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We are gradually reducing underweight in select financials and cyclicals: Parag Thakkar

The Portfolio Manager, ICICI Prudential PMS, says FMCG, pharma, telecom and IT are the recurring themes which will exist forever.

Auto has rebounded a lot from March lows. Do you expect the rally in auto to continue or are you spotting some opportunities in auto ancillaries now?
I would say that easy money has definitely been made. We have recovered significantly from the bottom. There can be some consolidation, some retracement but as you rightly pointed out, auto components stocks have not moved at all. There is a good headroom in auto component stocks because as you rightly said, this quarter was a complete washout, plants were shut for 45 days and there were so many logistical issues. Many auto components companies had a negative operating leverage and they reported very bad numbers. I would say that auto components should be a good investment opportunity from here on.

You have managed to generate quite a lot of alpha in your large cap and the contra funds. Let me start with the contra fund first. What worked for you ahead of the curve?
I strongly believe that you have to buy good companies during bad times and that is the philosophy which is very close to our heart at Prudential ICICI PMS. The other thing is we avoid leverage. We tried to buy large genuine clean businesses which are gaining market share with a very decent ROE, ROCEs and I would say that we completely avoid leverage and that that has helped.

For example, in January, the financials’ weight was around 42% in the benchmark and we were completely underweight at that time because even the pre-Covid economy was not doing that well and financials are a leverage proxy to the economy. So we were underweight. We were overweight on pharma, telecom and FMCG names. That has helped us generate this kind of alpha.

As we move around, we feel that as the economy opens up despite the partial lockdowns, there is money to be made in cyclicals. For example, we are reducing our underweight in very select financials which have very good deposit franchises, prudent lenders and of course they have a very large value sitting in the non-lending businesses like mutual funds or insurance and those names have helped us. We are underweight financials and cyclicals going into the event and then FMCG, pharma, telecom gave us very good alpha. Now, we are gradually moving into cyclicals.

In the large cap space, which are the themes you got in early which helped you outperform the benchmark in your large cap scheme?
Pharma has helped us a lot across our portfolios and we as a house had a very constructive view on pharma when valuations were very attractive. Now we have seen a significant rally in pharma but we were very bullish in pharma at the very beginning of the cycle. FMCG has helped us across the portfolios and FMCG, pharma, telecom and IT are the recurring themes. We believe that these themes will exist forever and when the economy is not going that well, we stay away from cyclicals or leverage names. But when there is a clear visibility that economy is gradually improving, then we try to bottom fish in the cyclical names but that too we avoid leverage and that has actually kept us in a good stage because if you have a leverage in the business, if you have a very high fixed cost, then one quarter of lockdown or 45 days of lockdown can wipe you out. That is why the portfolio companies have survived and we are very confident that they will emerge even stronger in this cycle.

What is your outlook in the contra fund? Have you made any changes in your strategy?
As I said these three-four sectors – pharma, FMCG, telecom, IT — have delivered fantastic returns. We are increasing our weights in very select financials and that too gradually. We are not saying that we should put our entire money in financials today but gradually we have to invest because now financials have corrected significantly, they have underperformed significantly, at the same time gradual opening up of the economy, RBI policy will help them sail through this and I am talking about very select financials where the deposit franchises are very strong, where the distribution reach is very good and lending is also prudent which is the most important part,

Non-lending subsidiaries have a large contribution in their SOTP values so that provides a cushion to you. The other part is auto components. The tractors, two-wheelers have started seeing good traction. The auto component companies that were suppliers to this will start benefiting now and they have not yet shown that kind of a momentum unlike the larger OEM companies which have actually given very good returns. We were positioned well from that perspective. We had 6-7% weight in auto companies which were more rural centric in portfolios. So that is the stance that one has to gradually build up cyclical names as the confidence comes back on the economy side.

Have you started looking at good quality midcaps favourably in any of your schemes? What are your thoughts on valuations there?
Whether it is large cap, midcap or small cap, we follow is framework and that framework tells you that if a management is absolutely clean and we have seen them through cycles in the down cycle as also their capital allocation and we have a positive view on management and the way they have handled the business over the last so many years.

Apart from that, we consider if the balance sheet is very under-leveraged and there is no debt or very minimal debt or if the promoter is clearly committed to reduce debt. For example, in the last quarter results, some of the cement companies have started reducing debt even in a Covid quarter. It is very exciting for us that in a Covid quarter where the plants were shut for 45 days, a company is reducing debt. The company should not be on very high leverage levels, net debt to EBITDA was already below 1.5 and still it is reducing debt. We look at those kinds of qualitative factors before we start investing.

Third one is of course ROE, ROCEs, return ratios and cash flow conversion. There should be no significant working capital leakage, debtor days, inventory days should be properly in order in line with the industry trend or better than the industry trend.

The fourth factor is valuations and valuations I believe that in a good company which you always want to buy when the right opportunity comes is when there is a problem in the market or the sector or that company and that is how the contra positioning helps that you can buy when others are selling but you can buy the best company of that sector.

How are the flows right now to your schemes? What kind of AUM have you achieved now and across the PMS business?
So we have around Rs 3,000 crore in our PMS portfolios and we are getting good flows. It is a reasonable good inflows and I would say that things are pretty good for us in the sense of inflows.

What kind of conversations are you having with your HNI clients? There is a sense we are getting that a lot of new investors are joining the markets be it traders or investors?
Yes, definitely there is an equity cult going on, I hope that like everytime in the past it does not end in a sorry state. I would say that global liquidity is very strong. The US Fed has expanded its balance sheet by $ 3 trillion in the last quarter post Covid, bond yields are low. I would say there is a complete lack of alternate investment avenues in the world and that is why everybody is attracted towards either precious metals or equities.

Zoom market cap has touched $ 75 billion and it hardly has any earnings. So I would say that yes equity cult has caught up and when interest rates are zero, all these things can happen and continue for a while. My only reckoning is that you one has to be very careful, especially in such times of momentum and one has to control emotions and not get carried away.

We keep advising to our investors that we will ensure that we invest in good names and as I said, companies without any debt or very low leverage names and where we have seen then through last three-four decades. We are not venturing into something which is very new and exciting. If you keep some moderate cash in the portfolio, that should be fine but right now long institutional volumes are at all time highs. I would say that things are in a momentum phase driven by liquidity and lack of alternative investment avenues,

The other conversation which always happens is how is it that in the midst of lockdowns, when economies are in such a volatile phase, stock markets are roaring? We have to agree it is a liquidity driven zero interest rate driven bull market, but wherever we see companies outperforming and breaking above 20% ROE, ROC, companies which are debt free, those are getting the attention. The PE multiples are getting rerated over there. Of course, there is another basket of the trade where the stocks are very cheap and dividend yields are very high so that when you put money in FDs, you get 6% return in some of the power stocks. You are getting 8%, 9%, 10% dividend yields and those are very exciting contra opportunities and the dividend yields are sustainable.

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