Transcript

Can Micro Caps Create Multibaggers? Interview with Mr. Mohit Khanna (PGIM India) 

Ms. Akshara Menon: Welcome to another episode of the Fund Manager Interview Series with PMS Bazaar. I'm your host, Akshara Menon. Today we will dive into the equity markets where the next big question remains: where does the next alpha opportunity lie? As we move through the rest of the financial year, we will explore how the markets could shape up, where investors should look for opportunities, especially in small and micro caps, and most importantly, whether a 20 to 25 stock portfolio can potentially deliver superior alpha. There's plenty to discuss. Joining the conversation is Mr. Mohit Khanna, Portfolio Manager at PGIM India PMS. Welcome to the show, sir.

Mr. Mohit Khanna: Thank you.

Ms. Akshara Menon: Let me ask you this first question about your personal journey. People would know about the professional part, but on the personal side, how is Mr. Mohit Khanna? How do you manage your own money?

Mr. Mohit Khanna: I do invest in ETFs and I have a couple of mutual funds also at my end, and that's about it. 

Ms. Akshara Menon: On a fund manager's portfolio, it's into ETFs, mutual funds, and stocks. 

Mr. Mohit Khanna: No stocks right now. When I joined PGIM, I exited all my direct stock positions to keep myself focused just on the portfolio.

Ms. Akshara Menon: Let me ask you the second question on the quarter one earnings. This has come with a pleasant surprise. How do you see the quarter one earnings and how has that affected your portfolio?

Mr. Mohit Khanna: If you see, the geopolitical tensions started in March itself and now continue to extend. The market did have a view on the upcoming earnings in the first commentary that we had with the management in the March quarter earnings, and then that got extended in the June quarter earnings. If you see how oil has behaved, which is largely the biggest delta factor in earnings, what we have really seen is that the June earnings have come out better than expected due to the margin expansion of the companies, and this is due to inventory revaluation in most cases. I don't see in the near term that this inventory revaluation benefit will sustain. I think in the coming quarters it will trickle down a little bit. However, if you see on the demand aspect, we have not seen any dent as of now. India's demand has been very decent. We continue to see strong demand even with a poor monsoon this year. Demand has been pretty strong. But again, nothing can sustain at stronger points or weaker points for a very long period of time. Things do normalize. If you see the ongoing monsoon progress and the reservoir levels, apart from western India, there is a huge deficit of reservoir water levels across other geographies and monsoon levels as well. So if this does not culminate into much better numbers as we are right now, then it would be a problem for the Rabi season or probably demand in the coming year, the next year. Having said that, for this year, for calendar year 26, I think progressively every quarter should be slightly coming down or leveling down on margins. Demand should remain resilient.

Now if you want to take a little longer period view because of this delta 2, delta 3 sort of event that is taking place, the earnings should start coming back hopefully next year if, and that can be a big if, if oil or the Brent settles around 85-90. That's the assumption I'm working with. Why so? Because a little bit of inflation actually helps equities and corporate earnings in the longer run. So that should start to probably benefit the corporate earning cycle. That's the view we are working with.

Ms. Akshara Menon: But is that inflation contributing to the growth?

Mr. Mohit Khanna: It does. It does. But again, not a runaway inflation, not a very subdued inflation. Inflation which is very checked between 3 to 4 percentage points should actually help not only the corporate earnings but also consumers at the base level economies in the rural areas as well.

Ms. Akshara Menon: From the investor perspective, not many investors would be aware of the geopolitical tensions. It still prevails, but not many of them are still aware of it. From an investor perspective, in their terms, how should they look into portfolio construction in terms of giving more allocation to Indian equities or global equities or into the unlisted side?

Mr. Mohit Khanna: It is very similar to how you would have your food thali. You would want to have a little bit of everything because that's what gives you complete nutrition, even though you like one part more. That's exactly what you should do with your portfolios also. You should keep them diversified. You should not go overboard with a certain asset class, with a certain geography, with a certain raw material input, with a certain set of products. For example, somebody's very good about autos, so he has a lot of autos in his portfolio. We should not do that. In the longer term, a diversified portfolio is much more likely to deliver much healthier growth rates or a much lower standard deviation of returns, which will give you a much better sleep and also help you achieve your financial goals.

Ms. Akshara Menon: When you say diversification, how do you define diversification? Some people go with 50 to 70 stocks for diversification. Some say even 25 stocks is diversified. If you want to mention diversification, what is your definition towards it?

Mr. Mohit Khanna: Looking at diversification with the number of stocks is not a very healthy way. There has been one very famous legendary fund manager, Mr. Peter Lynch, who used to manage 400-500 stocks in his Magellan fund and delivered superior 20% plus CAGR for multiple years, for decades. On the other hand, you see a lot of promoters across the world concentrated in just one or two companies, creating generational wealth. What is the right answer over here? As an investor investing in listed equities, we should remain very focused on the kind of raw material impact or raw material inflation impact that can have on the companies we are interested in. Now these can be 25 companies, these can be 50 companies, or these can be 400 companies. If there is going to be an impact on a particular sector, a particular industry, it is going to affect all the companies in the portfolio. So it's not about the number of companies in the portfolio. It's about the way you manage the other risk in the portfolio, and that is diversification. You are trying to diversify the risk and not increase the number of stocks.

Ms. Akshara Menon: So basically what matters is not the number of stocks rather the allocation given to it and the risk on how you manage your portfolio.

Mr. Mohit Khanna: Correct. Correct.

Ms. Akshara Menon: That defines how diversified the portfolio is.

Mr. Mohit Khanna: Correct. Also, for example, if somebody wants to have a 10-15 stock portfolio, he might not be fully exposed to all aspects of the economy or subsectors within the economy. For example, we talk about autos. In India particularly, autos can mean four-wheelers in the listed space, two-wheelers, ancillaries, and off-road tractors. All five have a very different set of raw material or input supply chain and a very different set of customer profiles. Now we call it auto, but you are exposed to different mechanics of market forces in all different subsegments. So if somebody wants to really have a diversified portfolio, they might want to look at something deeper than just the heading of an auto as a component in their portfolio. Therefore, sometimes 10-15 stocks are not good enough to have a diversified portfolio. You might want to have a little bit more. Maybe 25-30 is the sweet point. But as I said, you can still have a 500 stock or 200 stock portfolio which can also be a perfectly diversified portfolio or can not be a perfectly diversified portfolio.

Ms. Akshara Menon: With that, let me move to your portfolio—Core and Phoenix. I got to see that you have 20-25 stocks in that. On the very first question, how do you differentiate Core and Phoenix? On the performance end, the last 6 months have been quite a good time for your portfolios. The last part of the question is: is there a change in fund management? When you came into PGIM and you had been serving with Core and Phoenix, what were the changes you had brought in?

Mr. Mohit Khanna: Core Equity portfolio, as we call it, PGIM's Core Equity portfolio, the PMS offering, is a multicap fund that we run wherein we have large and midcap stocks accounting up to 70-80% of the portfolio, and the remaining 20-30% goes to small cap stocks. This is for the customers or likely investors who want largely to maintain a certain level of returns from equities because we are more exposed to large and midcaps, and want a little kicker on the performance aspect from the small cap side as well. For Phoenix, the fund is completely small and micro cap. Just as an example or a benchmark, the small cap index would have a median market cap of companies somewhere around 14-15,000 crores, maybe slightly higher these days. For Phoenix, we are running it at around 10,000 crore median market cap, so lower than the small cap index itself. We are doing a completely pure-play small and micro cap strategy for the Phoenix fund, and the large midcap strategy is a big aspect for the Core fund.

An important aspect between these two schemes that I manage is that even though Core has an allocation of approximately 20% into small caps, we don't have any stock overlap between the two strategies. That was not the case earlier. So that is one thing that has changed. We have stopped having overlaps between the two strategies. Now if you see the changes that I have brought in since my joining PGIM in August last year, they can be defined in two ways. First, I would like to speak about the daily fund management part, and the second piece is how we are selecting the stocks in the portfolio.

In the fund management aspect, what we have really done is that we don't really take a very large overweight position or a very large allocation to a particular stock or sector. If you see the current portfolios, my biggest position is somewhere around 5.5-6%, and my smallest active position is somewhere around 2.5%. So from 5.5% to 2.5%, all 25 stocks lie in between. The way to understand is pretty simple. If I'm going to run a 25 stock portfolio, my average position is 4%—100% that I can invest divided by 25 stocks is 4%. Now if I'm very bullish about a stock, if I like it much, I would take it to 5.5-6%. 

Ms. Akshara Menon: That's the max. 

Mr. Mohit Khanna: There's nothing carved in stone, but I don't intend to go a lot higher, maybe 7%, but not more than that because I don't want to have a very large head and a long tail in the portfolio.

It's a 25 stock portfolio where every stock has to play its role because I'm not trying to hit a sixer on every stock. There's a certain role that a stock has to play in the portfolio, and that role has to be played by it. My conviction is on all 25 stocks, and therefore whatever weighted average ratios that you would calculate for both my Core and Phoenix is largely coming from all the contributors, all the stocks. Whether it is the market cap number that I'm telling you, whether it would be a valuation number that you would look at, whether it would be an earnings growth perspective that you would look at, the contribution from the largest and the smallest allocated stock in the portfolio would not be very different. That's how we are managing it since I have come in last year for both Core and Phoenix.

Also, if you see the stock selection aspect, we were previously doing three important checks. We still continue to do that. We have not changed the disclosure document of both the schemes. Our original core way of analyzing stocks remains the same, but we have added additional layers to our filtration process. That has been done because in a universe of 3,000 stocks in small and micro caps, I only need 25-30 stocks. We can track some more internally, but in the portfolio it's going to be 25-30 stocks only. So I can be a lot more selective with my filters, and that's where, keeping the headings the same, we have added a lot of layers.

Let me just go through them one by one. For example, scalability is one aspect that we look at. In small companies, it's very critical for a company to be able to grow its capacity because if you're not growing capacity, you're not participating much in the ongoing growth in the economy, which in underlying numbers can be 5% to 7% real economic growth. So if you're not participating in that, then you are probably not creating shareholder value enough.

Now what we have added in this capacity expansion is the relative checks as compared to the ongoing industry for that particular stock. For example, if a company is expanding capacity by 25% next year, everything else remaining the same, the EPS or the earnings for that company should grow by 25%. Let's take a very basic example. Let me introduce another example in this: while the company's increasing capacity by 25% next year, the market or the industry is expected to grow by 40%. Now if I'm just looking at earnings, my earnings for that stock will go up by 25%. But what would happen about its market standing? It has lost market share. Why? Because the market grew by 40%, you only grew by 25%. What do you think would happen to a small cap stock in that situation? If it is a very high quality stock, it would probably remain flat or would go up by 25%, whereas the index or the industry would have gone up by 40%. Or because now you are losing out on your negotiating power with the market participants, whether it's the supply side or the customers, your P/E might take a compression. So this is something that we have added as a layer in the stock selection aspect on the scalability front.

The second important aspect is OCF generation or cash flow generation. There is no doubt that a company which is creating cash flows will create wealth for the shareholders, and we are absolutely clean about it. This was being done before. We see a history of cash flow generation by the company and how it has evolved over a period of time. That aspect of cash flow generation has been taken up a level further wherein my additional check is that the cash flow improvement, or the OCF improvement, which is the operating cash flow improvement in the company, should not come at the cost of margins. The company should be at least having stable to increasing margins while it is improving the cash flows. And then another aspect to that is: when the cash flow has been generated, where is it going to be invested? What will you do with that cash? The incremental returns from that incremental capital is important. What we do see is the return on incremental capital, ROIC, as to where that capital is getting redeployed. Because these are smaller companies, or even mid or large companies, if you are going to compromise on margins and your ROIC is going to come down, your valuations will also start to come down even with higher OCF generation. The market sees through that.

The third aspect, as I said, is the turnaround or being contrarian. In the Phoenix strategy, which is the small cap and micro cap, we do a lot of turnaround situations wherein we want to be sure that if by some reason the turnaround is not happening in this quarter and would happen in the next, or maybe has been trickled down the road, there has to be enough margin of safety in the stock where it does not really fall much because it's already undergoing a lot of external issues in its turnaround story. The stock has probably fallen much, much poorer returns in the last few years already, and now if you have one negative shock again, the stock might go down again. So what we try to see is that there has to be enough margin of safety for that stock. Sometimes it comes from hard assets on the balance sheet, sometimes it comes from zero debt on the balance sheet, sometimes it comes from high cash flow generation even at the downside cycle, sometimes it comes from the continuing market leadership in the industry-level down cycle. So you have to have that margin of safety. There can be multiple things that we analyze. This is something new that we have added as a filter because Phoenix was always participating in turnaround stories, but margin of safety is something that we added.

On the Core side, we do more contrarian calls because, again, as the large aspect of that money is allocated in large and midcaps, we do get a lot of contrarian ideas over there. For example, IT is a contrarian sector right now. At one point in time, chemicals were the favorite of the market, which doesn't seem to be the case right now. There are multiple infrastructure subsegments which are not in favor right now. Those kinds of things, as contrarian bets, come into the Core portfolio.

Ms. Akshara Menon: With that, I have one more question on the multibagger side. On the Phoenix portfolio, I suppose one or two of your stocks have given over 100% returns since you have taken over. It's almost been a year. That's immensely done better. In terms of investors, they don't define multibagger, but they are very much interested to know how many stocks have done multibag in their own portfolio. How do you define this multibagger part and how do you see it in the Phoenix portfolio?

Mr. Mohit Khanna: We don't really have a clear definition of multibaggers. From my perspective, if something is able to deliver much better returns than the market, it can be something which is close to a multibagger. We'll stop there for the multibagger aspect.

What we really try to do when we are trying to select the stock and create the portfolio at the same time is we are trying to manage multiple levels of diversification into it. As I had said in the previous question, the weightages given to the stocks are not very different. They lie in a very tight range. Now, if you see closely, you would see that the multibaggers that you mentioned come from the growth companies' perspective. The growth stocks, the growth companies. We also have value stocks and value companies in our portfolio. What we are trying to do in that 25 stock portfolio, both in Core and Phoenix, is that we are buying both growth and value stocks at the same time. Because there is no end date of our portfolio, this year the growth stocks are doing well, they are outperforming. So what I'm basically doing is selling the outperformance, booking the profits on the outperformance, and buying the underperformance, hopefully the next cycle might turn. This is one level of style diversification.

Now even when I'm buying both growth and value at the same time, if you look at the consolidated numbers of valuation of both my portfolios, they are not overvalued portfolios. We are close to a one-time PEG ratio. Even with this sort of outperformance or the returns given by the multibaggers, the other stocks have held us during the downturn. So our downside capture ratio is also quite good.

As I was saying, we are buying both growth and value stocks at the same time. We are also trying to diversify a lot of operational risk. The raw material supply chain—there are multiple stocks which do well when oil actually goes up. There are a lot of stocks that do well when oil goes down. So that is a balance that we want to maintain in the portfolio. There are a lot of stocks which do well when the rupee loses its value, and then there are a lot of stocks that do well when the rupee gains its value. So all those external factors are getting diversified in the portfolio to an optimal level, and therefore this change in the portfolio management that we have brought in has helped us to deliver a strong alpha.

It is not just about the multibaggers because if you see the BHB study on asset allocation done in the 1980s, it tells you that if you have earned 100 rupees as a return in your portfolio, 92-93 rupees come from asset allocation and five rupees comes from stock selection. So stock selection continues to remain a very critical aspect of fund management, but it is still not ahead of the asset allocation that we try to do in the fund. 

Ms. Akshara Menon: So if you want to rank it, it is asset allocation, stock picking, risk management. These are three aspects for any portfolio to be the benchmark. 

Mr. Mohit Khanna: Hopefully we become the benchmark. We are still following a big boys, but yes, I would have that approach. 

Ms. Akshara Menon: With that, we have very robust risk management.

How do you decide your exit, mainly into Phoenix where you're into small and micro caps and you bet on the loss-making company which you tend to believe will be a profit at one point of time? On that front, how do you exit a company when you find it? What are the triggers that you undergo?

Mr. Mohit Khanna: Everything that we do is fundamental analysis, right? Even when we are buying or when we are selling, there can be multiple ways an exit can be thought about. First way is that your original thesis is no longer valid, and you probably might be right or wrong, but it is no longer valid and you want to move out of the stock. Probably when you have gone wrong, that happens.

Second is when the story has already played out. You try to see where we are in the cycle in terms of the theme that you want to play. For example, a capacity expansion theme that you want to play in a company which has a lot of spare land, and that's where the brownfield expansion would come up. That has happened, that has given the returns, and now for the next leg of growth, the company might have to lever up the balance sheet. That's where we want to take a call on the stock and how the management is going about it.

Then the third point, and a very critical point, is the opportunity cost. If I have a stock which has already done well for me, but now the incremental upside looks limited, and in front of me I get another stock which fits well within my framework of that 25 stock portfolio of diversification of value and growth and is offering a larger upside, then probably I will take a decision to exit the one in the portfolio.

Ms. Akshara Menon: Let me ask this one question. A fund manager who sold most of his stocks just to be a fund manager and to concentrate only on the portfolio—for him, is there any attachment towards the stock?

Mr. Mohit Khanna: There's 100% attachment to the stock, and all the stocks I have attachment to are in my portfolio. Because you want to divorce some of the stocks, that means you want to exit it, but having a mental thing that you bought it and you gave it maximum allocation—just imagine 6-7%. But when you cap it up at 6-7% and you feel that you're missing the uptrend of it because you're limiting your cap to 6-7%. If you're going to give 10-12%, the kind of return it's going to give is higher when compared to 6-7%.

Fair enough. That's a very fair ask and a very fair way to think about it. But what happens to risk management? That is another part of the coin. Sustainability is more important than longevity. That's how I try to think about it. For example, if you are not able to generate a sustainable rate of return in your portfolio, you are likely to have less longevity in that portfolio. Somebody who has delivered or who has generated a very high return in one portfolio—maybe this year, maybe last 2-3 years—how long can that go? Things will reverse, revert back to the equilibrium. Then what happens? Then you have to see a couple of years with probably lesser than expected return because now your expectation is set at the highest number. What I am trying to do with the portfolios here is that while I'm capturing the power of compounding, I am not losing my night sleep with my overall allocation.

Ms. Akshara Menon: Can I take it as capital preservation over capital appreciation?

Mr. Mohit Khanna: No, because I'm still running a fund which is more than one times beta. I'm still running funds which are 1.2 times beta. So it is not really a capital preservation thing. The way to look at it is more about asset allocation. It is more about risk management. You have to tame the risk. You don't have to stop the risk. If you don't take the risk, you will not make the return. So you have to get the risk exposure done, but by how much?

Let me give you an analogy, probably simple for multiple investors to understand. There was a time in Indian cricket wherein our openers such as Sehwag, Dravid, Ganguly used to be the top-heavy guys, and then we had a full team below it. Now during any match, if all these four players are out, the chances of India's win fell dramatically. Why? Because it was a top-heavy and a long-tail kind of a portfolio. Now compare that strategy to today's strategy wherein even when your openers are out, you still have hope that at number six or number seven, Hardik Pandya or Ashwin or some other player would come in, and Kuldeep Yadav might come in and hit a six, and we would win the World Cup. That is what I'm trying to achieve. The stability of returns, lower standard deviation of returns, is something I'm trying to achieve.

In the same parallel of cricket and the portfolio here, I'm trying to be the Rahul Dravid of the portfolio. Now Rahul Dravid might sound conservative as you said, might sound capital preservation as you said, but it is actually not because if you compare Rahul Dravid's batting average with Virender Sehwag in all forms of cricket—Test, ODI, and T20—Rahul Dravid has scored better than Sehwag. That's historical numbers. Just by taking names, we get a picture in our head that Rahul Dravid is much more stable, much more risk-averse than Sehwag, but it's actually not. He scored more because he stayed longer. He was sustainable to stay longer. That's the point.

Ms. Akshara Menon: It was a great analogy. Now people can listen to your portfolio as well. With that, let me talk about the global market as well. India is still inclined to the global market, or the US tensions which are going on, and people are more inclined to US global equities. Not only US, they have also moved to the Japan and Taiwan stories as well. Considering that part, do you feel India has missed out on the AI journey? Is there any other story that India is going to miss that you feel is already happening in global markets?

Mr. Mohit Khanna: There are two aspects to look at it the way I do. Just take the AI question first, and that will probably help answer the other question easily. I am in a camp which has criticism for IT companies in India wherein they have not utilized their balance sheets much to finance growth or look for newer business models or similar kinds of business models just for growth and scale up over the period of years and have sat on cash. I am totally critical of Indian IT companies on that aspect. But you have to see the other side as well.

The other side is that there are two ways you can define an IT business. One is the service, and the primary is the product. There's a product IT company and then the service IT company. Now a product IT company spends billions of dollars for multiple years to develop a product. Once that product is developed, that needs to be installed across the client's existing infrastructure, and that is where our Indian IT companies—just perfect and the best systems integrator in the world—come in. Now the criticism for Indian IT that we have got left behind in the AI space is, I think, a little bit myopic in the sense that what were we expecting from Indian IT companies? Either to develop an AI-based product—that is not their job. Their job is that once the product is developed, to go and implement that.

So now it's very similar to what happens with innovators and scalers in pharmaceutical businesses as well. Once a product is developed and then that product is required by some pharmaceutical company or a bank or a manufacturing firm to be installed, that's where the Indians will come in. This is not the first time that we have seen. We have seen that when the cloud was getting bigger, we have seen that with big data, the web was coming in, we have seen that before as well. Even with the technology front of 5G, 4G implementation, we have seen that with India IT, right?

So yes, you can say that Indian IT has been a laggard in not developing new products. But as an investor, were you ready for subdued return ratios and high R&D expenditures for multiple years before the results would come in, and nobody was sure if they would come in? Indian IT companies, if they were involved in product development as well, they would have delivered very poor return on equity because they would have been investing a lot in R&D, in developing new products. That has not happened, so you enjoyed a good run over the period of years of high free cash flows and high buybacks and high dividends from those IT companies and high cash today in the balance sheet. On the other hand, product companies which are innovators—which can be Facebooks or Gen AI, you know, cloud has been developed—then you have Microsoft of the world which develops the product. Now that needs to be implemented. That's where Indian IT comes in. So I think it's a natural progression. As more products come in, as the market matures, Indian IT will have a much bigger opportunity for themselves to implement those products in the industry.

Ms. Akshara Menon: And that's why you have a bigger weightage on it.

Mr. Mohit Khanna: Yes, 

Ms. Akshara Menon:  That's a contrarian call now.

Mr. Mohit Khanna: Yes, it's a different view altogether.If you see my IT weight in the Phoenix portfolio, that involves SAS companies and IT companies with zero US dollar revenue exposure, completely hinged to Indian consumer growth. 

Ms. Akshara Menon: So I'm curious to know what are the companies ,that can't be taken offline. 

Mr. Mohit Khanna: That's one aspect of building the portfolio as well. So you can have an IT company in India listed in India with zero US dollar revenue, with zero exposure to H1B visa issues. 

Ms. Akshara Menon: So let's take this question offline. 

Mr. Mohit Khanna: We are also trying to find new stocks, find great businesses as well. While constructing the portfolio, I'm not losing out or giving less importance to stock selection or finding a new stock. That piece continues to remain there, but it has to fit in the portfolio. All things have to work in sync. It's just like when you are driving a car, the front wheel should match up the speed of the rear wheel also, only then the car runs smoothly. That's exactly what we are trying to do with the portfolio.

Coming back to our IT question, that is why a little bit overweight on IT because that's a bet on Indian consumer growth as well for the SAS companies that we are invested in. Also, if you see, there is one IT company that I am invested in—that's a platform business. Hopefully that particular piece will turn around in that business. I'm sorry I cannot take names here. On the other hand, in Core, which is more contrarian, is the traditional midcap IT company which have used its balance sheet in times where the organic growth is a little low to produce growth by acquisition on its P&L account.

Ms. Akshara Menon: Got it. So with that, we've come to the end of the session. We have talked a lot about it and we've spoken about your journey as well as the Core and Phoenix part of it, and also about your risk management, which is the highlight of the interview, and also about the exit. With that, we have filled the Indian map of your portfolio and about PGIM. I would love to have you again onto the show. Again, we can expect a lot of changes moving forward. With those changes, I would like to have you on the seat once more again.

Mr. Mohit Khanna: Absolutely. Absolutely. And if I have to just sum it up in one line, we are trying to be prepared and not trying to predict.