Funds ka Funda: Midcaps, Market Valuations and Aggressive Hybrid Funds

Vidhi Mehta: On today’s Funds ka Funda, we have with us Mr. Atul Bhole, Fund Manager   Equities at Kotak AMC. He manages two very different mandates at Kotak. One is Kotak Emerging Equity Fund, which is one of the largest funds in the midcap fund category, with around ₹50,000 crore of AUM. The other is Kotak Aggressive Hybrid Fund, where he manages around ₹7,000 crore of AUM.Today, with Mr. Atul Bhole, we will understand his view on current markets, the midcap category, and how investors should think about building their portfolios. Hi Atul, welcome to the show.

View on Indian Markets Today

Vidhi Mehta: I would want to start the show with the current valuations of Indian markets. There is so much news around us. While India was moving towards becoming one of the fastest-growing economies, there were headlines that we would become the third-largest economy. Now, there is also conversation around India’s relative position slipping. Similarly, Indian markets were among the largest globally, and now there are concerns around where we stand. For our viewers, what is your view on Indian markets today?

Atul Bhole: Hi Vidhi, and first of all, thanks for inviting me to your podcast. When you look at the Indian market, we have seen that for the last two years, Indian markets have been largely sideways. At the same time, other global indices, whether NASDAQ, S&P 500 or other markets, have moved up anywhere between 20% to 80% or even 100%. So, one thing is that India has underperformed for almost two years, and by a significant margin. Now, if you look at Indian market valuations, Nifty is trading at around 19 times one-year forward PE. Historically, Indian market valuations have moved between roughly 16 to 24 times PE. So, I would say current valuations are at fair levels or attractive levels. Of course, PE ratios have gone to 12 also, but those were during very significant events like the Lehman crisis or COVID. Today, we are in the middle of that historical range. And particularly when we are expecting earnings growth to come back to double digits, I think from that perspective, we are attractively placed. The correction also needs to be understood. Two years ago, after the general elections in 2024, there was euphoria and Indian markets moved to almost 24–25 times one-year forward PE. Obviously, those kinds of valuations cannot sustain. Because of various reasons government spending not happening during elections, very tight monetary policy, and consumption fatigue setting in after the high post-COVID consumption period earnings growth decelerated from 15%–16% to around 6%–7%. So, with 6%–7% earnings growth and valuations at 24 times PE, we saw this time correction. But now things are reversing. Valuations have come down, and earnings growth, which had gone down to 6%–8%, is expected to move towards 12%–15% this year and probably higher next year. Given this backdrop, we are reasonably constructive on the markets now.

Should Investors Continue Their SIPs?

Vidhi Mehta: When markets become negative, it can be disappointing for investors who started investing in late 2024. Their portfolios may be in the red because markets have gone down. Patience is obviously important, but for such investors, should they continue their SIPs, hold on for some time, or restart later? What advice would you give them?

Atul Bhole: Unfortunately, that is the reality of markets.Investors often enter the market looking at the returns of the past one or two years. In late 2024, the past one- or two-year returns were looking very good. There were also favourable events like the government coming to power for the third time.So, a lot of money came in during 2023 and 2024, and the experience may not have been very good.But investing often has to be done when there is too much negativity and a lot of bad news is already factored into prices.Today, after these two years, there is a significant amount of negativity. We are also seeing that SIP closure rates have gone up.These are typical signs that we may be approaching a level from where a good market move can start.For investors who had a bad experience over the last two years, the first thing is that they should continue with the market. They should stay invested.And if possible, they can actually top up their investments at this point, so that they can get the full benefit of the move that may come over the next three to five years.

Large Cap, Midcap or Small Cap  What Looks Attractive?

Vidhi Mehta: When you scan the three major categories large cap, midcap and small cap which one looks the most attractive to you right now?

Atul Bhole: I am not saying this because I manage the Kotak midcap fund, but I genuinely feel that the midcap universe is placed in a very sweet spot. Obviously, midcap companies are trading at higher valuations than large caps. For example, midcaps are trading at around 27 times one-year forward PE, while large caps are around 19 times. But if you look at the growth differential, the midcap universe is expected to deliver earnings growth of around 18%–20%, while the large-cap universe is expected to deliver around 11%–12% earnings growth. So, as long as this growth differential is there, valuations being higher can be justified to some extent. Also, if you look at what is happening in the Indian economy, the size of the economy is growing and different categories are emerging. Many of these new growth areas are housed in the midcap bucket. For example, electronic manufacturing is getting a big push from the government through PLI and other schemes. Many of those companies are in the midcap and small-cap space. Hospitals are another theme where we are bullish from a five- to ten-year perspective. Many hospital companies are in the midcap and small-cap space. Capital markets are also doing very well exchanges, brokers and asset management companies. These are also housed in the midcap and small-cap buckets. So, these high-growth areas, which are largely domestic plays, are in the mid and small-cap space. Because they are domestic plays, there is some secular growth in their earnings.

That is why I think midcaps can continue to do well. At the same time, I want to highlight one caution, particularly for smaller-sized companies. Because of what has happened in the last two to three months, including the West Asia crisis and oil prices, some smaller companies may find it difficult over the next six to eight months. Raw material costs have gone up and the currency has depreciated. Large and mid-sized companies can manage this volatility in their P&L and balance sheet, but smaller-sized companies often find it difficult. So, one has to be a bit cautious there. But when it comes to midcap companies, I am reasonably confident.

Active Midcap Funds vs Midcap Index Funds

Vidhi Mehta: The midcap category has somewhere been missing alpha, while index funds have been doing better. In that context, why should an investor choose an active midcap fund versus an index fund?

Atul Bhole: This has been a phenomenon particularly post-COVID because we have seen shorter business cycles and shorter market rallies. For example, for six or seven months, defence stocks may do very well. Then for another six or seven months, power equipment stocks may do very well. For another six to twelve months, hospitals may do well because of narratives and earnings pickup. Because there are so many participants in the market now retail investors, AIFs, PMS, mutual funds, hedge funds the space gets crowded very fast. A sector does very well, stocks go up 40%, 50% or 100%. At the same time, some other sectors get totally neglected and underperform massively. In active fund management, either the fund has those stocks at that point or it does not. We cannot chase every short rally that happens in pockets. We try to book profits when there is excessive optimism in one segment and look at other opportunities. But we cannot chase momentum just because stocks are doing well. That is one reason why some midcap schemes might not have matched benchmark performance or may have lagged. But over a period of five to seven years, if you give enough time to an active midcap fund, I think the funds can do well. Also, with index funds or ETFs, at the start itself, there is some underperformance because of expense ratio and tracking error. So, index funds also underperform the benchmark to some extent. I think active funds definitely have merit in the midcap space, and over a period of five to six years, if stock selection goes right, they can do better.

Red Flags in Midcap Investing

Vidhi Mehta: You manage a very large midcap fund. Are there any red flags that investors should look for when investing in the midcap category?

Atul Bhole: I would say there are not many red flags in companies, corporate India or the economy. The red flags are more in stock prices and valuations. As I said earlier, when a particular sector or sub-sector starts doing well and there is positive news flow, narratives build up. People chase those four, five or ten stocks in that sector or sub-sector. Often, there is a lot of euphoria. Valuations go up. People extrapolate good times for the next three to four years. On those higher earnings, they also assign higher multiples. That is the classic mistake that happens in this space. Even in this market, we can see that there is euphoria in certain pockets. People are assigning higher valuations on already higher multiples. So, investors need to be cautious in those kinds of areas.

Parameters to Evaluate a Midcap Stock

Vidhi Mehta: Are there any parameters investors should look at, such as promoters, debt levels or corporate governance? What parameters do you look at before investing in a stock for the fund?

Atul Bhole: Exactly the same parameters. There is no rocket science in investing. We start with the strength of the business. Then we look at the promoter or management quality. We look at how the sector is positioned in terms of growth, how the company is positioned to capture that growth, and whether it is increasing its market share. Once we develop comfort on these three things business, management and growth we look at valuations. We try to understand how much is factored in and how much is not. These are the classic things to look at. What one has to avoid is narrative-based or momentum-based investing, which has become common post-COVID.

Is AI a Bubble?

Vidhi Mehta: AI is one of the themes where a lot of momentum is visible globally. There is also concern now that AI may have become a bubble, and corporates are worried about large AI-related bills. How do you look at AI as a theme? Do you think it can do well over the next four to five years?

Atul Bhole: Indian markets are at the receiving end because we do not have any large AI play in India. The AI plays are mostly in the US and some markets like Taiwan and Korea. Those companies have gone up significantly over the last three years. To a large extent, from whatever I read, I believe there is euphoria or excessive optimism around those AI stocks. If you look at the capital expenditure being done for chips, data centres and other infrastructure, whether that kind of return or monetisation can happen is a big question mark. At the enterprise or corporate client level, the bills for AI tokens are going up significantly. While AI is promising productivity improvement, those productivity gains are yet to be seen. Most of them are still promises. The costs, however, are already going up in terms of token usage and infrastructure. So, there can be a reality check in the next three to six months. We will see how markets that have gone up 80%–100% over the last one or two years perform. Looking at past rallies in our markets and other markets, it feels like AI is at bubble-like levels. If there is a crash in that rally, we will also face consequences because there are global linkages. But I think our fall may be much lesser compared to the crash in AI markets, and recovery can be faster in our case because we did not benefit much from that rally earlier. Also, FIIs that were selling emerging markets, including India, and chasing AI cash flows or AI markets may reverse those flows.

What Does an Aggressive Hybrid Fund Do?

Vidhi Mehta: Now I will move to the next category that you manage the aggressive hybrid category. What does an aggressive hybrid fund actually do versus a pure equity fund?

Atul Bhole: Aggressive hybrid is a category where we can keep around 65% to 75% in equity, and the rest remains in debt. It is a very good category because it allows dynamic rebalancing between the two asset classes equity and debt. If you look at the long-term record of this category, many times aggressive hybrid funds have delivered returns similar to Nifty or diversified equity funds, despite having only around 65% to 70% equity. With lower volatility, the category has been able to deliver returns similar to broader markets or diversified equity funds. This is because of the constant rebalancing feature built into the product. Suppose I am at 70% equity and the market falls by 10%. I have the ability to increase my equity allocation back to 70% at those lower levels because this fund will always have some debt allocation. I can take some money out of debt and rebalance equity back to 70%. This feature may not be available in pure equity funds because they may operate with only 2% to 3% cash. Even if the market falls, they may not be able to take full advantage of it. On the reverse side, if I am at 70% equity and the market goes up 10% to 15% in a short time, that 70% may become 74% because of mark-to-market gains. Over a period of 15 to 20 days or one month, I can book profits and bring it back to 70%. This happens in a tax-efficient way. If an investor invests separately in stocks and debt and tries to rebalance constantly, there can be tax implications. But within an aggressive hybrid mutual fund, the rebalancing can happen without such implications for the investor. So, the category captures alpha in both falling and rising markets. Also, these funds are diversified. The equity side can have large caps, midcaps and small caps, while the debt portion helps balance volatility. In one product, investors get exposure to large cap, midcap, small cap and debt. Rebalancing happens automatically and in a tax-efficient manner. These are the good features of this category.

Aggressive Hybrid Fund vs Balanced Advantage Fund

Vidhi Mehta: There is a lot of confusion between aggressive hybrid funds and balanced advantage funds. Can you simplify this for investors? Which category should they look at and what goal should they have in mind?

Atul Bhole: We discussed aggressive hybrid. In terms of balanced advantage funds, they are slightly lower-risk products compared to aggressive hybrid funds. Depending on equity markets and valuation ratios, most balanced advantage funds can keep equity anywhere between 20% to 80%. When the market goes up, they bring down equity exposure and use equity arbitrage to make the product tax-efficient. Both categories are good, but they are positioned for different investor needs in terms of risk profile and time horizon. An investor who has a time horizon of five years or more and can take slightly higher risk can look at aggressive hybrid funds. Where the time horizon is shorter, say two to three years, and the risk appetite is lower, investors can look at balanced advantage funds. Because of the portfolio construct, aggressive hybrid funds can deliver maybe 200 to 300 basis points higher return than balanced advantage funds over a five- to six-year period, because the equity proportion is higher in aggressive hybrid funds.

Themes for the Next Five Years

Vidhi Mehta: Before we start speaking about the funds you manage, I want to understand if there are any sectors or themes for the next five years that investors should look at. Every market cycle has a theme. Last year, defence, infrastructure and PSUs did well. If you had to pick a theme for the next five years, what would it be and why?

Atul Bhole: Post-COVID, we have seen that every six months or one year, a different theme works based on narratives and news flow. But one thing I really like is private hospitals. I think this can be a big story for the next five to ten years because the sector is similar to where private banking was 20 to 25 years ago. Twenty-five years ago, we had a PSU banking system where customers may not have been very happy with service. On the other side, there were unorganised players like cooperative banks and money lenders. There was a genuine need for banking services. RBI and the government came out with private banking licences, and we saw the journey of private banks. There were some failures, but overall, the sector did very well in terms of wealth creation and helping the economy by boosting credit flow. If you look at India today, demographics are changing. We are all going to grow older. Incidence of diseases such as cardiology and oncology-related illnesses is also rising. The government healthcare infrastructure may not be robust enough, and many people may not want to avail those facilities. On the other side, we earlier had 10-bed or 20-bed nursing homes run by doctors. But real estate prices have gone up significantly, and equipment used for modern diagnosis, like MRI and CT scans, is also very costly. Individual doctors may not be able to build those hospitals. So, a significant burden is coming to private hospitals in terms of patients and treatments. Many hospital chains are now managed by very good managements. Their balance sheets are robust, business models have evolved, and internal accruals can take care of future expansion. Today, in Indian private corporate hospital chains, there are close to 90,000 to one lakh good-quality beds. They may double over the next five years through internal accruals. So, I think good wealth creation can happen in this segment over the next five to ten years.

AI, Data Centres and India’s Digital Infrastructure

Vidhi Mehta: You spoke about hospitals as a theme that can do well over the next five to ten years. I am also curious about another theme data centres, AI infrastructure and IT. These are the backbone of the digital economy. Can India benefit from this theme, or will the money again go to Taiwan and the US when it comes to technology?

Atul Bhole: Often, whenever a new technology comes, the companies or sectors in developed markets do well first. But when the use of technology starts at a wider scale, countries like India come into the picture. AI implementation may go through a bubble or crash, but the technology itself is very good and will improve further. When implementation starts at a wider enterprise level, Indian IT services companies will come into the picture. There is too much negativity around IT companies right now, but I think they will evolve and have their place in the ecosystem when it comes to wider AI implementation. In terms of India using AI and data centres being set up in India, that will also happen. A data centre needs cheaper power. Globally, along with data centres and AI, power is one sector that is benefiting because data centres are big power consumers. India has an advantage of lower power prices. So, many data centres can also get set up in India. After some time, many governments globally may require data localisation. The data generated by using mobiles, laptops and digital services is currently stored in data centres outside India. Some European countries are already putting localisation requirements that data should remain within the country.So, India may also see many data centres getting set up. There will be many beneficiary companies. For example, for a data centre to be set up, a significant portion of the cost goes into cable and wire companies. So, investors can indirectly benefit through cable and wire companies. Data centres also need air conditioning, so air conditioning companies can benefit. We may find indirect ways to capture this theme through cable and wire companies, air conditioning companies, power suppliers and similar businesses.

Defence and Manufacturing as a Theme

Vidhi Mehta: Defence and manufacturing did very well in 2023 and 2024, but slowly it was noticed that valuations were much higher compared to earnings. Is this still a theme, or should investors be cautious?

Atul Bhole: It is definitely a very strong theme, and it is doing well on the ground. It is not just a theme in the air. Because of favourable government policies around indigenisation and export promotion, defence and electronic manufacturing are doing well. We are also seeing that many auto ancillary and electronic manufacturing companies have started getting work from aeroplane manufacturing companies that are shifting some manufacturing to India. That ecosystem has started to develop in India. Manufacturing, including defence, has good momentum. In the last six months to one year, we have signed free trade agreements with Europe. The US has also lowered rates, and India is competitive from a tariff standpoint. At the same time, the Indian currency has depreciated against most global currencies, such as the euro, US dollar and renminbi. Exports have become more competitive because of tariffs and currency depreciation. Government policies are also favouring manufacturing setups in India. So, manufacturing is definitely a strong theme. It can continue for the next five to ten years. But there is a mismatch between valuations and what companies can deliver. Valuations have gone higher compared to growth rates. Even if a theme is strong, there can be glitches in delivery. One or two quarters can be painful because of oil prices going up or currency depreciation. So, these stocks can go through consolidation for six to twelve months. But they can come back because things are happening on the ground.

Fund Manager’s Investment Philosophy

Vidhi Mehta: Now, I would like to shift to the theme of our show Funds ka Funda where we talk about the funds you manage, the philosophy behind them, and why an investor should consider investing. Before that, for our investors to know you better, since you manage such a large amount of money, what is the philosophy you follow when it comes to investing?

Atul Bhole: There are two aspects to the philosophy. One is stock selection and the second is portfolio construction. Both go hand in hand. In terms of stock selection, I start by looking at the business of the company  how strong the business model is and whether it can survive changes in the economy, competitive dynamics and so on. Then I look at management quality or promoter quality  how committed they are to the business, their integrity, their ability to scale the business and manage cycles of greed and fear. Often, there are good times and bad times. How management has navigated those periods is very important. The third aspect is growth. Depending on the economy, what the company is doing and what is happening in the sector, we look at growth potential. Once these three things are in place business, management and growth I look at whether valuations are palatable. Whether valuation justifies the growth and quality of the company. Quality growth at a reasonable price is my stock selection framework to a large extent. Sometimes, maybe 10%–15% of the portfolio, I may take some opportunistic calls. For example, when I look for quality, growth, management and business, commodity stocks often do not pass these filters. But if there are strong tailwinds in a sector, such as metal prices moving up 50% or 100%, I may look at those companies from an opportunistic perspective. But this component will not be 50%–60%; it will be limited to 10%–15% of the portfolio.

On portfolio construction, I do not believe in taking cash calls. We believe in staying invested.

Indian markets are diverse. We have exporters, infrastructure plays, banking plays and consumption plays. At any point, we focus our energy on finding the right sectors and stocks rather than taking cash calls.

The portfolios are also diversified. I do not believe in concentration. Typically, the portfolio may have 60 to 80 stocks.

These are the two key aspects of managing funds.

Kotak Emerging Equity Fund

Vidhi Mehta: You manage Kotak Emerging Equity Fund, which is nearly ₹50,000 crore in AUM and one of the largest midcap funds. Is the same investment philosophy followed for this fund as well?

Atul Bhole: Yes. In both funds whether it is the midcap fund or the aggressive hybrid fund the stock selection framework remains the same. Whether it is a large-cap, midcap or small-cap company, the framework remains the same.

Are Midcaps High Risk, High Reward?

Vidhi Mehta: Midcap funds are usually placed in the high-risk, high-reward bucket. Do you think this is an oversimplification or is there truth behind it?

Atul Bhole: Midcaps and small caps are high-risk categories. Fluctuations in macroeconomic parameters like oil prices, interest rates and currency impact midcap and small-cap companies to a larger extent. Large-cap companies can manage these things better because of scale and balance sheet size. Midcap and small-cap companies can get impacted disproportionately more compared to large-cap companies. So, these are high-risk, high-return categories. Also, because of market forces, these companies often get crowded very fast. Investors chase these stocks based on narratives and growth, and they can become expensive at a point.Then, if there is disappointment, there can be a sharper correction. These things are inherent in these categories.

Portfolio Concentration in Kotak Emerging Equity Fund

Vidhi Mehta: Let’s dive deeper into Kotak Emerging Equity Fund. You have almost ₹50,000 crore-plus to deploy. How concentrated are you willing to go for a high-conviction idea, and how many stocks do you hold right now?

Atul Bhole: As we discussed earlier, I do not believe in over-concentration. Typically, the portfolio will have 60 to 80 stocks. Currently, as of last month, we had 65 stocks in the portfolio. Even where I have very high conviction in a particular stock or company, generally I do not go for very high weight. My top weight remains around 4%. Then there will be many stocks with 3%, 2.5% or 1% allocation. Even the last holding will also have a decent weight of around 60 to 70 basis points. So, there is no long tail, and there is no over-concentration. Whatever conviction we build on any company or stock based on research, there can still be risks. Risk can come from anywhere. For example, many years ago, I was holding a gas distribution company as a top holding in my portfolio, with around 3.5% to 4% weight. Gas distribution is a utility business. It was growing at 15%–20%, and everything looked good. It appeared to be a structural story. But one day, the gas regulator came out with a concept of capping margins for these gas distribution companies, and the stock price fell 40% in one day. That was a regulatory risk. There can be market risk and many other risks. So, whatever conviction we have, we have to manage it, keeping such risks in mind. Fortunately, we are in India, and there are multiple opportunities across themes, sectors and sub-sectors. So, there is no need to concentrate in one place.

How Should Investors Evaluate a Fund Manager?

Vidhi Mehta: If a retail investor wants to evaluate a fund manager, what parameters should they look at?

Atul Bhole: The track record of the fund manager is very important. People will obviously look at returns and outperformance. But how those returns have come is also very important. Did the returns come by taking higher risk, chasing momentum stocks or concentrating in certain segments? I understand that for a retail investor, tracking all this is difficult. But today there is a lot of information available. Investors can do some research and look at portfolios. Long track record, podcasts and TV interviews can help investors understand the thought process and framework of fund managers, and whether they are following what they say in their portfolios. These softer aspects are also important while allocating funds.

Role of a Wealth Manager

Vidhi Mehta: Do you think having a wealth manager to handle your portfolio can be the right way to go? Investing requires a lot of knowledge. Even though there is a lot of MF awareness and podcasts like this, a wealth manager may be able to give better insights than personal research alone.

Atul Bhole: Definitely. As I said, it is difficult for retail investors to look at all these things. We can talk about these topics because we have a background in finance. Many retail investors may not have a finance background. They may be engineers, doctors or from other professions. For them, understanding all these things can be difficult. In that case, a wealth manager can play a big role. Apart from fund selection, which comes later, the first point is allocation. Wealth managers can add a lot of value in helping investors understand their own risk profile and time horizon. Within that allocation, they can also help decide the right instruments. Wealth managers are placed between fund management and investors. They can combine both perspectives and select appropriate funds for investors.

Kotak Aggressive Hybrid Fund Portfolio Construction

Vidhi Mehta:
Now let’s move to the next fund you manage Kotak Aggressive Hybrid Fund, which has nearly ₹7,000 crore of AUM.

Can you quickly take us through the portfolio construction of this fund?

Atul Bhole: As we discussed earlier, this category can invest up to around 75% in equity. Kotak Aggressive Hybrid Fund has an old vintage. Earlier, SEBI used to allow 60% to 80% in equity. Currently, because my outlook on the market is constructive based on valuations and earnings, I have taken the equity exposure to a higher level, around 80%. Generally, it holds around 74%–75%, but right now it is around 80%. Within that 80%, around 35% is in mid- and small-cap companies, and the remaining is in large caps. Around 20% is deployed in debt instruments. That is the current portfolio allocation for the aggressive hybrid fund.

Who Should Consider Kotak Aggressive Hybrid Fund?

Vidhi Mehta: How should an ideal investor look at Kotak Aggressive Hybrid Fund?

Atul Bhole: This is a good category in multiple ways. It can be considered for lumpsum investment depending on the market situation. In today’s market, this fund can be looked at for deployment of lumpsum money. This category is also suitable for SIPs. It is slightly less risky compared to midcap or pure equity funds, but still, equity is on the higher side, around 70%–80%, depending on the market. On the other side, this category can also be suitable for SWP after five to six years, once an investor accumulates enough corpus. Retired people or people running smaller businesses can look at monthly withdrawals from this fund to supplement other income or for running household expenses. So, it is an ideal category for lumpsum, SIP and SWP. It is a good solution because in one product, investors get multiple segments  large cap, midcap, small cap and debt. Rebalancing happens without tax implications. So, it is a good solution for a normal investor.

Conclusion

Vidhi Mehta: Got it. Atul, thank you so much. It was wonderful speaking to you.

Disclaimer: Mutual Fund investments are subject to market risks. Please read all scheme-related documents carefully before investing.