Fund Focus: Principal Balanced Fund

Small is beautiful for this champion balanced fund

PVK Mohan - Head Equities and Bekxy Kuriakose - Head Fixed Income, Principal MF

6th June 2017

In a nutshell

Strong alpha, top quartile performance, and an AuM growth that has only just started to do justice to its track record. That's in short the story of Principal Balanced Fund - once ignored, but now increasingly coming into advisors' radar on the back of consistently strong performance. Mohan says performance is a function of bottom up stock picking - but, while every fund manager says that, he backs it up with a clearly defined approach on how he looks for mispriced opportunities and then proceeds to build high conviction positions in them. Another factor that helps him is the current size of the fund - which enables him to participate in smaller companies that his larger balanced fund counterparts let go for size issues.

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: The fund's strong CY16 performance seems to be continuing into CY17 as well. What are the factors driving fund performance? What does your attribution analysis suggest as key contributors to alpha?

PVK Mohan: We believe that sustainable performance is driven by good stock selection and hence we have a bottom-up approach to portfolio construction; though we do have a view on economy and sectors. Our performance attribution analysis has at most times shown that most of the alpha comes from stock selection

In the Balanced Fund, stocks across sectors and across the market capitalisation range has contributed to the performance. Stocks from diverse sectors such as pipes (for Oil & Gas sector), sugar, cement, pharmaceuticals, housing finance, auto & auto ancillaries all contributed to the performance of the Balanced Fund

Some of the common characteristics of all these companies are that they:

1. Are either dominant players in their sectors or strong niche players in their domains,

2. Have scalable business models

3. Under-priced by the market due to underappreciation of growth prospects or undervalued due to past concerns which in our opinion have been adequately addressed by management

WF: Would you then say that there is a contrarian bent of mind that guides stock selection?

PVK Mohan: I wouldn't say exactly contrarian because we are not betting against the market. Rather, we look actively for undervalued opportunities in stocks that may be neglected due to legacy issues or due to underappreciation of growth prospects of the company. This often involves researching stocks that are under-researched/under-owned by Institutional investors, doing a scenario analysis to project the potential rewards if the hypothesis plays out. And most importantly, it involves greater in-house research efforts that allows us to build a stock position and hold it with conviction till the investment hypothesis plays out.

WF: Do you keep market cap segment weights in mind when casting the portfolio or is it a go-anywhere approach?

PVK Mohan: We don't have a fixed market capitalisation allocationbetween large (Top 100 by market cap), mid (ranked 101-200 by market cap) and small caps (>= 201 by market cap). Out of the 65% - 70% equity allocation range, slightly more than half is in Top 100 market companies and the balance in companies with market capitalisation below that.

WF: What are the sectors that you are significantly overweight in and why?

PVK Mohan: We are overweight in domestic cyclicals as a theme. This is spread across financials, auto, auto ancillaries, cement, construction, industrials. We believe domestic cyclicals will benefit from a cyclical upturn post demonetization as well as structural reforms such as GST. In the run-up to the 2019 elections, we believe there will be strong focus on execution by the Central and State Governments, which will aid the domestic cyclicals theme considerably.

We have been underweight global businesses like IT and pharma for a long time now. In pharma, our concerns always were more around pricing pressures in US base business besides the FDA issues. In the IT sector, the headwinds have been the muted growth prospects and policy initiatives by US which could increase costs and hence impact margins

WF: Are you concerned about markets running far ahead of themselves? Are market valuations a concern?

PVK Mohan: Yes, we have been highlighting concerns on valuations in our interaction with distributors. Markets are well ahead of long term valuationsfrom an FY18 perspective, but the focus really is on FY19. Even if we take FY19 consensus earnings estimates, markets are trading perhaps slightly above long term mean valuations. It is not a bubble, but markets are above mean valuations. We believe on FY19 basis, there is still upside in the market but since that is some time away, one must perhaps be prepared for a period of consolidation in the coming quarters. From a fund management perspective, this means keeping a slightly larger cash position than normal so as to capitalise upon opportunities that may arise during a correction.

WF: Is it time to expect a mean reverting correction in the market now?

PVK Mohan: The domestic inflows have been a big positive surprise and that could have two implications - limit the downside to some extent and keep valuations slightly elevated.We could also possibly see some time correction during which the market is by and large headed nowhere for a quarter or two.

WF: What is the fixed income strategy for this fund? Is it predominantly an accrual based strategy?

Bekxy Kuriakose:The debt portion is managed keeping in mind the interest rate environment.Currently duration has been reduced and portfolio is substantially invested into corporate bonds spanning short to longer term maturities. Exposure to medium to long dated gilts continues to be there although exposure has been pared down over past few months as RBI shifted to neutral stance.

WF: Though AuM growth has picked up smartly in recent months, the fund is as yet relatively small, given the fund performance and the business momentum that the balanced fund category has witnessed in recent years. What are your plans to grow this fund to scale?

PVK Mohan: We have seen good inflows in recent months, with the fund moving from a size of barely Rs.25-30 cr to Rs.180 cr approximately now. We have constructed the portfolio in a manner such that even if the fund grows 3-4x from the current size, the portfolio is largely replicable. Being a small fund is currently advantageous compared to the much larger funds in terms of capitalising upon opportunities in the mid and small cap space that the very large funds may let go.

The views expressed and information herein are independent views of the Fund Manager(s) and for informative purpose only and under no circumstances should be construed as an opinion or Investment advice. The information contained herein is not intended to be an offer to seek solicitation for purchase or sale of any financial product or instrument. Investment involves risk.

Recipient of this article/ information should understand that statements made herein regarding future prospects may not be realized. Investors are requested to consult their investment advisor and arrive at an informed investment decision before making any investments. The Sponsor, Trustee, AMC, Mutual Fund, their directors, officers or their employees shall not be liable in any way for any direct, indirect, special, incidental, consequential, punitive or exemplary damages arising out of the information contained in this document.

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

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