M R Blog: The Stars, Dogs and the Darlings

This article was originally published in The Global Analyst

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?

An emerging market like India is a place full of mine fields as well as opportunities. Active fund managers are paid to avoid mine fields and identify opportunities in order to generate alpha and enrich investors. However, this is not what we see in this study. We see fund managers just hugging benchmark names even where they are in distressed sectors or in uncompetitive situation. On the other hand, fund managers did not seriously go after “the stars” in big measure even though the businesses seem highly attractive, with most of them rewarding their shareholders generously through dividends and have attractive balance sheets with near zero debt. Rather they went after “the dogs” which were mostly in sectors that are uncompetitive, with high debt and low margins. It is time fund managers add true value.

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 138. 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.

Obviously, some of these stocks enjoy a phenomenal following from fund managers while others don't. Our classification shows that only 5 % of the 138 stocks enjoy tremendous following from fund managers. These 5 % of the stocks had the approval and investment of more than 10 fund managers (out of 16) and 13 % of these companies enjoyed an average following between 5 to 10 managers. The bulk of the 138 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 138 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 32% of the stocks fall in the Nifty 50, which predominantly contains large cap stocks, about 22 % into the Mid cap index, and 7 % into the Small cap index. Surprisingly nearly 40 % 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 42 of these 138 stocks, or rather, only 30% can be classified as excellent performers (with annualized return of more than 15%), nearly 40 % of these 138 stocks can be easily classified as poor performers meaning, performance with negative rates of return. So in general, a high percentage of fund stock selection, by fund managers ends up performing very poorly, and a reasonable number of stocks end up performing excellently, and that very much explains the overall performance of these funds.

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.

METHODOLOGY

The data for the Mutual Funds was sourced from www.valueresearchonline.com, which provides the constituent information for the top-rated funds under different styles. 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.

The results are as follows:

How to read this table? - 7 stocks out of 138 enjoy the patronage of more than 10 fund managers while 18 stocks enjoy the patronage of 5-10 fund managers.

How to read this table?
- 44 out of 138 stocks figure in the CNX Nifty 50 index, while 30 stocks figure in the CNX Midcap index. CNX_N – CNX Nifty 50, CNX_M – CNX Midcap, CNX_S – CNX Smallcap

THE STARS

THE STARS
Company	Sector	Count	Index Presence	3-year Performance	Annualized Performance
Wockhardt	Pharmaceuticals	1	CNX_S	644.40%	95.26%
Kaveri Seed Company	Seeds/Tissue Culture/Bio Technology	1	-	474.57%	79.11%
Page Industries	Textiles - Readymade Apparels	2	-	337.67%	63.57%
Eicher Motors	Auto - LCVs/HCVs	1	CNX_S	257.35%	52.88%
Bata India	Leather/Synthetic Products	1	CNX_M & CNX_S	206.70%	45.29%
Sun Pharmaceutical Inds.	Pharmaceuticals	3	CNX_N	183.33%	41.50%
Amara Raja Batteries	Auto Ancl - Batteries	2	CNX_S	179.28%	40.83%
V S T Industries	Cigarettes	1	-	170.13%	39.27%
Blue Dart Express	Couriers	1	-	160.83%	37.65%
Shree Cement	Cement	2	CNX_M	129.41%	31.89%

Source: www.valuresearchonline.com, www.nseindia.com, Thomson Reuters Eikon

This table represents the best performers in our list of 138 stocks. They need not necessarily be heavily invested by the fund managers. In most cases, they found favor only from one fund manager and in only one case i.e., Sun Pharmaceuticals we can note interest by 3 fund managers. The stars are widely spread in terms of sectors and are nearly absent from the bellwether Nifty 50 index except for Sun Pharma. Most of them are either midcap or small cap stocks.

In general the following makes them tick:

· Market leadership (Kaveri seeds, Bluedart, Shree Cement)

· Strong Distribution channels (Kaveri, Page, Bata, Bluedart)

· Brand ownership (Page, VST)

· New Successful product launches (Eicher, Page)

· Zero-debt status (Kaveri, Eicher, Bata, Sun, Amar Raja, VST, Bluedart,

· High dividends (Page, Eicher, VST, Bluedart, Shree Cement)

Wockhardt exports generic drugs and its business in the US has been a key contributor to its growth in the past three years. From 2010 onwards, Wockhardt received US FDA approval for Levofloxacin, Toprol XL, and Effexor XR, and tentative approvals for various other drugs. Launch of numerous products, year-after-year, in the US and Eurozone markets, and limited competition in the foreign markets have contributed to increase in stock price at over 95% CAGR during 2010-13.

Kaveri Seed, a vertically integrated agri-input company with strong R&D, is the most prominent hybrid seed producer in the Indian market. Renowned for its hybrid corn and sunflower seeds, KSC entered the cotton market with its BT cotton seeds, which contributed over 25% to its topline, despite holding only 2% market share. The company has made significant CAPEX investment in the recent years and its stock price has grown at nearly 80% per year in the last three years.

Page Industries enjoys exclusive brand ownership of JOCKEY, and various other brands, and has relied on strong distribution channels to grow in the underpenetrated innerwear market in India. From 2010, it has seen significant growth in both men’s and women’s segments, and has launched various products in different price ranges. Jockey currently has over 20% market share and the company is planning to expand further in the coming years. During the period 2010-13, its stock price rose at 64% CAGR per year.

Greater demand over supply for Royal Enfield motorcycles coupled with new launches (Thunderbird 500 and Café Rancer) and joint venture with US based Polaris Industries, to produce a range of personal vehicles, marked the activities of Eicher motors during 2010-13. The company’s joint venture with Volvo to produce commercial business vehicles has led to increase in market share in the heavy vehicles segment, light and medium trucks, and buses. Its stock price grew at 53% CAGR during the period.

Bata India leveraged on its distribution strength and product portfolio to successfully compete with global brands that have made their presence in India over the past decade. Growth of its own brands, Hush Puppies and Footin, cost and working capital efficiency, zero debt balance sheet, increase in number of retail outlets and international cash generation through regional subsidiaries have led to a rise in stock price at a CAGR of over 45% during 2010-13.

Sun Pharmaceutical completed acquisition of Israeli Taro Pharmaceuticals in 2010, after an arduous three year battle and entered into a JV with Merck & Co., in 2011, to develop and commercialize novel formulations and combinations of medicines for sale in emerging markets. It also acquired DUSA, a US based dermatology company and URL pharma, in an all-cash deal. During 2010-13 it launched generic drugs, such as Exelon and Zyprexa, in the US.

Double digit growth in automotive replacement and UPS batteries segments leading to plans for further capacity expansion in both segments, and increase in brand equity of AMARON, led to growth in stock price at a CAGR of over 40% in the last three years, for Amara Raja Batteries.

VST industries dominates the low priced cigarette markets, which contributes over 70% of its revenues. A totally debt free and consistently high dividend paying company, VST’s stock price rose at a CAGR of nearly 40% in the last three years.

During 2010-13, Blue Dart’s business volumes increased at a CAGR of 18% and its revenues grew at 22% CAGR. It continues to hold leadership position in this segment with the strength of its distribution channels, both domestic and international, and its air express dominance (market share of 48%). Blue Dart also holds 16% market share in the ground segment. The company stock price grew at a CAGR of 38% during the period.
Shree Cement is the 5^th largest cement manufacturer in India with a production capacity of 14MT in eight plants and four grinding units. It holds the market leadership position in the northern region, where the demand and price have remained fairly stable, which has helped the company outperform the industry consistently. During 2010-13, its stock price rose at a CAGR of 32%.

THE DOGS

THE DOGS
Company	Sector	Count	Index Presence	3-year Performance	Annualized Performance
Jaiprakash Associates	Construction & Contracting	1	CNX_N	-58.30%	-25.29%
Voltas	Diversified	1	CNX_M	-59.23%	-25.85%
Sesa Goa	Mining/Minerals	1	CNX_N	-59.51%	-26.02%
NMDC	Mining/Minerals	2	CNX_N	-60.29%	-26.50%
Future Retail	Retail - Apparel/Accessories	1	CNX_M	-63.91%	-28.80%
BHEL	Engineering - Heavy	2	CNX_N	-64.58%	-29.25%
Jindal Steel & Power	Steel - Sponge Iron	2	CNX_N	-65.18%	-29.65%
Crompton Greaves	Electric Equipment - General	3	-	-66.10%	-30.27%
Torrent Power	Power - Generation/Distribution	1	CNX_M	-67.26%	-31.08%
Jaiprakash Power Ventures	Power - Generation/Distribution	1	-	-72.50%	-34.97%

Source: www.valuresearchonline.com, www.nseindia.com, Thomson Reuters Eikon

This table represents the worst performers in our list of 138 stocks. They need not necessarily be heavily invested by the fund managers. In most cases, they found favor only from one fund manager and in only one case i.e., Crompton Greaves we can note interest from 3 fund managers. The dogs are mostly in infrastructure areas like construction, mining, engineering, steel, power, etc. They are strongly present in the bellwether Nifty 50 index.

What makes this list race to the bottom?

· Demand decline and order lag (Jaiprakash, Voltas, Sesa Goa, BHEL, Jindal Steel)

· Regulatory actions (Jaiprakash, Sesa Goa, Jindal Steel)

· Large debt (Jaiprakash, Future Retail, Jindal, Torrent Power)

· Capacity constraints (Torrent Power and Jaiprakash Power)

Decline in demand for capital goods due to depressed investment conditions, rising input and fuel costs, increased debt in its balance sheet, and associated high interest costs, impacted the stock value of Jaiprakash Associates. The company was fined Rs.1323crores in 2012, for violation of the Competition Act, 1992. During the period 2010-13, its stock price dropped at a CAGR of over -25%.

Underperforming electro-mechanical projects and services segments, negative business outlook and lagging order books contributed to the fall in share price of Voltas, by over 59% in the last three years. The company is finding it a challenge to maintain profitability in both international and domestic markets, with declining orders in the Middle East, its major market outside India.

Increase in export duty and Supreme Court enforced mining ban in Goa and Karnataka, for the last two years, have led to drop in production and loss of customers for Sesa Goa, which primarily exports low-grade iron ore to Chinese and other overseas firms. While weak demand for steel and frequent price cuts due to economic slowdown, coupled with export duty increase, impacted NMDC. Their share prices declined at a CAGR of -26% and -26.5% respectively, during the period 2010-13.

Large debt in balance sheet, associated high interest costs, decrease in cash flow from operations (Rs 1148Cr in Jun’10 to –Rs 5Cr in Dec ’12), reduction in discretionary spending, due to rising costs and inflation, and lower consumer sentiments compressed the share price of Future Retail by -64% during 2010-13.

Deteriorating order book, dwindling industrial growth, fuel shortages, rising costs and downturn in the capital goods sector has led to a bleak situation for power equipment manufacturers, such as BHEL. Private sector orders have dried up and the company is focused only on cash collection. Its stock price declined at a CAGR of -29.25% during the period 2010-13.

Drop in demand for steel, problems plaguing the power sector (discussed later), and legal & regulatory issues faced by Jindal Steel and Power, have led to fall in stock price at a CAGR of -30% over the last three years.

Weak investment cycle and entry of Chinese and Korean competitors in the transmission and distribution markets have resulted in margin pressures for Crompton Greaves. In addition, it faced losses due to restructuring its foreign operations. The company’s stock declined at a CAGR of -30% during 2010-13.

Power sector has come under heavy strain in the last few years due to economic downturn and high borrowing costs. Lack of funding due to crowding out; delays in land acquisition and project approvals such as environmental clearances; lack of power purchase agreements; fuel shortages that increased the dependence on coal imports and the subsequent increase in the price of foreign coal are causes attributed to the sector’s underperformance in the last few years.

Power plants have been operating below production capacity because of the inability of state-owned Coal India Ltd to meet demand and also, the declining gas production. The worst affected were Torrent Power and Jaiprakash Power Ventures whose stock prices declined at CAGRs of -31% and -35% respectively.

THE DARLINGS

THE DARLINGS
Company	Sector	Count	Index Presence	Annualized Performance
State Bank of India	Finance - Banks - Public Sector	15	CNX_N	-5.32%
HDFC Bank	Finance - Banks - Private Sector	13	CNX_N	20.38%
ICICI Bank	Finance - Banks - Private Sector	13	CNX_N	7.51%
Infosys	Computers - Software	13	CNX_N	-3.62%
Larsen & Toubro	Diversified	12	CNX_N	-8.02%
Reliance Industries	Diversified	12	CNX_N	-7.50%
Bharti Airtel	Telecommunications - Service	11	CNX_N	3.54%
ONGC	Oil Drilling And Exploration	9	CNX_N	0.09%
HDFC	Finance - Housing	8	CNX_N	14.29%
ITC	Cigarettes	8	CNX_N	28.54%

Source: www.valuresearchonline.com, www.nseindia.com, Thomson Reuters Eikon

This list is simply the list of companies embraced by leading fund managers. For example, 15 out of 16 fund managers have invested in SBI, while 13 have invested in HDFC Bank, ICICI Bank and Infosys. It is very clear that the simple reason is their presence in the Nifty 50 and hence, fund managers are reluctance to deviate from benchmarks. Nearly half of the list produced negative or zero returns on an annualized basis during the last 3 years. Only ITC, HDFC Bank and HDFC stand out in performance. The sector representation is dominated by banks and financial services.
Falling Net Interest Margins (NIM), lower deposit growth, slow loan disposables and concerns over asset quality contributed to SBI’s poor performance during 2010-13, while HDFC and ICICI bank showed better performance, due to superior asset quality. HDFC Bank, the 3^rd largest in India in terms of assets, has posted 30% growth in profit, every quarter, over the last decade, due to its conservative lending strategies and relatively lower net non-performing loans.

Market leadership in housing finance sector, superior underwriting standards, stable spreads, well diversified borrowing profile and unlocking value of subsidiaries are the key value drivers for HDFC stock, and have contributed to its borderline “Excellent” performance at over 10% CAGR during 2010-13. The housing loans business continued to grow at around 20% y-o-y and the asset quality of the loans are the best in the segment.

Uncertain outlook for global IT space created poor revenue visibility for Indian IT companies over the last three years, resulting in disappointing performance for one of the country’s top IT firm, Infosys. After the US government started providing tax breaks for firms opting for in-sourcing, Infosys, among other Indian IT companies, looked for further expansion in Europe. But even with quarter of its revenues now coming from the region, the company still had difficulty meeting its own expectations, despite the free-fall of rupee against the US dollar.

Weak macro-economic environment in the capital goods sector, availability of funds and inflation impacted companies such as L&T. Many infrastructure projects were shelved due to economic reasons and some were delayed awaiting environmental clearances. The share price of the company dropped at a CAGR of -8% over the period 2010-13.

Decline in gas output in 2012 from Reliance Industries’ KG-D6 gas wells and doubts over the company’s ability to ramp up productions in the near future caused concern in the market, as Reliance shares fell at -7.5% CAGR in the three year period.

Despite a ratings downgrade during mid-2012 and subsequent double-digit drop in share price, due to a tenth straight quarter of profit decline, loss of market share to competitors, Bharti Airtel bounced back to post an “Average” performance of 3.54% CAGR for the period under consideration. Lower prices due to increased competition, poor telecom governance, the 2G scam and its African investment (a $9bn debt funded deal) not providing returns as expected are cited as the reasons for underperformance of the telecom giant.

Taking into account the split announced early in 2011, ONGC shares have showed almost nil net movement during 2010-13, despite which 9 out of the 16 considered funds have held it in their portfolios.

The ITC share price has moved from strength to strength in the period under consideration, with consistent upward movement, recording a CAGR of 28.5%. The company has managed to report strong margins despite increase in state as well as central excise duties in cigarette prices, by successfully passing the increase to the consumers. The contribution FMCG business to the topline has been increasing year-on-year, with improvements in Agri and Paper margins.

CONCLUSION

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August 12, 2013

The Stars, Dogs and the Darlings

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