'Currently, there is very little valuation differentiation between value and growth stocks'

"Phenomenon", "surprise". These are two words Ajay Argal uses about Indian investors' unprecedented discipline in the equity market. That retail investors have played a major role in the rise and rise of the market in recent years is something that has pleasantly surprised the Franklin Templeton AMC's senior vice president. "This (kind of disciplined investing) has occurred for the first time in Indian markets," he quips during our hour-long conversation that covers diverse topics, ranging from his fund house's investment philosophy to his take on the new-age companies.

Argal, who currently oversees five funds with assets around Rs 27,500 crore, including the four-star-rated Franklin India Focused Equity and Templeton India Value funds, also speaks about how there is "little valuation differentiation" between value and growth stocks.

Here's an edited version of our conversation with him.

You completed engineering at IIT and then went to IIM. What sparked your interest in the financial markets?

I have always had a keen interest in numbers, and in our generation, individuals with a passion for maths and numbers often pursued careers in engineering. I had always aspired to attend IIT, and fortunately, I managed to secure admission into the aeronautical engineering department. However, I realised that, at least then, the opportunities were very limited in India, and I wanted to stay in India.

Gradually, while at IIT, I enrolled in an economics course and developed a keen interest in it. Later, I decided to pursue a management course. I aimed to gain admission into the IIM, and once there, I explored a variety of subjects. In my second year, I primarily pursued finance courses, which eventually led me into the financial industry. That's how I transitioned from engineering to finance.

Can you describe your investment philosophy? What types of stocks or market situations excite you the most?

At Franklin Templeton, our investment philosophy prioritises growth at a reasonable price, also known as GARP. The starting point for us is always the growth outlook, but at the same time, we are conscious of valuations and not willing to get into stocks at any price. Within the GARP, we have an investment framework called QGSV, which means quality, growth, sustainability, and valuations.

Most of us understand the concepts of quality, growth, and valuations. I want to emphasise the importance of sustainability. Basically, we focus on trying to identify growth compounders, and they are a predominant part of our portfolios. We prefer to invest in stocks where we can forecast growth for a five to seven-year timeframe. Even if you look at our funds, those portfolio turnover ratios would be around 25-35 per cent, typically meaning that our holding period would be nearly four and a half years. Therefore, we don't just buy and hold but also regularly monitor various factors such as growth outlook, cash flows and return ratios. Our stock investment style is bottom-up, but we look for sectors or themes from the top-down approach.

What criteria do you have before investing in a stock?

Stocks to enter our portfolios should have a good combination of growth and valuation, as I discussed earlier. That said, there will be a predominance of growth compounders in the portfolio, which will be marquee names. So, if you look at our portfolios, you will find that a few top names are quite different from the market, competitors or benchmarks. We focus on stocks with a different view and an investment horizon of three to four years. We don't adopt a long-term investment horizon of seven to ten years, as we believe that investing too early in any cycle can lead to both positive and negative returns. All these factors contribute to our thought process, which essentially involves striving to differentiate ourselves from the market.

What are your views on new-age tech companies, especially since you hold a few in the Franklin India Focused Equity Fund?

It's a very interesting space because we've seen them as disruptive forces across various sectors. Disruptive means they do business in new ways and shake up old ways. Several sectors listed their stocks in 2021, but we refrained from participating in the initial public offering (IPO) due to excessive hype and unappealing valuations. Simultaneously, the business presented a promising growth opportunity, but the founders prioritised market share over cash flows and profitability, resulting in low profits. However, things started to change around 2022 when there was a correction at Nasdaq, which was the driving force behind all the private equity players financing these kinds of companies globally and in India.

As liquidity tightened, it instilled discipline in numerous stocks, compelling them to turn profitable. As a result, they began to reduce costs and devise innovative strategies to increase profits, ultimately guiding some stocks towards profitability. So, we are identifying stocks that are leaders or have a dominant position in the industry with a solid growth outlook. Therefore, we are seeking companies whose promoters or management have redirected their efforts towards achieving profitable growth rather than pursuing growth solely for the sake of profit. Some stocks in our Build India Fund and Focused Fund contributed to our performance last year, and we are always looking for such opportunities. We are very positive about the space because these kinds of companies have created a lot of value in other markets, like the US, and we think similar things can happen in India as well.

Value as a theme has performed well over the last four years. Given the current valuations, do you think it can continue to outperform?

It's quite challenging to make a definitive statement, particularly given the recent success of value as a theme. So, in that sense, currently, there is very little valuation differentiation between value stocks and growth stocks. We have generally seen value stocks have lower growth, and that still continues. However, investing in stocks with lower growth and a higher valuation is extremely difficult. Typically, we have seen value stocks doing well for a shorter period of time compared to growth stocks. This is because India is a growth market, and we have faster gross domestic product (GDP) growth than most other countries. So, from a long-term perspective, growth will continue to do well.

That said, some pockets still have opportunities, such as the banking and financial services sector. The valuations in the banking sector are very reasonable, and it is likely the only sector where the current valuations are lower than the last five years' medians. Similarly, in the IT sector, valuations are close to the five-year medians, but growth is lower than previously.

The mid- and small-cap segments have been phenomenal lately. Do you think this momentum is sustainable?

From a long-term perspective, mid and small caps tend to do better than their large-cap peers. On a compound annual growth rate (CAGR) basis, mid and small cap might have given extra returns of 2-3 per cent over large cap in the last 20 years. Since they give higher returns, the volatility is also higher, and drawdowns can be bigger than large caps. In the last two or three years, they have done well, and valuations are on the higher side. The current Nifty valuations are very close to the average of the past 10 years, but the mid-cap index is trading at a premium of nearly 50 per cent to Nifty. This situation has never occurred before.

Similarly, the small-cap index is trading at a premium of 10 per cent over Nifty. Therefore, we plan to exercise caution in the near term when investing in mid- and small-cap stocks. That's why we prioritise large caps more heavily in our diversified strategies, whether it's the focused fund or the flexi-cap fund. Therefore, we take a more cautious approach in the short term. But as I said, in the longer term, if you are coming to the market for growth, it will be higher in the mid- and small-cap segment, and it makes sense to participate there as well.

Most infrastructure funds have underperformed as a category. What causes this underperformance despite the benchmark being up 130 per cent in one year? Does it still make sense for investors to invest in cyclical thematic funds?

I think investors can still look at active funds in these segments. We need to understand the reasons for underperformance compared to the index. The primary reason is that the BSE Infrastructure Index is very skewed, with illiquid or low-floating stocks. This segment accounts for nearly 30-40 per cent of the index, and neither we nor other infrastructure funds have invested in many of the names within this segment.

We have seen in the past that whenever the markets do well, such segments of the markets do better, and we have seen that happen in the last one year. From an investor's perspective, we have been cautious and have not ventured into some of these names, which has resulted in some underperformance. However, in the past, we have observed outperformance of up to 20 per cent. Therefore, I would argue that the benchmark is not truly representative because of these constraints.

Is there any market trend or event that has caught you off guard?

Retail investors have largely led the kind of market movements we have seen in the last few years. This is a phenomenon that I believe has occurred for the first time in Indian markets. I think retail investors' participation was building up from 2014-15, and there was a substantial increase in equity flows and investments through systematic investment plans (SIPs). This trend has intensified over the last few years, with investors consistently buying the dips. So, the kind of discipline they are bringing in and the consistency of their investments is something that I am seeing for the first time, and it surprises me.

Also read: Interview with Rajat Chandak of ICICI Prudential Mutual Fund