"If there is a great company available in a bad cycle, I would love to own that"

Even as the S&P BSE Mid Cap Index has given single-digit returns in the last one year, Motilal Oswal Midcap Fund has delivered around 20 per cent. Niket Shah, Fund Manager at Motilal Oswal AMC, speaks about the performance of the fund and how he plans to manage Motilal Oswal Flexi Cap Fund, where he has been recently appointed as a co-fund manager.

Motilal Oswal Midcap Fund has given returns of around 20 per cent in the last one year, while the BSE Mid Cap Index is up by just 7 per cent. What has worked well for the fund this year?
There are a few things which have worked in our favour, with the first being the sector selection. In October last year, we went extremely underweight on the IT and cement sectors. We did not just trim down the position due to expensive valuations but we brought down the holdings to zero in Motilal Oswal Midcap Fund. From the start of this calendar year, IT and cement corrected dramatically and we had no impact on the portfolio as we were completely out of those sectors. On the other hand, we went overweight on sectors such as banking and capital goods and some consumer names started doing well, so we had the double benefit of exiting IT and cement and entering into banking and capital goods at the right time.

Secondly, even in some of the sectors which were marginally overweight, our stock selection was spot on. We had one auto stock in our portfolio and that ran up six times since our initial buying, which is benefiting the fund. So, our focus always remains on choosing the right sector and within that sector, picking up the winners. To give an example, IT stocks did quite well in the last few years but one of the biggest players in the industry underperformed compared to some of its midcap peers. So, even if the sector selection is right, one needs to identify the right stock within that sector. We ride through our winners and don't just sell after the stock prices have moved up significantly. We also had a lot of multi-baggers in our mid-cap portfolio, so our performance didn't come from one stock or one sector but it was very broad-based. Also, we like to buy companies when the overall environment of that sector is bad. If there is a great company available in a bad cycle, I would love to own that. Apart from that, at Motilal Oswal, our investment process revolves around the 'QGLP' framework, which denotes the quality of the business and management, growth in earnings and a sustained return on equity (ROE), the longevity of the competitive advantage or economic moat of the business, and our approach to buying a good business for a fair price rather than buying a fair business for a good price.

Can you explain the rationale behind completely exiting the IT and cement sectors and going overweight on consumer names and banking?
In the IT and cement sectors, earnings had dramatically moved up in terms of growth post the COVID-19 era. Particularly in the IT sector, businesses across the world invested heavily in tech and in our opinion, a lot of demand was preponed. So as discussed earlier, in October last year, we reassessed the earnings growth of some of these sectors and we were able to clearly see that the earnings-upgrade cycle was about to end. Tech companies got all the benefits during 2020 and 2021, like lower costs due to less travel and everyone working from home. On the other hand, the revenue remained extremely strong. This situation hasn't happened in the past 20 years and we thought this is not sustainable. We believed that the earnings cycle was about to end, coupled with valuations at the peak and a lot of headwinds coming due to cost escalation post the opening up of the economy. All these factors, put together, clearly make a case for not owning any of them. A similar pattern was seen even in the cement sector, with the high demand in the post-COVID era, which helped companies improve their profitability. But later valuations peaked and we thought of exiting the sector.

Let's talk about the sectors we bought after exiting IT and cement. Post COVID-19, banks were not growing as there was no major growth in assets under management (AUM) and they continued to do aggressive provisions. On the other side, we believed that the compression in net interest margins (NIMs) and cost to income were behind us and their balance sheets were looking extremely strong. So, all these factors led to us being bullish on the banking sector. Similarly, we went aggressive on one consumer name in the mall space. We envisaged opening up of the economy and that company had a massive capex to double the square foot (sq ft). From seven million sq ft, they were planning to go for 14 million sq ft and we entered the stock before the earnings started to play out. Again, we had another footwear company in our portfolio whose target was more into sports and leisure wear. Our premise here was that we believed in casualisation, where more and more people went for casual shoes, sneakers and sports shoes, which also played out quite well for us.

Can you elaborate on how you take sector and stock calls? There is also a high turnover in your fund. Is the sector play reason for that?
First of all, sectoral calls are extremely important for us. But at the same time, there are cases where a sectoral call is negative but we still would have gone long on a stock. To give an example, we were quite bullish on one auto-ancillary company as it was getting aggressive on the EV space but was not completely in awe of the auto sector. We do marry bottom-up and top-down approaches together at a reasonable level. Having said that, we do take sector views but for us, bottom-up is extremely important. There are cases where we have taken bottom-up views, for example, one of our recent holdings has been one of the finance-distribution companies. Even though we are not bullish about the asset-management space in India as of now because of the growth factor, we have an extremely positive view on that particular stock. In the second part, the high turnover ratio is due to the higher concentration. We have concentration in our funds and we liquidate our entire holdings if we are negative on those stocks. So, if there are three stocks having an allocation of 7 per cent in the portfolio and we plan to exit, then there is a churn of 21 per cent in a matter of days. For us, the reason we've been able to perform over the last two years back-to-back has been sector selection.

Motilal Oswal Midcap and Flexi Cap funds have long maintained a focused portfolio of maximum 30 and 35 stocks, respectively, they are now free from any such restriction. What led to this significant change in the fund style after so many years?
It's not by design. Our fundamental view was that we want to have complete freedom in terms of investing in a number of stocks and not restrict ourselves only to 30 stocks. The drawback of having 30 stocks is that tomorrow for some reason, suddenly, if the funds start seeing massive inflows and assets move up from Rs 3,000 crore to Rs 8,000 crore, then we don't want to be in a situation of searching for ideas to deploy the cash. To ensure that performance doesn't get impacted, irrespective of the flows, we had clearly taken a call that we would remove that limit and it's just an enabling thing. If you look at our portfolio, we have still not crossed 30 stocks. We don't think we will cross it soon. But it's an enabling resolution.

What has caused the Motilal Oswal Flexi Cap Fund to significantly underperform its peers over the last five years? Now, with you co-managing the fund, how do you plan to turn it around?
Yes, there were a few things which we have, of course, corrected now. So, earlier our flexi-cap fund had a low exposure towards mid caps (around 10-15 per cent, compared to our peers which had 40 per cent) and more towards large caps. In the last two years, the market rallied and mid caps disproportionately outperformed the broader market. The second thing which was also important is that while the sector selection was always right, in the flexi-cap fund, the stock selection was a bit of a concern. So, if we were bullish about the IT sector, we invested in top large-cap names and not in mid-cap IT stocks, which gave much higher returns compared to that large-cap stock. Third is I think we had a slightly higher allocation to insurance, which hasn't done so well. And we've kind of done some course corrections there to ensure that now we don't have a disproportionate allocation to a sector where things are not very clear. The longer term might be clear but the near term might have some impact. So, we've been very clear in terms of what weights we are putting on every stock in the fund. We are very clear that we want to increase the exposure towards mid-cap stocks in the flexi-cap fund going forward.

What are your views on new-age tech companies as they have corrected significantly?
This new-age technology sector is still evolving and it must focus on profitability. I do see more corrections happening in these companies, as India has not seen one proper slowdown for start-ups. Between 2017 and 2020, they got massive capital from private-equity guys and they continued to burn cash to show growth. From late 2020 till now, everything went online due to the pandemic and they continue to survive. But they haven't seen one bad cycle of slowdown and the lack of capital to grow the business. Once this cycle evolves, there will certainly be a winner among the listed peers, but is it a good time to buy? The answer is no. I think we still have to see how they navigate and come out of this whole cycle.