Largecap Funds | Midcap Funds: Safety with a bit of alpha creation? Trideep Bhattacharya on essence of a Large & Midcap Funds

“A large and midcap fund is for investors who are either new to investing or have a very risk-averse kind of investment outlook. This is a very good fund to take a look at because we have the largecap as the base and on midcap as a flavour on top which can add an element of alpha to the return for investors overall. So that is a bit about the fund in itself, the category in itself,” says Trideep Bhattacharya, CIO, Edelweiss MF.

“In the near term we expect volatility, hence how we get into midcap stocks or funds would be worth thinking about but for investors with a 3-5-year horizon or longer, midcap certainly as an area which would have a lot of potential from a wealth creation standpoint.”On a global front, interest rate hikes are still on the card due to the data that is coming out. On the domestic front too, inflation has gone beyond the comfort level of RBI. Chances of a pause that was expected looks very unlikely. Six months from now, do you think time is tough?
Since the beginning of this year, we have been talking about the theme this year is going to be recession before a rebound. In a sense what we meant and what we still mean is that we expect recessionary conditions globally to persist, particularly in the first half of this year, post which, the economies might see different degrees of bottoming out and subsequent recovery.

So yes, given that in the second half of last year, we have seen an interest rate increase of close to 400 to 500 bps globally, in the first six to nine months of this year, we will see the impact of the same flowing through the economies. The impact will be there in various degrees but there will be an impact and that would make the economic conditions and markets quite volatile.

Do you think corporate earnings are a bit of a concern for you going ahead because so far we have seen a decent earnings season but it is going to be troublesome, specifically the midcap sector?
I would characterise the earnings season a little differently; rather than going largecap, midcap and smallcap, I would go with the sectors and I would say that by and large, the earnings season that went by was a great earnings season from companies exposed to the industrial or the manufacturing side of the economy but not so great from the companies exposed to the consumption side of the economy.

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That might be a bit of a bother, particularly in coming quarters as well. We think that given the government’s focus on capex, given that we are heading into the pre-election year, we would see a strong capex and industrial side of the economy. On the other hand, we have seen a meaningful amount of interest rate increases which has resulted in higher inflation. It has hurt the consumption side of the economy and might continue to do so for the next three to six months. Whether it is large, mid or small, companies exposed to the consumption side of the biosphere, particularly the consumer discretionary element, could see a bit of soft conditions in times ahead.The weakening rupee and the FIIs outflow is quite a concern and do you also think the DIIs are capable enough to hold up the Indian market?
At the moment, the biggest thing that I would hang my hat on is the earnings momentum. India is driven by its bottom-up earnings drivers. That has the potential to keep the DIIs as well as FIIs interested. The issue that we are dealing with in the context of FIIs is that our relative valuation premium versus a whole bunch of other global markets are looking abnormally high. They looked abnormally high at the beginning of the year. It has corrected to a certain extent but it probably still looks a little bit on the higher side.

We think that in the first six months of this year, that will probably get addressed through the relative performance of different markets but the bottom of drivers that we see in India, we do not find in many other countries and hence we think that given the bottom of earnings drivers that we see for the Indian economy for the next two to three years, it will keep both the DIIs as well as the FIIs with the long term outlook pretty much interested in the market.

Let us talk about midcaps and smallcaps. Do you think the valuations over years are stretched or are they attractive right now to place a bet for a longer period of time?
We think that midcap is a very decent place to be in the current scheme of things. The medium-term drivers that I alluded to which are the India capex cycle, real estate demand and also indigenisation of defence, etc, are going to keep the midcap segment of the market fairly attractive for investors who have a slightly long-term horizon which is five years plus.

In the near term we expect volatility, hence how we get into these stocks or funds would be worth thinking about but for investors with a 3-5-year horizon or longer, midcap certainly as an area which would have a lot of potential from a wealth creation standpoint.

Let us talk about Edelweiss Large and Midcap Fund. What is your current strategy? How is the play rolling out when it comes to largecap specifically?
First of all, a bit on the positioning of the fund. This is targeted at those investors who are fundamentally risk-averse but are mindful of the fact that if they only take exposure to the largecap segment that might mean strict competition from the index fund point of view or they want to have an alpha layer on top of the largecap.

For such investors who are either new to investing or have a very risk-averse kind of investment outlook, this is a very good fund to take a look at because we have the largecap as the base and on top of it midcap as a flavour on top which can add an element of alpha to the return for investors overall. So that is a bit about the fund in itself, the category in itself.

You asked how we have constructed the fund. I would say that broadly there are three themes that we are overweight on. First of all, we are extremely positive on the capex cycle that is currently ensuing in India, driven by the private sector. We think that it will intensify over the next two to three years. That is certainly one theme that we are overweight on in this fund.

The second area that we are overweight on is basically going bottom up in the real estate sector which is overall both direct and indirect plays that are a good place to be playing this dynamically. After almost a decade of consolidation post RERA, we are seeing this sector bottoming out and we will see this play out over the next three to five years as well.

The third is basically domestic cyclicals and by domestic cyclicals I mean a combination of financials and other sort of cyclical sectors like autos, where the earnings are bottoming out, the bad asset cycle is behind us and we have a few decent growth years ahead. A combination of these three themes makes us feel that we have a bit of safety along with a bit of alpha creation angle attached to this particular fund through our holdings.

What exactly is the fair strategy of constructing a portfolio for this particular fund? Could you please elaborate on that?
One of the things that we keep in mind is the risk averseness or categorisation of this fund. The beta of this fund is kept in such a way so that we do not go out of kilter and take undue risks and we give investors the stability.

But at the same time, there is a little bit of a kicker with regards to alpha from exposure to the midcap segment as well. So, net-net, a decent exposure to largecap plus a midcap element of 30 odd percent makes it an ideal candidate for investors who want to take a calibrated view on Indian equity markets.

What is the risk management strategy that you have adopted because largecaps will obviously provide a certain level of stability but the kind of volatility you incur due to midcaps, how is that maintained in the fund?
If you look at the way the category is defined, 35% to 65% is kind of largecap and about 35% is midcap. So our exposure is limited to a certain extent so that we do not overdo the risk element in terms of exposure to the midcap part. The largecap part provides a bit of stability. The midcap adds an element of growth to the overall portfolio and makes us feel that the risk or risk averse nature is captured by the higher largecap component and alpha component is captured by the midcaps and smallcaps which could be up to about 35 odd percent.

That is one of the ways to measure the risk. On the other side, we take a calibrated view with regards to corporate governance and with regards to profitability of the companies that we bet on and the valuation consciousness. These are the other risk mitigating characteristics which we particularly adhere to to make sure that we do not fall into the trap of taking undue capital risk which is one of the big things that we are mindful of, particularly when we are managing a fund in this category.

I want to focus on the theme and within that also, the domestic cyclical recovery which has almost 54% of exposure. You have mentioned financial, realty, automobile and consumer durables being a part of it but I want to understand in a few quarters what is the outlook for these particular sectors and the exposure to the call that you have taken. What are the positives that you are looking at?
In our opinion, domestic cyclicals are the place to be given the bottom-up earnings drivers that I have been talking about so far. The outlook is based on the last three-four years that we have seen, particularly the biggest segment of domestic cyclicals which is financials. Over the last two to three years, the corporates in India have gone through a major deleveraging cycle.

Most of them are generating cash flows and are ready to invest from that perspective. Also, the bad asset cycle is by and large behind us. Both these make us feel that the country is ripe for capital formation and credit growth is likely to be fairly robust at about 13% to 14%. That makes us feel that along with profitability, as lending picks up in different parts of the economy aiding the capital creation point of view, financials is a decent place to place your bets from a medium-term standpoint, whether it is largecaps or to a certain extent midcaps as well.

You are underweight on this fund in power, oil and gas and consumer. What are the red flags here?
We do not want to call it a red flag but I think these are the areas where we could see more headwinds than tailwinds. We talked a bit about consumption. We think that overall in the last six months of CY22, we saw a good amount of interest rate increase which is driven by high inflation. As that feeds through the economies and leads to higher interest rates for mortgages, we would see a bit of slowdown, particularly when it comes to consumption of the categories which are rate-sensitive or for that segment of the population for whom inflation makes a meaningful dent. Hence, we are underweight on consumption.

As for oil and gas, given that we have seen a peak in oil about a year or so driven by geopolitical crisis, it is likely to be more down rather than up and hence we have taken a more dim view of oil and gas from a sectoral position standpoint.

What kind of an investor should be investing in this kind of a fund because we do have separate largecap and midcap category funds as well?
The positioning of the fund is probably a very important part to understand for investors who are either new to equity markets or who are very risk averse, who want to have the cushion or the comfort of the largecaps but are yet to take a little bit of exposure to the midcap segment or the wealth creation angle of the Indian economy, this particular fund is very suitable. This investor is historically a debt investor, new to equity markets or has low equity allocation and is quite risk averse and maybe a higher age group based investor.

For investors like this, the fund provides the right concoction of safety along with a little bit of risk in the form of midcap, not waving towards the smallcap but more towards the midcap. So, a very calibrated risk, along with safety. As long as characteristics appeal to the investors, they should be interested in this one.

What is your understanding of the Adani crisis and what does the kind of maturity the market has shown actually mean and why mutual fund houses and schemes are still invested in such a controversial group?
So, first of all, the fund that we talked about, the Large and Midcap fund and several different funds that I run on the active long-only strategy at Edelweiss, none of those funds have any exposure direct or indirect to the Adani Group. I think most of the mutual fund industry has by and large escaped a certain group of companies from a direct investment standpoint. Ultimately that goes on to show that active management works.

Just because the company is part of an index, we have not taken an exposure just to cover our risk. We have taken an active view with regards to a certain group of companies where our views could be divergent with regards to where the index is. It is a thumbs up for the active management industry because the majority of the mutual fund investors or mutual fund houses do not own the group names that you have talked about.

At the same time particularly from our fund house standpoint, we have a strong philosophy oriented around forensics, corporate governance, etc, which makes us sometimes take more conservative bets but at times, makes us feel a little better given that we have not taken undue risk not only in large and midcap fund but for that matter in any other long-only fund of our fund house as well.

For investor education, would you like to explain why this kind of a crisis should not change their decision to stay put in a fund or to make an exit?
At times like these, occasionally investors’ appetite wanes and they start to question the ethos. But overall, given the fact that none of our funds have exposure to the group that you talked about, gives some comfort on the due diligence that we do. So first, trust the fund house that you invest with. You will see over a period of time whether they have done the due diligence or not and as long as they have done that, it is worth paying attention to the fact.

Second, pay attention to the process and the philosophy that they follow. We talked about corporate governance as an investment pillar of how we go about selecting investments.

Third, bear in mind that for an economy worth trillions of dollars, instances like these are a drop in the ocean. The way I see this is that this will make the governance of regulators as well as the powers to be more stringent and will make markets more efficient and better for investors to invest in. So there is no need to really panic on the back of one isolated incident. This will not drive the economy into some sort of a tizzy or a recession or something of that sort. This should be treated in isolation. The details will come out as time passes and I am sure there will be pros and cons.

But on net balance, this will not destabilise the themes that I talked about in the context of India like capex or for that matter the real estate sector or for that matter the domestic cyclicals part that we talked about. So net-net stay put, stay invested and keep the faith in the fund house that you are invested in. By and large, you will come out in flying colours. Largecap Funds | Midcap Funds: Safety with a bit of alpha creation? Trideep Bhattacharya on essence of a Large & Midcap Funds

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