Interview with HDFC Mutual Fund – Part 2
Oct 12, 2007

Author: PersonalFN Content & Research Team

In the second part of this interview, Mr. Jain outlines HDFC Mutual Fund's investment philosophy and airs his views on sector/thematic funds, mid caps and large caps and interest rates among other topics.

Pfn: Could you please describe the investment philosophy and style (across equity and debt funds) that is followed at HDFC Mutual Fund?

Mr. Jain: It is actually quite simple; our target is to beat the benchmark consistently; for us, peer group is less relevant as it is a moving target. Each year number one fund is different. People also compare focused or thematic funds with diversified funds, which is not fair. There was a time when people used to compare technology funds with diversified equity funds. Then there was a time when banking funds were popular and as of now, infrastructure funds are popular. This is not the right way to look at funds. Mid cap and large cap funds also tend to behave differently at different points of time. Lastly, funds with a poor track record keep on dropping out of the list and the peer group itself actually is a winners list.

In my opinion, broad benchmarks represent the market, and if we continue to beat the market consistently, over 3-5 years, we should be at the top or near the top. This is so because though each year some funds may do better than us, few funds manage to beat the indices consistently.

How we go about trying to beat the indices is by avoiding big mistakes. We try to avoid buying poor quality businesses and would like to buy businesses, which create genuine wealth over time, have competitive advantage and a good track record. We don't buy businesses because they are in momentum or we expect the share price to grow up.

We have a list of companies, nearly 230 in number today, and it keeps increasing over time. This is a list of businesses that in our opinion are of an acceptable quality, have a reasonable track record and have competitive advantages, which gives sustainability to the businesses. Portfolio managers create portfolios from this list. This results in our funds not owning businesses, which are below a certain threshold quality.

We invest with a medium to long-term view. For example, today in our funds, we are underweight cement stocks as they are trading at roughly two times replacement costs, even though the near term P/Es appear to be reasonable due to very high cement prices. This is unjustified as over 2 years, cement supplies should catch up and profits should moderate. This is what happened to aluminum stocks over last one year for example. Finally, we aim to be always effectively diversified and limit exposure to any one sector or theme e.g., we have been positive on the capital goods space for last 5 years or more. Still, exposure to this space and correlated sectors has been and is limited to nearly 25% in our funds. We will not indulge in hair splitting either to increase exposure to a theme. We will not reclassify a theme into multiple sectors e.g., say construction, power, capital goods, engineering etc; because theme is same and risks are the same too as these are highly co-related sectors. This discipline hurts performance in the short run, particularly with respect to peer group but this discipline is necessary to protect and build a long-term track record. We think this is fundamental to diversified equity funds.

To sum up, investment philosophy is all about discipline discipline of buying quality, not overpaying for it and remaining diversified.

Pfn: How should a risk-taking investor allocate his investments across large cap and mid cap funds, if he has a 5-Yr investment horizon?

Mr. Jain: Over time, a company performs in line with the business performance and therefore large caps or mid cap classification is a bit of a misnomer. It is however true that in the short to medium run, large caps and mid caps do tend to perform in different cycles e.g., the rally in the last few weeks has been predominantly led by large caps.

Internally we distinguish more between leaders and others, than between large and mid caps. This is because large and mid cap classification is more of a function of which industry a company is operating in. An automobile company and a steel company will always be a large cap company. But a battery company and a bearings company will always be mid cap companies. A car costs you Rs 500,000 but a battery costs you Rs 3,000. A battery company cannot be a large cap company even if it is a leader. But even the number 3 automobile company is likely to be a large cap company. This is because the business is more capital intensive and a high value business. We are actually focused on buying leaders across businesses. If we buy a car manufacturer, it is likely to be a large cap company, if we instead buy a bearings company or a paint company or a battery company chances are it will be mid cap company. We focus on leaders because leadership gives advantages. And unless a leader starts sleeping, it should outperform other players over a cycle. And one has seen it happening in one industry after another. Larger tech companies are growing faster than the smaller tech companies; larger automobile companies are growing faster than smaller automobile companies. Because large companies have better pricing power, lower costs due to scale. Unless the leader is sleeping or unless the market shifts i.e. if the market moves from typewriters to PCs and leader is not able to move, I think the leaders should do better.

Pfn: Will the investment horizon vary in case of large and mid cap funds?

Mr. Jain: Though ideally investment horizon should be same in case of large caps and mid caps, it actually tends to be higher in case of mid caps because of lower liquidity.

Pfn: Theoretically, between close-ended and open-ended funds, close-ended funds are suppose to deliver better returns from a fund management prospective, fund manager can stay invested longer. Does the difference really show over a period of 5 years?

Mr. Jain: Logically difference should be there, but so far experience has not demonstrated that. It is probably because bigger difference is made by the investment strategy and the manager or simply because enough time has not elapsed.

Pfn: Global funds have emerged as the latest trend in the mutual fund industry. What are your views on the same?

Mr. Jain: If you look at it from a diversification perspective, it has some value. However, from a returns perspective, there are very few geographies that offer the kind of potential, which India does. The reason for that is very simple; I think the growth part is known to all of us. Apart from India and China, there are no other large countries that are growing at this rate. We are also an extremely well-diversified economy. Virtually all sectors, barring a few, are represented here.

It is true that Indian P/Es are higher than many other markets, but when viewed in the context of higher growth, P/Es still look reasonable, particularly to foreign investors who have a lower cost of capital and who are the large marginal buyers.

Pfn: Sector/thematic funds (like infrastructure) have made a come back of sorts. Your views¦

Mr. Jain: Sector funds tend to become popular after big returns, not before. In a sector or thematic fund, the mandate to the manager is very restricted and therefore the Fund has to continue to remain invested in the same sector or theme even after it has lost investment relevance.

This shifts the onus of moving out of a sector/theme from the manager to the unit holder from the fund; and that is contrary to the very idea of a mutual fund viz., give money to people who are expected to do a better job of managing it than the investors themselves. A majority of investors look at trailing returns to make investment choices and this results in sector/thematic funds growing after the sector/theme doing very well. Similarly as stock prices are forward looking and peak in advance of the earnings, it is very hard to time the exit as well. In view of the above, such funds can add value only to well-informed investors who have capability to pick sectors on their own.

Pfn: What are your views on interest rates going forward?

Mr. Jain: There are opposing forces at work. Despite huge latent demand for loans from manufacturing/infrastructure sector over the next few years in my opinion over the medium to long term local interest rates should converge with global rates which are significantly lower. This is because 5 years down size of Indian economy will be comparable to the largest economies in the world. When that happens you can't have interest rates very different from the rest of the world. If you work on that hypothesis interest should go lower over long period.

Pfn: 3 individuals who have influenced you the most?

Mr. Jain: Parents, teachers (particularly from IIT), and Warren Buffet

Pfn: What books do you like to read?

Mr. Jain: Books on economics, business publications (local and international), periodical magazines and papers

Pfn: Where do you invest your money?

Mr. Jain: Bulk of my money is in mutual funds and bulk of that is in the Schemes of HDFC Mutual Fund. I am not an active participant in stocks directly.

Disclaimer: These views have been expressed by Mr. Prashant Jain, Chief Investment Officer of HDFC Asset Management Company Limited. All opinions included in this Q & A constitutes the author's views as of this date and are subject to change without notice. The answers to questions are for information purposes only and not an offer to sell or a solicitation to buy units of HDFC Mutual Fund schemes. Neither HDFC Asset Management Company Limited, nor any person connected with it, accepts any liability arising from the use of this information. This information is not sufficient and shouldn't be used for the development or implementation of an investment strategy. It should not be construed as investment advice to any party. The recipient of this material should rely on their investigations and take their own professional advice. Mutual Fund investments are subject to market risks and please read the offer document carefully before investing.



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