AMC Speak

Geared for the next cycle, with downside protection

Srinivas Rao Ravuri, Fund Manager, HDFC AMC

29th June 2017

HDFC MF has launched a 3 year closed ended equity fund - HDFC Equity Opportunities Fund - Series 2, which is geared to participate in the three themes the fund house believes will lead the next market cycle, while at the same time offering downside protection through put options on the Nifty. Read on as Srinivas takes us through the segments he believes will lead the next market cycle and why and how the put options strategy will work.

WF: Why do you believe that market cap / GDP ratio is a more prudent metric to evaluation market valuation as opposed to PE ratios?

Srinivas: A lot of people follow P/E ratios, while we believe the markets are not richly valued as P/E suggests. EBITDA margins are below long-term averages and therefore P/E multiples are looking high. Also, equity markets have lagged nominal GDP growth for several years now and the market-cap-to-GDP ratio is near lows. We believe at these low margins, the market-cap-to- GDP ratio is also an important tool to analyse markets along with P/E. With an improving macro environment, improving margin outlook of corporate, sharp fall in interest rates, the outlook for profit growth is also improving.

WF: Your presentation suggests that the next market cycle can be led by banking, infra and capex. Haven't banking and infra participated in the ongoing rally? Why do you expect them to outperform the market from hereon?

Srinivas: Our call on banking and infra has worked well for us, as we have seen them participate in the ongoing rally. We believe there is still room for value unlocking and PE re-rating in these sectors as macroeconomic conditions in India have improved significantly in the last few years. Inflation has halved, the rupee is appreciating, the current-account deficit is negligible, the foreign direct investment has doubled and metal prices have stabilised at reasonable levels. This is likely to support faster profit growth in sectors that were laggards in the last cycle - capital goods, corporate banks, metals.It will slow growth in sectors with relatively higher valuations like FMCG and pharma that were leaders in the last cycle. This once again has created a conducive environment for a new cycle in markets in our opinion.

WF: There is growing concern that earnings recovery is getting pushed back for one reason or another for a couple of years now. The latest was demonetization and now the expectation is that GST implementation will disrupt earnings recover for 2 quarters. Are we running too far ahead of fundamentals - are we building more hope than is prudent?

Srinivas: The Indian economy now appears to be at the threshold of a period of faster growth. The current government, through its several initiatives-giving a bank account to everyone; replacing physical subsidies with cash transfers; focus on infrastructure; simplifying tax laws and targeting better compliance; improving ease of doing business; emphasizing local manufacturing; cleanliness; better price discovery for agricultural produce; following policies that lower inflation and fiscal deficit-has created conditions that are conducive to drive real growth to a higher level.

Further, profit growth is now improving and earnings growth for next 2-3 years is expected to be strong (Bloomberg consensus NIFTY EPS growth - 16% in FY18 and 20% in FY19). NIFTY is currently trading at ~16.7xFY19E EPS which is reasonable in a low interest rate and strong earnings growth environment. In our opinion therefore, there is merit in increasing allocation to equities (for those with a medium to long term view) and to stay invested.

WF: Why have you decided to adopt put options into your portfolio strategy? How will this work and what is the benefit?

Srinivas: We believe that event risks are difficult to forecast and markets have seen sharp corrections in the past over short term periods. Hence, to ride such volatility, we have decided to embed put options into the portfolio strategy as the same will aid to limit downside and at the same time also help participate in the upside. The below table gives an illustration how the strategy will work in different market conditions:

The above illustrates the payoff in multiple scenarios of index levels at maturity. For e.g., if the index falls to 7500 after 3 years (i.e. a 21.88% fall), the scheme falls only by 5.66% assuming 0% outperformance. However, given an outperformance of 10% over the 3 year period, the scheme returns 3.77%. (See row corresponding to NIFTY 50 level at 7500). The scheme thereby provides downside protection.

However, in scenarios with higher index levels, the scheme delivers commensurate returns with no upside cap. Please refer to risk factors detailed below#

The above simulation does not in any manner offer any assured returns and is subject to market risks. The above simulation does not take expenses into account and that the returns shown are assumed figures and not to be constructed as actual returns and/or guaranteed returns. HDFC Mutual Fund/AMC is not guaranteeing returns on investments made in the Scheme. The information provided herein is used to explain the concept and is given for illustrative purposes only. The same is not sufficient and shouldn't be used for the development or implementation of an investment strategy. It should not be construed as an investment advice to any party. Past performance may or may not be sustained in future. In view of the individual circumstances and risk profile, each investor is advised to consult his / her professional advisor before making a decision to invest in the scheme.

Outperformance in this illustration refers to excess returns over the NIFTY 50 index.

WF: Your fund house has historically been a little wary of launching closed ended equity funds. What has changed to make you confident of going ahead with such fund launches now?

Srinivas: The funds structure of investing a predominant portion in diversified equity and a marginal portion into 3 year NIFTY50 put options warrants a close ended format. This is a differentiated strategy and it will be difficult to run such a strategy in an open ended structure as frequent inflows/outflows can impact the returns of the overall portfolio.

#Risk Factors

1. The strategy may or may not provide returns in excess of the benchmark. Downside protection is based on the movement of the index, not the scheme's stock portfolio. In the event of underperformance to the benchmark, the scheme can erode further capital to the extent of the underperformance.

2. The risk/downside, if the index remains above the strike is only limited to the option premium paid. There is positive return from the put allocation only if the index falls below the strike price.

3. The put option strategy will have as much loss / gain as the reverse of the underlying index. For e.g., if the index depreciates by 10%, the underlying exposure from the put rises by 10%. However, this is only true for options held till maturity.

4. While options markets are typically less liquid than the underlying cash market, there can be no assurance that ready liquidity would exist at all points in time, for the Scheme to purchase or close out a specific contract.

HDFC EOF - II - 1100D June 2017 (1)

MUTUAL FUND INVESTMENTS ARE SUBJECT TO MARKET RISKS, READ ALL SCHEME RELATED DOCUMENTS CAREFULLY.

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