'We are bullish on economy-related sectors'

Dileep Madgavkar, chief investment officer, Prudential ICICI Asset Management, has never been known as a hot-shot fund manager.

But being in charge of investments at the largest private-sector mutual fund in the country with assets of Rs 13,117 crore (Rs 131.17 billion) (as on July 31, 2003) spread across 19 mutual fund schemes, the objective is to create wealth for investors consistently over a long period of time without assuming undue risks, says Madgavkar.

He has certainly lived up to that reputation. Most of his funds have been consistent in beating the benchmarks with a relatively low level of volatility.

A chartered accountant by profession, Madgavkar's strength in analysing financials is incredible and most of his investment ideas also culminate from his incisive understanding of numbers.

His most successful calls in the past have been Telco (now Tata Motors), Bharat Forge, Mahindra & Mahindra, Tata Steel, Gujarat Ambuja, Punjab National Bank and UTI Bank. Most of these stocks have more than doubled in the last one year.

Currently, Madgavkar is betting on an economic upturn and is bullish on most economy-related sectors including automobiles and ancillaries, steel, cement and banking and engineering.

Madgavkar talks about his investment strategy and top sector picks.

Could you briefly tell us about your investment philosophy?

Risk control, the overriding feature

We are aggressive investors. However, the overriding feature of our investment philosophy is risk control.

One should not confuse aggression with dilution of risk control. You can be a very aggressive stock picker without diluting risk control; and that's where we really stand.

Concentrate on efficient growth, not just growth

We concentrate on buying stocks that offer efficient growth -- not just growth but growth with efficiency -- at reasonable prices.

I say reasonable prices because very often the markets pass through phases of extreme elation or extreme depression. A phase of extreme depression is the best time to pick up stocks, if you have conviction.

Look at risk-return, not return alone

Also, we apply risk controls at every point in time. We look at risk-return, never return alone, and this has very often shown up in our performance.

While we are always in the top quartile, we are never really number one. We avoid taking extreme positions.

We were one of the earliest to spot the PSU rally but we didn't go overboard and invest 50 per cent of our corpus in PSU stocks.

We picked these PSU stocks not just because of the divestment story but because of their fundamentals.

Extraneous factors such as PSU divestment should not be the very basis for investment. We have believed in these stocks, stayed invested in them and have ridden the rally.

The re-rating of PSU stocks due to the divestment can at best be called a bonus.

Again, we were one of the earliest to pick up mid-cap stocks that offered tremendous growth potential. However, mid-caps constituted a very small percentage of our larger diversified growth fund.

Under our tax plan, which is smaller and more akin to a closed- end fund, we bought a higher percentage of mid-caps. This is because our ability to take risks was higher under the tax plan.

Risk is tied to the investment objective of the fund. So, at a more micro level, the investment philosophy must per se always be aligned to the investment objective of the fund that we are talking about.

For an aggressive equity fund that takes radical views, the appetite for risk would be very different from a diversified benchmark-oriented growth plan.

You mentioned efficiency. Would that mean that the return on capital employed (ROCE) is more than the cost of capital?

ROCE is not enough; look at the delta factor

Of course ROCE should be higher than the cost of capital.

But is that enough? I don't think so. ROCE is just static data. You have to look at what is called the delta factor. The delta factor is what actually gives you fantastic returns.

Let's take for instance an auto-ancillary company, which has a very high operating leverage. It has huge idle capacity and given that the chances of its exporting more are very high, its delta factor would be extremely high.

What we are really looking at is the rate of change in the return on capital -- the incremental return on capital.

Stock markets tend to discount trends; so it's not enough to look at the absolute figure in isolation. One must look at the trend and that is reflected in the rate of change in the return on capital.

How would you incorporate this in the valuation process?

Quantitative analysis must have a qualitative overlay

We are great believers in the discounted cash flow (DCF) model.

While we are aware that the DCF model has its own limitations, it throws up far more objective numbers in terms of intrinsic values of companies than can otherwise be seen.

There is a huge element of subjectivity in how you calculate your terminal value and that can sometimes be a large part of the entire value of the company.

Also, the issue of what discount rate to use is highly subjective but then which evaluation parameter is not?

Even if we use these quantitative parameters, there will always be a qualitative overlay. So, whenever we talk about efficiency or growth, there will always be a certain qualitative overlay.

Stock markets demand constant review

When we talk of free cash flows, it takes into account operating and investing activities. In a company where the operating leverage is very high, any movement in the topline would contribute manifold to the bottomline.

So, we would take this factor into account as also the fact that when we are looking at cash flows we have to look at capex.

Let's say that the company under consideration would not require extensive capex for the next three years.

Any improvement in its topline would have a massive impact on its bottomline and, therefore, on ROE, which is EPS by book value.

One has to keep looking at these things periodically -- we do quarterly checks. After all, stock prices are dynamic and we cannot afford to use static measures.

What are the qualitative aspects you look at?

We buy stocks in companies with good management. What does good management mean? We can understand that from what I call the six Cs -- competence, competitiveness, credibility, corporate governance, concern for minority shareholders and capital efficiency.

Competence: To gauge competence, we can look at the management's strategic vision, for one.

Secondly, we can see whether the company's diversifications make sense and whether there is a justifiable rationale behind any forward or backward integration the company has made.

Another important factor is to measure the depth of the management. A single-handedly run company would score poorly on this variable.

Competitiveness: Competitiveness of a company usually depends on its comparative advantage in the business it is in. In could be in terms of efficiency resulting from human capita or other assets, a brand or a geographical location.

Scale is another issue. It depends on whether you have the scale to deliver good services or attract the best. Unless you have reasonable scale in your niche area, you will stagnate if not die.

Credibility: The company's accounts should be such that they can be relied upon.

The time to worry starts when you see variations without any logical explanations. It is also important to track whether the management is keeping its promises from time-to-time.

Corporate governance: This partially overlaps credibility. But corporate governance is much deeper than credibility and is not restricted to the external world. It also includes internal practices, communication and transparency.

Concern for minority shareholders: Here, the track record of tapping the markets for more resources can be judged. Very often companies dilute the equity once share prices go up. This is not seen as a good management practice.

Capital efficiency: For this we take into account human capital, tangible assets, intangible assets (marketing network, brand, credibility, goodwill, etc.) and regular parameters like ROE, ROC and the delta factor.

The focus is on free cash flows.

Some other factors to assess are the extent of value addition and the ability of a business to pass on the pricing pressures it may face. All these factors will go into determining capital efficiency.

What do you think will help the rally this time around?

Well, fundamentals have been in place for a long time now. What has converted fundamentals into price performance is the inflow from the FIIs.

The difference between this rally and the others is that the broad market ROE is more than the cost of equity. This never happened in the last decade or so (exceptions being a few sectors or companies of excellence).

Secondly, we have never seen the opportunity cost or the interest cost so low as today. Apart from that there is no difference in fundamentals.

So stock prices must eventually track fundamentals. It is only a matter of time. Coupled with this is the delta ROE factor.

The market is very swift in reacting to this factor. Even in the past decade, companies that have continuously delivered positive delta ROE are the ones that have posted excellent returns.

All said and done, the markets will not have a one-way traffic. Corrections are abound to happen, though short and swift. Liquidity inflows from FIIs largely led the rally this time.

Given that much of corporate restructuring has already happened, interest rates are low and the economy is poised for an upturn, is there a different way to approach stock selection in this time's rally?

Presently, interest savings contribute heavily to profitability. Besides, companies must have huge operational efficiencies that improve operating margins dramatically.

Companies' break-even points have reduced and ability to curtail fixed costs has risen. All these have been factored into the market already.

In the future, sales growth and contribution margins will come into play. Any incremental sales will have an exponential impact on the companies' bottomlines.

For instance, any company which does not incur additional fixed costs will increase the bottomline dramatically. This, along with operational efficiencies, is what will be looked at now.

Again, the delta factor is what I would capture here. The incremental ROE is the factor that indicates which company will do the best. Delta ROE will decide the winner.

Here we would look at rate of change in ROCE or the incremental ROC. To capture this factor one must look at the trends in the delta factor, not just at standalone figures.

Let's once again take the example of an auto-ancillary company which has very high operating efficiency and idle capacity. If its export chances are very high, its delta factor, too, will be high.

What are the sectors you are currently bullish on?

We are bullish on automobiles and ancillaries, steel, cement, IT, banking, oil and petrochemicals.

Second-rung pharmaceutical companies, capital goods and engineering also look attractive now. Engineering and capital goods because there is a huge potential for exports of value-added products.

The top three sectors I would look at on a 12-month horizon would be cement, automobiles and auto ancillaries and engineering and construction. All these sectors are banking on an economic upturn, which we might see soon.

All these benefits will accrue when we finally see the Golden Quadrilateral taking shape (we are yet to see the effects of improved roadways).

In the engineering segment, we have not seen any capex for some years. Now all companies are lining up for an increase in capex.

This also signifies the bullishness of these companies in terms of capacity utilisation. Also, the gross block expansion that we saw a few years ago was all funded by high-cost loans, which is not the case now.

The automobile sector is looking up now with the availability and accessibility of cheap consumer finance. There has been consistent improvement in operating margins.

Also, there is underutilised capacity in the sector. Therefore, any growth will yield an exponential benefit in terms of bottomline.

One way to assess these companies is to look at the difference between earnings per share (EPS) and cash earnings per share (CEPS) and the current capacity utilisation.

Overall, for the sector, we see demand going forward and better still for auto ancillaries because of export opportunities. The banking sector is one where I am cautiously bullish.

The sector has already had its share of re-rating. From an investment viewpoint, we just look at whether the bank, public or private, meets our investment criterion in terms of delivery and valuations.

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