The Stars, Dogs and The Darlings
Stock selection has always been difficult and that’s what fund managers are paid for, but how well have they stood up to this challenge?
In the context of the Indian stock market, the game of stock selection can be understood by looking at fund holdings that have managed the best ratings. We have adopted www.valueresearchonline.com ratings and have zeroed in on funds that enjoy five star ratings. There were 16 funds spread across large cap, mid cap and small cap universe, and the total number of stocks, adjusting for overlaps, narrowed down to 285. It’s surprising to note that the Indian stock market boasts of listings of more than 7000 stocks, but still the universe of what has finally been invested by leading fund managers is a very small number (4.1%).
Obviously, some of these stocks enjoy a phenomenal following from fund managers while others don't. Our classification shows that only 2.5% of the 285 stocks enjoy tremendous following from fund managers. These 2.5% of the stocks had the approval and investment of more than 10 fund managers (out of 16), followed by 17.2% of stocks that enjoyed an average following between 5 to 10 managers. The bulk of the 285 stocks under analysis had very low following from fund managers. We are still not talking about whether fund managers are correct in terms of their stock picking, which we will look into very shortly, but all we are looking at this stage is whether the fund managers go after the large basket of stocks or do they go after a small basket of heavy weight stocks.
There is another dimension to this problem. Of these 285 stocks, how many of them are represented in the index, especially the Nifty index, which has large following today. The Nifty has three main categories: the Nifty 50 (the bellwether), the CNX Mid cap and the CNX Small cap. We found that 16.5% of the stocks fall in the Nifty 50, which predominantly contains large cap stocks, about 23.5 % into the Mid cap index, 7.7% into the Small cap index with the balance 52.3% with no index representation. Surprisingly nearly 52.3 % are off benchmark stocks, which mean these stocks don’t form part of any benchmarks. This is very interesting because the fund managers will be taking a tracking error risk by doing so, and therefore there must be more than one reason as to why they are often chasing, off benchmark stocks to add alpha to their performance. In general, from a performance point of view, we found out that nearly 192 of these 285 stocks, or rather, only 67.3% can be classified as excellent performers (with annualized return of more than 15%), nearly 9.5% of these 285 stocks can be easily classified as poor performers meaning, performance with zero or negative rates of return. So in general, a high percentage of stock selection by fund managers has fared well, and less than 10% of the selected stocks have disappointed. During this three year period, the Nifty index returned 17% per year, rising from 5,296 points in Mar’12 to 8,491 points in Mar’15.
Moving forward, we would now like to take a specific look at the excellent performers and the poor performers, and also take a look at the darlings of fund managers, in other words, stocks that most of the fund managers frequently invest in, most of the times.
The data for the Mutual Funds was sourced from www.valueresearchonline.com and www.moneycontrol.com, which provide the top-rated funds under different styles and their complete constituent information. Analysis focused on three major styles: Equity Large Cap, Equity Large-Mid Cap and Equity Mid-Small Cap. The constituent stocks for the top-rated funds in the above-mentioned styles were organized into a single list, to facilitate study of stock selection of different fund managers across the three styles. The index representation of the stocks was another facet of the analysis; to examine how closely the indices are tracked by the different style managers. The indices considered were: CNX Nifty, CNX Midcap and CNX Small Cap.
The individual stocks’ presence in these funds was counted, and their annualized returns calculated over a three year period, from the Reuters’ database. The returns were then classified as: Excellent (greater than 15%), Good (between 10% and 15%), Average (between 0% and 10%) and Poor (less than 0%) and the stocks ordered in terms of returns; from highest to lowest. The top 10 and bottom 10 from the list are presented here, as well as their occurrence in the three considered indices.
Another aspect of the analysis is the stocks that are present in most funds, their performance and if their presence is justified by their performance. Many fund managers have an obligation to closely track the index and to have a minimal tracking error. We examine if this tendency benefits or hurts the investors. NOTE: For 11 stocks performance could not be calculated and classified, as these stocks are less than three years old. They have been left out of our analysis.
The results are as follows.
Source: valuresearchonline, nseindia, moneycontrol, Thomson Reuters Eikon
This table represents the best performers in our list of 285 stocks. They need not necessarily be heavily invested by the fund managers as they may lack liqudiity. In most cases, they found favor only from one or utmost two fund managers, and in only one case i.e., Eicher Motors we can note interest by 6 fund managers. The stars are widely spread in terms of sectors and are entirely absent from the bellwether Nifty 50 index. Only two stocks are part of the CNX indices: Ceat Tyres (CNX Smallcap) and Eicher Motors (CNX Midcap).
In general the following makes them tick:
Strong Distribution channels
New Successful product launches
Growth in core products and IT services has boosted Ricoh India’s share to the top of the stars. The company continues to focus on printing and documenting solutions, and communication systems. Majority of Ricoh’s IT services revenues comes from the Government of India, with GoI pushing the agenda of digitization, the IT services market have received a boost. The company is active in executing government-to-citizen (G2C) projects.
CCL Products is a global coffee manufacturer that has manufacturing plants in India, Switzerland and Vietnam, which produce a combined capacity of 35,000 MT per year. The company went on an expansion drive over the last few years, and opened its facility at Vietnam, which currently produces its premium product. The facility is now functioning at full capacity, and its Indian facility has also ramped up production. The company also plans to upgrade the technology at its Indian facility.
Since 2012, Hitachi home & life solutions introduced two trademarked innovations: air conditioners with twin motor technology and inverter technology in refrigerators. The company underwent a 1:5 rights issue, and has emerged as the top contender to buy the promoter's stake in Crompton Greaves, a power transmission and distribution company. Recently, the company signed a memorandum of understanding (MoU) with the Confederation of Indian Industry for setting up 100 smart cities.
After input prices on its core products increased, Eveready Industries hiked its market price and passed the entirety of the cost to consumers. The company repaid Rs.50 crore worth debts in 2014, and intends to do the same in 2015, cutting down its debt from Rs.225 crore in Mar’14 to Rs.100 crore by FY16. New product launches in the flashlights and portable power product fueled the topline growth.
In the last three years, Alembic Pharma entered into product development and license agreement with Accu-Break Pharmaceuticals, Inc, USA, got approval for its new drug Desvenlafaxine Base Extended Release Tablets, and also entered into an out-licensing agreement with Ranbaxy to market its product in USA. The company also announced a joint venture with Adwiya Mami SARL Algeria through its wholly owned subsidiary - Alembic Global Holding S.A. – in 2014. The recent subdued growth notwithstanding, the company’s profitability profile is on the rise on the back of restructuring process embarked upon by the management.
One of India's largest manufacturers of electrical and telecommunication cables with 9% market share, Finolex cables has facilities at Pune, Goa, and Uttarakhand. The company has over 3,500 dealers and distributors in its traditional strongholds of South and West India, and has recently added over 500 channel partners in North. Finolex emerged relatively unscathed from its misadventure with exotic options, by expensing its loses, and plans to launch switchgears in the last quarter of 2015 will augment revenues from the communication cable segment.
Despite falling exports due to competition from China, Ceat’s share grew at over 100% CAGR over the last three years. Low crude oil prices, which form 30% of raw materials, and low price of rubber have helped increase the margins. The company has announced capacity expansions in its Nagpur plant for two- and three-wheeler tyres, and is in the process of setting up another 120 tonne radial plant in Gujarat.
A delayed monsoon, erratic rainfall and prolonged dry spells in 2014 have not dampened investor sentiment for Kaveri Seed Company, as the company’s PAT grew by more than 40%. Market share gains in cotton, higher corn acreage and stabilizing agricultural commodity prices are expected to drive company growth in the coming year. The company recently launched a new hybrid pest-resistant cotton, which it believes will lead to higher market share gain in Maharashtra over the next three to four years.
Eicher Motors unveiled the all new Pro Series of trucks in 2013, and commenced commercial production at Oragadam Manufacturing facility. YoY volume has grown by 42% for Eicher Motors in FY2014/15, and global sale of its marquee product, Royal Enfield, surpassed that of Harley Davidson in 2014. After rolling out a slew of contemporary models, such as the Classic, Thunderbird and Continental GT, the company has had a strong run, with volume sales growing at 63% CAGR since 2012.
Globally the third largest home textiles company, Welspun India has a dominant presence in 50 countries with a distribution network in over 32 countries including USA, Canada, UK and Australia. The company exports close to 97% of its produce, and has seen consistent volume growth of over 20% over the last few years, with vertical integration playing a key role in the margin growth.
Source: valuresearchonline, nseindia, moneycontrol, Thomson Reuters Eikon
This table represents the worst performers in our list of 285 stocks. They need not necessarily be heavily invested by the fund managers. In most cases, they found favor only from one or two fund managers, and in only one case i.e., GMDC we can note interest from 3 fund managers. The dogs are mostly in areas like banking, industrial & commercial services, and mining. They are strongly present in the Nifty Midcap index (4), while only one company is present in the bellwether Nifty 50 (Cairn India).
What makes this list race to the bottom?
Demand decline and order lag
Deteriorating asset quality due to increase in non-performing assets and higher loan loss provisions led to fall in stock for Union Bank of India early this year. The Q3 FY2014/15 results declared in Jan had disappointed analysts, falling 8.1% YoY due to higher provisions and jump in employee costs. Provisions for bad loans spiked 39.7% YoY, and gross NPA rose 123bps for the same period.
Godfrey Phillips hit a 52 week low by end of Mar’15 after the Q3 FY2014/15 net profit plunged 85% YoY, along with a 16% drop in net sales. The mid-cap cigarette manufacturer underwent a 5:1 stock split in 2014 to make the share more affordable, but increase in excise duty of cigarette affected revenues.
Falling oil prices and trouble with the taxmen led to fall in share prices for Cairn India. The tax authority has alleged that the company did not pay capital gains tax when shares changed hands from Cairn UK Holdings Company to Cairn India in 2007, which, according to the tax department, resulted in capital gains of Rs. 24,000 crore. The company’s corporate governance was called into question mid last year, when it was revealed that a related party received a large loan on a concessional terms. Speculation about merger with Vedanta and mentions in the recent corporate espionage issue have not helped the company.
Extreme weather events, significant decline in oil prices and consequent reduction in polymer prices, coupled with lower agricultural commodity prices has resulted in lower demand for irrigation products in rural India, affecting share price of Jain Irrigation of Systems. The company reported a consolidated net loss of Rs. 39.7 crore for the third quarter of this 2014/15 fiscal due to poor sales.
Fall in international coal prices and a CAG report mentioning instances of deficiencies in financial management, planning, implementation of projects, running of operations and monitoring affected share prices of GMDC. The company, along with other PSUs, was subsequently panned by Gujarat assembly's public sector unit monitoring committee for causing financial losses to the state government.
Halving of net profits in two consecutive quarters due to lower other income, higher provisions, tax expenses, and exposure in shipping, power, textile and hospitality turning into significant non-performing assets led to decline in share value for Allahabad Bank. Gross bad loans in the quarter ending Dec’14 were 5.46%, an increase of 10bps from the previous quarter.
Barring the quarter ending Mar’14, USG Tech Solutions has posted eight consecutive quarters of net loss. The company’s share price has been on a slippery slope since Feb’14, and posted a new low of Rs.2.55 in the last week of Mar’15.
Shares of Jindal Saw have been sliding down the slope, especially since 2012, as the company was affected by higher raw material costs in coal and iron ore. Recently, low oil prices, and OPEC’s decision not to stopper supply have affected demand for pipes in the oil and gas industry.
High debt levels despite heavy disinvestment continues to hamper Jaiprakash Associates. The company carries Rs. 60,000 crore debt in its balance sheet, despite selling-off its hydropower assets to JSW Energy and part of its cement assets to Aditya Birla Group. Debt-to-equity ratio has gone down from 7.3 to 5.8, which still is one of the highest among its peer group.
Delays in several projects due to financial instability has led the infrastructure major Consolidated Construction Consortium Ltd (CCCL) to apply for corporate debt restructuring scheme at the end of 2013, which was approve in Apr’14. The company reportedly owes close to Rs. 740 crore to a slew of banks. Majority of the debts are in the form of short-term loans. CCCL was terminated from the Chennai Metro Rail project due to delay in executing the contract awarded to the company.
Source: valuresearchonline, nseindia, moneycontrol, Thomson Reuters Eikon
The above is simply the list of companies embraced by leading fund managers. For example, 13 out of 16 fund managers have invested in ICICI Bank, while 12 have invested in HDFC Bank and IndusInd Bank. It is very clear that the simple reason is their presence in the Nifty 50 and hence, fund managers are reluctant to deviate from benchmark. Also, being index heavyweights, they enjoy good liquidity. Barring Bharti Airtel, all of the stocks produced over 15% returns on an annualized basis during the last 3 years. The sector representation is dominated by banks and financial services, with 5 banks in the above list of 10 companies, and two from software and IT services.
Despite worsening asset quality, Q3 FY2014/15 net profit of ICICI Bank grew by 14% on the back of growth in net interest income and other income. The bank continues to maintain NIM at 3.5%, and has a CASA ratio of well-above 40%, and these continue to be stable growth drivers. The bank has also planned to re-start the Stressed Assets Management Group in order to get a handle on the increasing NPAs and provisions.
Stable asset quality, lowers exposure to NPLs compared to peers led to increase in third quarter net profit of 20% for HDFC Bank in the previous fiscal year. The bank has a stable earnings profile and a healthy balance sheet, and has no constraints for either funds or capital. Recently, the bank received RBI clearance to raise USD 500mn as External Commercial Borrowing (ECB) to fund its growth.
In the last quarter of FY2014/15, net profit of IndusInd Bank rose 25% YoY, while Gross NPA declined, improving asset quality. The bank recently entered into an agreement with Royal Bank of Scotland to acquire its diamond and jewelry financing business in India and related deposit portfolio, an acquisition which will enhance its position in this segment.
Net profit of Axis Bank has been growing at a YoY rate of 22% since 2011. In the recently declared quarter, the company reported 18.5% growth in net profit, and stable NPA. The bank also raised Rs 5,700 crore of infra bond in the last month of 2014, the largest ever infra bond issuance till date, as a means for long term funding and to reduce rates.
Aggressive bidding for spectrum has led to increase in debt for Bharti Airtel, which paid Rs. 4,725 crore towards both renewal of spectrum and to add fresh bandwidth for future use. While it did get its spectrum license extended for 20 years, decreasing voice revenues, stiff competition and the entry of Reliance Jio would increase pressure on revenue growth.
Federal Bank shares have witnessed continued growth since Sep 2013, as the bank enjoys significant operating leverage, and a well-capitalized balance sheet. The bank’s loan growth is driven by SME and Retail sectors, and domestic institutional investors have raised their shareholding by 4.71% in the first quarter of 2015. In total, DIIs hold 32.9% of Federal Bank shares at the end of Mar’15.
Tech Mahindra posted good third quarter numbers in FY 2014/15, despite seasonal weakness, as strengthening dollar helped bump revenues up by 2.7%. Constant currency growth of 4.7%, also helped in net profit growth, which came in at 11.9%. The company has inked a USD 150-200mn deal with telecom solutions provider Comverse, which will help the firm beef up its operations in Israel.
Heavy commercial vehicles (HCV), the major segment for Bharat Forge amounting for 40% of its standalone revenues continues to do well both US and Europe, and is showing signs of pick up in India. Entry into aerospace components business looks well timed, as the airlines sector has enjoyed three years of strong profitability and order backlog with aircraft manufacturers like Airbus and Boeing are at record levels. The company is expanding its product portfolio in anticipation of the opening up of the defense sector.
Strengthening dollar and stronger momentum in the US market has led to growth of this IT major. State-owned life insurer LIC has up its stake in Infosys to 4.81 per cent, purchasing shares worth Rs 317 crore in the first quarter of 2015.
Increasing demand for passenger car sales in the EU for the 19th consecutive month bodes well for Motherson Sumi Systems. The European market currently accounts for close to 60% of consolidated revenue for the company.
Fund managers are good at avoiding dogs but not necessarily successful in catching stars. Benchmark and liquidity compulsions make them embrace darlings. Fortunately, the propitious market enviroment has helped them in this process during the last few years. This study is simply to see stock selection from a fund manager perspective. Whether a stock is a star or a dog, we will know only after the event. But the list of star performers can be used for further investigation and investment. Similarly, the dogs are surely something to be avoided. For liquidity conscious investors, darlings may be the best bet!
PS: I thank Nivas Lakshminarasimhan for his assistance on this study