourable. We believe that the decline in economic parameters has been arrested and we are now on a gradual growth path. Over the next 12-18months we believe that with improving economy, lower inflation and commodity prices, the EBIDTA margins for corporate India which are currently at 17 years lows should start improving. From a valuation perspective we are currently in a fair value zone and if earnings growth for corporate India picks up there is enough room for valuations to expand and markets to give higher returns.

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