Fund Focus: L&T Business Cycles Fund

Well positioned for a cyclical recovery

Venugopal Manghat, Co-head Equities, L&T MF

9th October 2017

In a nutshell

L&T Business Cycles Fund is uniquely positioned in that it changes colour in keeping with the phases of business cycles: cyclicals in the early stages of a business cycle, moving into defensives as the cycle matures. The last couple of years ought to have been challenging for the fund - it positioned itself for an economic recovery which has proved elusive thus far - but to its credit, the fund has posted healthy performance despite this. Venugopal takes us through how he made this happen and also shares his perspectives on what it will take for this business cycle to gain momentum, the sectors that should do well as recovery gains momentum and how he is positioning his fund to make the most of the imminent cyclical recovery.

What do percentiles and their colours signify?

Fund performance is typically measured against benchmark (alpha) and against competition. Performance versus competition is measured through percentile scores - ie, what percentage of funds in the same category did this fund beat in the particular period?

If a fund's rank in a year was 6/25 it means that it stood 6th among a total of 25 funds in that category, in that period. This means 5 funds did better than this fund. In percentile terms, it stood at the 80th percentile - which means 20% of funds did better than this fund, in that particular period. If, in the next year, its rank was 11/26, it means 10 other funds out of a universe of 26 did better than this fund - or 38% of funds did better than this one. Its percentile score is therefore 62% - which signifies it beat 62% of competition.

Most fund managers aim to be in the top quartile (75 percentile or higher) while second quartile is also an acceptable outcome (beating 50 to 75% of competition). What is generally not acceptable is to be in the 3rd or 4th quartiles (beating less than 50% of competition). Accordingly, we have given colour codes aligned with how fund houses see their own percentile scores. Green colour signifies top quartile (percentile score of 75 and above), yellow or amber signifies second quartile (percentile scores of 50 to 74) and red signifies 3rd and 4th quartile performance. A simple visual inspection of colour codes can thus give you an idea of how often this fund has been in the top half of the table and how often it slips to the bottom half. A great fund performance is one which has only greens and yellows and no reds - admittedly a tall ask!

WF: In the context of the worries and impatience with the slower than expected pace of economic recovery, your fund - which is geared for an economic recovery play - seems to be doing rather well. What explains the sound performance of the fund amidst a tepid cyclical recovery?

Venugopal: The underlying strategy of L&T Business Cycles Fund is to ride the business cycle by investing in cyclical businesses during economic recovery / growth phase and steadily switch to defensives as we approach the peak of the cycle. Stocks of cyclical businesses typically are high beta stocks which deliver better performance than the broader market during a recovery phase whereas defensives tend to have lower beta, thus having lower sensitivity to market movement in a slowdown phase. The Fund has been invested in cyclical businesses since its inception in August 2014 as we have been going through a recovery phase. However, the pace of the recovery has been much slower than expected due to disruption on account of some of the game changing reforms domestically as well as slowdown in some of the key economies such as China. Despite such slow recovery, L&T Business Cycles Fund has shown a good performance as we have been focusing on areas within the cyclicals space which have shown stronger growth and also on account of our superior stock picking. For example, one of the key trends over the past few years is the significant increase in government spending in core areas such as roads, railways, defence, etc. and we have been investing in businesses that have been beneficiaries of such spending. Moreover, within cyclicals we have been focusing on owning businesses that have strong medium term earnings visibility and that are available at reasonable valuations.

WF: What in your view is really at the root of the continued disappointment in this business cycle taking off? Is it just a continuous set of transient impacts from far reaching reforms (demonetization, GST, RERA etc) as most market commentators tell us, or is there a deeper malaise here?

Venugopal: Apart from the impact of reforms such as demonetization and GST, the recovery has also been slow due to asset quality issues in the banking sector and low capacity utilization levels both leading to delay in private capex. However, given the government's focus on addressing the asset quality issues and the RBI's stricter NPA recognition norms resulting in increased provisioning, the worst is probably behind us and we could see incremental improvement over the next 12 months or so. Also, we believe the positive impact of policy reforms such as GST implementation would likely kick-in over the next 12-24 months providing strong boost to the recovery.

WF: You seem to have a significant exposure to midcap industrials. What are the kind of businesses you like in this space and how are they insulating themselves from a weaker than expected economic recovery environment?

Venugopal: Within the midcap space, we have a meaningful exposure to businesses in areas such as construction / construction projects, building products, industrial products and capital goods. Many of these businesses have relatively strong medium term earnings visibility given their strong order book aided by government's increased spending on roads, railways and defence. Also, there are a few businesses that are potential beneficiaries of government's focus on affordable housing which may not be too much dependent on the pace and strength of the economic recovery.

WF: How long does a typical upcycle last in a business cycle in India and where would you put us now?

Venugopal: A typical upcycle lasts for about 3-5 years. However, we need to recognize that we are going through certain structural changes in the economy, be it on account of some of the government's big policy reforms or for example the central bank's stance on having a 4% +/- 2% target for retail inflation. Some of these measures have also had short term negative impact resulting in delay in recovery. Therefor we believe we are still in an early stage of recovery and we could see this recovery gaining momentum over the next 1-2 years.

WF: What are the key risks to this upcycle stalling or continuing to splutter indefinitely?

Venugopal: From domestic perspective, a significant delay in addressing the asset quality issues remains the key risk. While recent reforms have led to some disruption in the recovery, our assessment is that over the next couple of years, government may be focusing more on effective implementation of these reforms rather than initiating any new reforms that can further delay the recovery. On the global front, geopolitical risk and slowdown in global trade are the key factors that could have impact on the domestic recovery.

WF: Which sectors/themes do you see leading the market from hereon as the cycle gathers momentum?

Venugopal: As the economic recovery picks up, we believe banks that are relatively well positioned to capitalize on the credit upcycle are likely to do well. Apart from banking, we believe businesses that are beneficiaries of government spending such as construction projects / construction, industrials and cement would continue to do well. However, one needs to be mindful of the valuations for some of these businesses.

*Investors should consult their financial advisers if in doubt about whether the product is suitable for them.

Risk Factors: Mutual Fund investments are subject to market risks, read all scheme related documents carefully.

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Past performance may or may not be sustained in the future. * Point to Point (PTP) Returns in INR show the value of Rs. 10,000/- invested ^Standard Benchmark Note: As per the SEBI standards for performance reporting, the since inception return is calculated on NAV of Rs.10/- invested at inception. CAGR is compounded annualized. Date of inception is deemed to be date of allotment. Mr. Venugopal Manghat manages 6 funds and Mr. Karan Desai manages 8 funds. Performance shown is of regular plan. Different plans have different expense structure. Performance of growth option. The scheme has been in existence for less than 5 years. Accordingly, returns for 5 years have not been shown.