Over the past few years, large cap funds have been struggling to generate alpha for a variety of reasons. Many investors are considering switching to passive large cap strategies to get benchmark returns. We spoke to Gaurav Misra, Senior Fund Manager at Mirae Asset Mutual Fund, to understand how he is navigating the large cap space as an active fund manager.
Not many funds have been able to outperform their respective benchmarks in the large cap space over the last few years. How are you navigating this space?
There is a certain approach we have towards stock selection and portfolio construction. Once we select stocks, we shortlist them based on certain filters like long term structural growth opportunity, good management, capital allocation, dividend distribution, vision, and high-quality robust business model. This is the first line of defense in periods of economic vulnerability. We get good business at a margin of safety. We try to get companies at a good price-value gap, which helps in providing the upside opportunity.
At the portfolio construction level, besides having stocks like these, we keep a band of up to 30% for value stocks. Though quality might be impaired for the moment due to certain headwinds, but they are likely to bounce back.
What have been the reasons for the underperformance in the large cap space?
The growth outlook of the economy has tapered off due to a variety of reasons. The earnings have not picked up for corporates for the last two years. That has created a restricted environment in terms of stock selection. The banking sector has been going through asset quality issues. The automobile industry is going through a cyclical downturn over the past six quarters. Real estate has been also facing a lot of issues. Telecom is going through hyper-competition. Thus, the growth itself has got weaker over the past few years. Corporate profits as a percentage of GDP has come down to levels seen in 2002. The average has been 4.2% of GDP. Now, it has come down to around 2.5%. After the corporate tax cut, it should have become broader, but it has not.
The large cap benchmark has been concentrated over the last two years. The top five stocks account for over 40% weight of the index. The concentrated stocks like RIL and HDFC Bank have outperformed. By virtue of regulatory caps, funds are constrained to increase weightage beyond 10% in a single stock. If you look at the other indices besides large cap, the highest weight of the largest stock will not be more than 3%. All these factors are posing challenges for managers.
Do you think taking concentrated bets (focused portfolio of 25-30 stocks) will help in generating alpha?
It will depend on the style the fund manager is comfortable with. If a particular style has yielded results for a manager, then that should be continued. In any given year for any benchmark, there could be only 30% of stocks that have done better than the benchmark return. There can be years when more stocks participate in the growth. For fund managers, it is a function of the size of their funds. If the fund size is large, the number of stocks will go up in the portfolio. Liquidity constraints and price impact will also have a bearing. Taking a conviction-based bet is a better way but I would qualify it by saying that each manager can have a unique style.
If alpha generation is becoming difficult in large cap space, do you think reducing total expense ratio, or TER, is necessary as investors could move towards passive large cap strategies to get benchmark returns?
The TERs would vary across fund houses depending on the size of the fund. As the size of the funds increase, the TERs come down. The TER is only one of the factors investors should look at. In fact, they should be comfortable with the style and approach of the fund house and the manager. I agree that TERs have to be reasonable. That said, TERs will not be the only factor to generate alpha. Investors should check if the two funds with similar AUM are charging the same fee. If one is charging higher, then that raises a question mark.
Given the sheer size of their business, can large cap companies continue to grow at a rapid pace in the future?
The underperformance is temporary. Around 20 years ago, we had companies with large market capitalization, and many thought they would not do well in future because they were expensive or had dominant market shares (like Maruti or in the consumer names like Hindustan Unilever, Nestle, etc.) If we analyze their growth, these stocks have done better than the market. If we are aspiring to become a $5 trillion economy, there is still huge potential for growth. Good companies, especially in the large cap space, will still participate in this growth as they have done in the last two decades. This gap will be not be only taken over by small and mid-cap companies. So investors need to have a slightly longer time horizon.
Would the market now be quality-focused, as a recovery in the broader markets may take time as earnings recovery would be pushed behind due to COVID?
If you look from the lows of March 2020, the Nifty has been polarized. RIL has been a runaway performer. It has contributed nearly 40% to the Nifty gains. If you look at other indices, if the Nifty has generated a certain return, Nifty Small and Mid-cap stocks have also contributed. There has been a reasonable recovery across market caps from the lows. Within the large caps, it has been polarized. In the initial recovery phase, every stock moves up. In the long run, investors look at the merit of the business.
During the recent market crash, which businesses have you increased allocation in the large cap space?
We identified the best business which met all our stock filtering criteria. They included stocks in consumer staple, discretionary, financials and agricultural space. We added RIL for its foray into digital economy. We could add RIL only up to the regulatory limits of 10%.
How do you manage large inflows when the fund is performing well?
It is a function of what time the flows are coming. If the flows are coming when the market valuations are reasonable then that is an ideal situation. It is tough to deploy if inflows come when the market has already rallied.
What proportion of an investor’s money should ideally be in large cap funds?
The recent market correction presents a good opportunity for those who were underweight equities. One should be prepared for some bouts of volatility though. At the levels we are in currently, I think 50% to 70% should be in large caps. But it also depends on the investors' risk appetite. First-time investors in mutual funds should have higher allocation to large caps.
