Prime Picks: 3 thematic funds for tomorrow’s markets

With inputs from Chandrachoodamani N V

In our Prime Funds quarterly review last week, we had removed two thematic funds from the recommendation list. We’d suggested you book profits if your exposure had swelled. So, where do you reinvest that profit? Or, if you are looking at specific themes to invest in, which ones should you go for?

There are 3 themes that make for timely investments today. These are themes that have underperformed the Nifty in the past 2-3 years and therefore do not have the high valuation risk that comes with overheated themes such as defence, PSU, or infrastructure. The re-allocation of money to large caps from cyclicals, mid & small caps and PSUs could act as an additional tailwind.

The 3 themes and funds

The three themes and the funds we recommend in each are as follows. Each of these themes are good fits for longer-term portfolios, too, even if they are thematic.

• Banking – Nippon India Banking & Financial Services Fund
• IT – Franklin India Technology Fund or ICICI Pru Technology Fund
• Consumption – Nippon India Consumption Fund

You can invest in any of these themes. Use these pointers:

• Pick based on the most theme convincing for you or a combination if your portfolio size is large enough to accommodate multiple themes.
• You should also consider your existing exposure to these themes and then decide which ones to add.
• The funds recommended above all have low overlaps with the Nifty 100 & Nifty Midcap 150 indices, indicating that individual overlaps with funds in your portfolio would also be on the lower side.
• If your portfolio is heavily dominated by large caps, though, you can first opt for the technology and consumption funds.

In this report, we detail the rationale behind recommending each of these 3 themes and our fund choices.

Banking & financial services

The banking sector has been an underperformer, compared to the Nifty 50, for nearly 2 years now. Two reasons – one, the sector was coming off a heady rally driven by earnings expansion in the prior period. The sector had a great run in FY22 until mid-FY23 as a combination of lower cost of deposits, higher net interest margins and falling NPAs boosted earnings and margin expansion.

Second, index heavyweights HDFC Bank and Kotak Mahindra Bank dragged and the all-round positive scenario began to reverse. Rising deposit costs squeezed net interest margins and the strong growth plateaued. Concerns also rose on credit costs and mobilizing deposits to fund credit growth. Stock-specific concerns played yet another role – HDFC Bank’s absorbing HDFC presented challenges, the RBI’s clamping down on Kotak Mahindra’s digital onboarding and multiple management headwinds led to sedate growth.

The table below shows the returns of the Nifty Bank index against the Nifty 50 index in the past 3 calendar years.

This flat performance, though, has meant that valuations have turned especially attractive across the board. It has been a very long time since HDFC Bank has traded at close to 2.75 times book value! Axis Bank, similarly, is at close 2 times book and Kotak Mahindra is also at about 2.7 times book (core banking valuation, excluding subsidiaries).

This puts the sector in sweet spot for with regard to value. The concerns in the banking sector seem overdone and medium-term earnings outlook appears strong. We have already discussed this in detail in our Nifty 50 fundamental outlook last month, which is summarized below:

• Credit growth is natural when inflation is under check and when a moderating economy needs a growth push. So, an entire absence of credit growth is unlikely.
• Rate cuts and lower interest rates can also serve as a growth trigger.
• Lower government borrowing releases more money for private credit growth

Credit growth can also help NBFCs earnings expansion. Meanwhile, other financial services segments such as capital market intermediaries and asset management have also seen reasonable earnings growth, which can sustain if stock markets remain resilient and the financialisation of savings continues in its current steam. Insurance companies have also seen a return of market favour, which bodes well.

Nippon India Banking & Financial Services Fund

Our recommendation in this space is Nippon India Banking & Financial Services, and is part of the Strategy/Thematic category in Prime Funds.

Why this fund: This is not the best performer, if current returns are taken. However, part of the Nippon fund’s comparative underperformance stems from its steady increase in private bank exposure over the past six months. In our view, this is a positive.

• The Nippon fund is otherwise a consistent performer within the banking theme category. The fund beats the theme-average an excellent 87% of the time on a rolling 1 year return basis in the past 4 year period. It is among the best at capturing the rally within in the sector, with max returns much higher than peer funds.
• The fund is also agile in shifting weights around within the theme to gain from where sentiment lies. For example, it had a higher share to public sector banks earlier when this set was doing well, which it has gradually shaved off now.
• Private banks form the heaviest weight now for the fund, with the top 5 holdings all banks. Given that valuations are the most attractive in this bucket, this presents a good opportunity to gain more when growth returns. The fund also has good support from smaller select holdings in pockets such as microfinance, NBFCs and individual stocks in other capital market-related financial services.

Suitability: The fund suits moderate to high-risk investors. The fund needs a holding period of at least 2-3 years for the effect of credit growth to play out. Lumpsum investments over the next 4-6 months are ideal. Keep allocation to sector funds at a max of 10-15% of your portfolio. Please note that if you already hold our other banking fund (ICICI) from Prime Funds, there is no need to shift.

IT services

The IT sector has swung from being undervalued pre-Covid, to becoming market favourite and back again to being an underperformer. Earnings disappointments, uncertainty over client spending in key overseas markets, slower growth in contracts signed for bigger players, and delays in order execution translating into revenue growth all contributed to the IT majors being shunned by markets.

The tide, though, is turning around. This is evident in the Nifty IT index’s recent performance with the index up 11% in the past 3 months against the Nifty 50’s 2.9%. Several factors are now working in the sector’s favour:

• One, there were no further disappointments on earnings. Market interest in the sector saw support coming in the June quarter results. Hiring trends are also starting to pick up.
• Second, most companies across the sector have revised guidance marginally upwards, and clients have begun to look to ahead and commit to fresh spending. The US rate cut cycle combined with a soft-landing (avoiding recession) scenario for the US economy was considered an ideal scenario for the sector. Therefore, expectations are pricing in a revival in discretionary client spending, especially from the Nasdaq 100 companies.A deeper look into the growth worries of the sector in the past 3 years shows that, growth was not happening even though companies were winning new deals at an appreciable pace. This was because spending cuts by existing clients were weighing. A reversal of this trend, now, can accelerate growth.
• Third, one of the largest verticals for domestic IT services companies is the banking, financial services and insurance. This vertical faced a setback following the Silicon Valley Bank crisis in March 2023 and normalisation in spending post Covid. The June 2024 quarter, though, saw the vertical score a revival.

Apart from the IT majors, differentiated smaller IT plays in segments such as ER&D continue to show promise. Discretionary spending pick-up can also help companies secure deals in niche segments such as AI, which is poised to become the next new technology.

Mutual funds in the space predominantly invest in the top IT majors. However, they do look at related plays such as tech-driven companies such as Zomato, Tanla Platforms, Bharti Airtel, Affle India and so on. The opportunity basket has further broadened with the rise of new-age tech business in the domestic market.

Franklin India Technology

Franklin India Technology is one of two funds in Prime Funds that is a good option to play the IT theme.

Why this fund: The fund is among the more aggressive funds within the category and is also slightly differentiated. The fund does not stick to the traditional names, but quite early on deviated from the IT index into mid-and-small tier IT companies, fintech companies, and e-commerce companies. This helped it score strong returns even during the phase where other IT funds saw lagging returns owing to their high large-cap exposure. The fund has, in periods such as 2023 and earlier 2024, beaten the IT theme fund average by a solid double-digit margin of about 12 percentage points.

The fund has further showcased its ability to move where opportunities are, and has now picked up large-cap IT stocks that are making a market comeback. The share of large-caps in its portfolio has jumped from 25% in September 2023 to 62% by August 2024. This places it well to pick up on the broader IT revival while retaining its niche plays. The fund also has good exposure to overseas tech majors such as Microsoft, Alphabet, and Amazon.

Suitability: The fund suits only high-risk investors given that it can swing between market capitalisations. The fund needs a holding period of at least 2-3 years. Lumpsum investments over the next 3-4 months are ideal. Keep allocation to sector funds at a max of 10-15% of your portfolio.

ICICI Pru Technology

ICICI Pru Technology is one of two funds in Prime Funds. This fund is the less aggressive, in terms of strategy, than the Franklin fund.

Why this fund: The fund is a fairly consistent performer compared to other IT thematic funds that tend to rise sharply and fall. Its steady large-cap focus has led it to being something of an underperformer in the past year, but recent returns show that the fund is picking up well. The fund has earlier been well able to capture rallies in the IT theme; its highest 1-year return in the past 4-year period has stood at 106%, better than funds who have the same history such as Aditya Birla Digital India or SBI Technology Opportunities. The fund is on par with Tata Digital India in terms of performance.

Its current portfolio is dominated by IT majors, but it possesses a long tail of small exposure to stocks that are not directly in IT but are a play on technology. Apart from those such as Zomato or Airtel, the fund also features stocks such as PVR Inox, e-commerce logistics players, and capital goods companies. The fund also holds some international tech stocks.

Suitability: The fund suits moderate to high-risk investors. The fund needs a holding period of at least 2-3 years. Lumpsum investments over the next 3-4 months are ideal. Keep allocation to sector funds at a max of 10-15% of your portfolio.

Please note that the Franklin fund is the more aggressive of the lot, considering tis higher exposure to mdi and small cap IT. You may choose between the above two funds based on your risk appetite.

Consumption

Consumption as a theme is extremely broad-based. Household expenditure, though, took a beating post Covid for multiple reasons.

One, rural demand slumped with incomes hit by poor crop yields, uneven monsoons and falling income. Two, there was a stark polarisation in spending with the premium end seeing demand sustain but the value end seeing a hit. Three, input costs for many companies went up, forcing companies to hike product prices which in turn hurt demand.

These challenges, though, now seem to be abating as seen from the following:

• Inflation pressures are abating. More importantly, rural demand is picking up. FMCG companies are a good sector to gauge demand – companies reported strong rural volume growth for the second quarter in a row in the June 2024 quarter, and growth even outpaced urban demand.  Another rural demand gauge is entry-level 2-wheeler sales, which saw growth pick up in the second half of FY-24.
• Other segments in the consumption basket, such as restaurants, quick service food chains, travel, hotels and so on are also seeing good growth. FMCG majors and consumer durables players indicate that the demand environment is now conducive, and has the strength to absorb price hikes which was absent earlier. Carmakers are now turning back to entry-level passenger vehicles as well, which had earlier heavily lost ground to the premium segment, indicating that demand revival is getting more broad-based.
• Growth in private final consumption expenditure, captured in the GDP numbers, show an uptick; PFCE grew at 7.4% in the June 2024 quarter after clocking a 4% growth in each of the two preceding quarters. Share of PFCE in GDP has also inched up.
• A stable currency, lower interest rates, increasing domestic manufacturing and discussions in terms of free trade agreements and duty cuts, and so on may act as further long-term stimulants to enhance consumer purchasing power.

Nippon India Consumption

Nippon India Consumption is the only consumer fund recommended in Prime Funds.

Why this fund: The fund is among the most consistent performers in the consumption theme, beating the average of other funds a good 88% of the time on a rolling 1-year return basis over the past 3 years. It also scores well in beating the Nifty Consumption index. The fund is also among the best among peers at capturing rallies.

The fund is adept at juggling stocks it holds to book profits and move into new opportunities. It invests across market capitalisations, given that consumption as a theme can cover a wide variety of sectors. It doesn’t hold a concentrated portfolio but instead has smaller holdings across a diverse set of stocks allowing it to play multiple consumption themes. It additionally does not hold financials, which reduces any impact of cyclicality in earnings of the stocks it holds. Its current portfolio sports a good share of FMCG, which can cushion the impact of any market correction.

Suitability: The fund is suitable for any investor with a long-term portfolio. the fund can be invested through SIPs or lumpsums, since it is extremely diverse and the theme is a long-term play on the Indian consumer demand. Keep allocation to sector funds at a max of 10-15% of your portfolio.

Disclosures & Disclaimers