Cautiously Positive

Advising investors to expect moderate returns going ahead, R Janakiraman, Fund Manager at Franklin Templeton Investments India, shares his investment approach and talks about the Franklin India Smaller Companies Fund in an exclusive interview with Mutual Fund Insight.

What is your approach to investing? Is it growth, value, growth at reasonable price (GARP), contrarian...?
I really would not classify my investing approach into any of these categories in a complete manner. I follow multiple approaches while investing. There are times when I have applied a contrarian approach. Those were stock-specific calls. Having said that, if you look at what kind of philosophy I have followed in the last decade, it is broadly GARP. It is not totally GARP, but predominantly what I follow is close to GARP. The idea is to identify good-quality stocks and buy them at relatively reasonable prices for a longer time period. The investment philosophy does not vary and stays the same across schemes.

Many money managers across the globe look at the investment strategies of well-known people like Warren Buffett, Peter Lynch, Charlie Munger and Philip Fisher? Have you ever done this?
All the names you have mentioned are great investors and their written material is also extremely useful. So, I have gone through much of their material but you do not follow a particular investor in toto. Instead, you pick the best of material from the investment luminaries. I am also influenced by the thoughts of people like Ben Graham and Adam Smith, who has written a classic book called The Money Game. The book mostly deals with the behavioural part of investments. I would say that I have gained a lot from the writings of investment gurus. For example, the writings of Peter Lynch are very useful for mid-cap investing and his style of investing requires people to have a very open mind and it also calls for going and meeting companies. It is a kind of exploratory investing, which fits very well in the mid-cap category. I have been influenced by a lot of such very successful investors and would not like to limit myself to a particular investor.

Franklin India Smaller Companies Fund has been a top performer in the mid- and small-cap category. What stocks or strategy contributed to the great performance of the scheme?
The strategy is the same across all our schemes. The strategy is to identify and invest in good-quality businesses. Along with that, there are certain financial parameters we look at while investing. The key metric that we look at is whether a business provides a good return on capital. We like business that are less capital intensive and are able to generate good cash flows through a business cycle. The management should be good at both day-to-day execution as well as strategic decisions. The board should treat the minority shareholders in a fair manner. One more factor I emphasise a bit more is the growth prospect as the overriding theme in the mid- and small-cap space is growth. So, we try to hold stocks which have the ability to generate sustainable growth over a longer time period. Having said that, if we look at the stocks which have helped the fund over the past one- or three-year period, the top five performers are Finolex Cables, JK Lakshmi Cement, Amara Raja Batteries, Gujarat Pipavav Port and AIA Engineering. Most of the alpha returns have come from the stocks which have been in the portfolio for a longer period of time.

How is your portfolio allocated? How much of your portfolio can be allocated to small-cap stocks or mid-cap stocks?
Franklin India Smaller Companies is a small- and mid-cap fund. As far as the offer document is concerned, the mandate is that a large portion (70-80 per cent) gets invested in mid- and small-caps and we intend to invest as much as possible in the small-cap segment. We try to be in both the mid-cap as well as the small-cap space. But it is difficult to build a position in the small-cap space because the impact cost is very high and we do not get time to build a position as the stock price is also running away too fast in strong markets like now. It is very frustrating for people like us. So, if you look at the current exposure, both small-caps and mid-caps account for 40 per cent each in the portfolio. There is no internal cutoff for the portfolio allocation, but we want to differentiate this product as a small-cap fund. Over the last one year, we have managed to keep the small-cap exposure to about 40 per cent. What has changed in the portfolio in the last one year is that the number of stocks in the universe was close to 43-45 stocks a year ago, but now the number has gone up to 65 stocks; the reason being relatively high impact cost and difficulty in building a position. So, to deploy the same amount of capital we need more number of stocks.

Does your investment parameter differ while choosing small-cap stocks, compared to mid-cap stocks?
Absolutely no. The characteristics of the business we seek while selecting companies and the philosophy we follow stay the same for both mid- and small-caps.

Do you or does any research analyst from Franklin Templeton meet the management of each company in your portfolio?
Definitely, the level of research in small-caps from the sell side is limited, especially during market downturns, and you have a limited number of analysts covering small-caps, with the quality of the analysts covering small-caps being a bit raw. Small-caps are the segments where promoters and the management can change strategies without much notice, and this can have an impact. Business changes and changes in the way of running a business are frequent in small-caps. These businesses are not very well-established and don't have a predictable momentum. The momentum can change direction, so periodic engagement with the management is required. We do meet the companies or engage in telephonic conversations with them or meet them at investor conferences. Engaging with the management is not a must for mid-cap stocks, but it is imperative for small-caps.

Do you come across very attractively priced good small- and mid-cap stocks which you wish you could buy but cannot buy in your fund for liquidity reasons?
In small-caps, liquidity is definitely a challenge, especially now since the market conditions are good and we have a large number of investors who are positive about small-caps. So, the demand for good-quality ideas in the small-cap space is on the higher side now. Hence, building a position is challenging. There are quite a few stocks where we could not build a position due to liquidity. Having said that, if the quality of the business is strong and the quality indicates that we can take a five-year view for the stock, then we can afford to ignore the poor liquidity and keep investing in that company. It takes longer to build a material position, say, two or three months and I will go ahead with that investment. I think the primary aspect is the quality of the business and the secondary is liquidity. There are a few stocks in the portfolio which have taken time to build a position. For instance, look at the industrial stocks which have been in the portfolio for a long time and are highly illiquid, like FAG. It took us a bit of time to build a position, but the fundamentals of the business are promising enough to overlook this handicap.

What kind of stocks do you avoid in your portfolio?
Companies which have business models that are difficult for our team to understand. We would choose a business which we are able to understand, especially from the risk perspective. As an investor, I am very particular about free cash flows. So, we are extremely hesitant in investing in companies that do not generate free cash flows, even during one full business cycle. For example, if you take a business cycle of five years and the company is strong in terms of revenues but it is unable to generate free cash flows, even in the entire five-year period, then I would avoid holding such businesses.

How long do you wait for a stock in your portfolio to perform? And when do you sell a stock?
As long as the business is doing well, I have no issue with the stock. But there have been instances where the underlying business is doing well and the stock is not performing. So, there is a disconnect between the stock price movement and the business performance. In such cases, it's very clear that we will hold onto the stock and we add to the position if the valuations become even more attractive. So, our decision of holding onto a stock is completely driven by the underlying business. As far as selling a stock is concerned, it happens due to two factors. When the valuation becomes expensive, we try to reduce the exposure to that stock. We consider both absolute valuation as well relative valuation. We also want to reduce the exposure when there is a fundamental deterioration in the underlying business. If you are able to identify the deterioration earlier than others, then you will be able to come out in a more elegant manner. But if you are late, you will be forced to sell the stock.

How different is the investing strategy from Franklin India Prima as both Prima and Smaller Companies Fund are part of the same category, though they differ in market capitalisation?
There is absolute similarity in terms of our approach and the way we choose a stock. The primary differentiator is the market capitalisation of stocks. Prima is primarily a mid-cap fund where the small-cap exposure stands at 10 per cent, whereas it is around 40 per cent for Smaller Companies Fund.

What are the risk mitigation measures you take for your fund?
Primarily, the main risk mitigation measure we take is that we do a thorough analysis before buying a stock. It is difficult to get in and come out of small-cap stocks without a high impact cost. In the past, when our business analysis was not very thorough, we have had problems invariably. Second, when valuations become expensive, we look at both absolute as well as relative valuation. Third, as an ongoing process, we keep meeting companies. As the momentum slows, we engage with the companies and find out what the company is doing and what the competitor is doing. Ideally, the standard way to mitigate risk is diversification. But I am not fully convinced with that and am fine with a concentrated portfolio. Unfortunately, in the last one year a lot has changed: like the kind of money that has poured in and the manner in which stock prices have run up. So, we have a larger number of stocks in the portfolio, but I try to have a more concentrated portfolio. In risk analysis, we try to do some scenario analysis and put the business in extreme conditions to see how the business will perform. This becomes very important for capital-intensive businesses, where, if business conditions deteriorate and the capital intensity does not, then the margin of safety goes through challenging times. Eventually, the business may come back, but the equity value gets hit very hard.

What strategic or tactical changes have you made in your portfolio after the election result and upswing in the market?
Not very significant changes. When we look at the last one-year portfolio, there is a marginal increase in industrial products and banking in the portfolio. Apart from that, there has not been a significant material change as far as the sector allocation to the portfolio is considered. Within that comment, I would also say that exposure in businesses dealing in consumer discretionary and industrial products have gone up. The thought process was that because of the macroeconomic recovery cycle, the consumer sentiment will turn positive. So, we have added exposure to consumer discretionary companies. And when the consumer sentiment revives, you will see a revival in the industrial capital cycle as well. So, we have added these stocks to our portfolio.

What is your outlook for the market? Will it sustain the momentum?
My outlook is a bit positive and a bit cautious also. The last one year was very strong, especially in the mid- and small-cap space. So, I think investor expectation should be a bit more moderate going forward. I do not think it should be influenced by the returns obtained in the last one year. Having said that, there is still a sizable amount of return to be made over the next four-five years, primarily because you are going to see a further strengthening of growth as far as macro growth is concerned. And I do expect the country's GDP growth to be at an average 6 per cent over the next five years. The combination of a recovery in corporate profitability and attractive GDP growth will ensure that the earnings growth is attractive. The moment the earnings growth becomes attractive, that will lead to stock returns as well. So, still a large degree of returns are there to be made. But those returns will be more measured and will happen gradually over a longer period of time unlike the past one year. I am quite optimistic about the market but cautious about the investors' expectation going forward.