IDFC Equity Opportunity Fund Series 2 – NFO Review

Marina Wealth

IDFC Equity Opportunity Fund Series 2 – Product Note

Investment Recommendation: Invest – suitable for aggressive investors

IDFC Mutual Fund is launching Series 2 of the Equity Opportunity Series from Jan 13, 2014. The theme of the scheme is based on the operating leverage. This Series 2 comes after a 9 month gap from IDFC when they launched a close ended fund focused on small and micro cap stocks.

What is Operating leverage?

Operating leverage refers to the ability of well established companies, which are currently operating at sub-optimal capacity, to take advantage of the business upswing expected over the next few quarters to dramatically improve their bottom line.

The fund aims to build a portfolio based on the “operating leverage” strategy of up to 35 stocks which look at the following type of companies:

Operating at low capacity utilization and therefore operating at below optimal margins
Sensitivity of earnings to capacity utilization is very high as demand picks up these companies can show big swing in profitability
Consolidating Business
Have a relevant and established product or service
Have strong history and stable promoter

Why operating leverage?

Many companies across industries like cement, steel, textiles, pharma and automobiles are currently operating at low capacity utilization levels. They have a high fixed cost structure, which at low capacity utilization, eats in to the bottom line (profits). As the business sentiment improves and demand slowly starts coming back, these companies would start using more of their capacities. As the capacity utilization starts improving, the top line starts to improve. As the fixed costs remain true to their name, more the capacity utilization, more would be the margins/profits for these companies.

As the margin improves, the profitability gets improved with the resultant re-rating of the stocks. A famous stock investing proverb is “valuations always remain slaves to profits”. There is a very strong possibility of well-run and established companies seeing greater growth in bottom line compared to the top line.

Risks:

The data which came out today morning with regard to manufacturing and IIP is not a positive sign with contraction in IIP being reported. Therefore, for a fund focusing on economic revival has its own set of risks.

The most important assumption is that the demand scenario across industries would pick up post elections and when a new government is installed. Any political instability would have a big negative on the demand scenario, the resultant profits and valuations.
This fund is a close ended fund where the redemption by surrendering units with the mutual fund is not possible. You have to necessarily stay invested for the whole period. The saving grace is that the fund comes only with a dividend option with the stated objective of booking profits when the price reaches targets and pass it on to investors.
Timing is very important in these types of funds. The strategy has to work out within the next 3 years. It is not like open ended funds where the fund manager has greater flexibility to move from one strategy to another or wait for longer periods of time, if she is convinced about a particular strategy.

Should you invest in this new fund offer?

As we all know economy moves in cycles. We have seen sluggish growth across industries and verticals over the last 5-6 years. Naturally, the cycle has to move from sluggish growth to demand stability and then actually growth phase again. It is very much possible that this cycle would start any time soon. There has been positive news on CAD, Fiscal deficit (of course, it has its own story!), demand pick up in few select areas in the economy.

The interest rates which are currently ruling at an all time high is also expected to slowly go down over the next 12 – 24 months. This would also give these companies which has taken debt to increase capacity to benefit with the reduction in interest rates.

We are convinced of the strategy of operating leverage turning out to be profitable to investors. There are many examples from the past, where the companies managed to grow their profits manifold with increase in their capacity utilization. For example, between Dec 2004 and Dec 2007, ACC grew its top line from Rs4171 crores to Rs6953 crores, a growth of 67%, whereas the profits during the same period moved up from Rs402 crores to Rs1427 crores, a growth of 3 times. The market cap of the company during the same period increased by 7 times.

We believe as a fund house, IDFC has remained steadfast to the core objective with respect to its funds. We have a positive opinion on the capability of the fund house to identify profitable opportunities under this strategy.

Considering the close ended nature of the fund and a concentrated portfolio strategy being adopted, you may invest if you are an aggressive investor who has the ability to take high risks. You may allocate a small portion of your investment corpus towards this particular new fund offer.

Key Facts: