I wrote in my last post on my views on inflation and one venue of investing or hedging against it – floating rate funds. Two key points to keep in mind, when reading my views on inflation or any other macro fundamentals. They are views and guesses, nothing more and nothing less. Even paid economists get it wrong more than 50% of the time and it is their job to get it correct.

The second point – I look at floating rate funds as temporary place holders for cash. If I don’t find attractive ideas, I invest the surplus cash in a floating rate fund till I find something interesting. That way, the cash is earning more than the paltry 1% in a savings account and I can liquidate with complete ease and within 1-2 days if I want to move the cash to an attractive idea.

Due to the second point, I don’t agonize on finding the most attractive fund as the difference would at best 1-1.5% per annum which is not worth the effort for me.

A caveat – I am not a typical investor (that does not mean I am a super smart investor). I spend far more time looking for attractive ideas and as a result my focus and effort is directed towards higher return opportunities such as equities or arbitrage. If you do not fall in this category – investing being an area of extreme interest – then my suggestions on personal finance may not be entirely valid for you. If you really want to invest in a debt fund for the long turn, it makes sense to do more homework and invest intelligently

Floating rate funds are basically debt funds which invest in floating rate securities. So if the interest rates rise, the return on these securities and hence the fund rises and vice versa.

This is not the same in case of fixed rate funds. A fund which invests in fixed rate securities faces a different risk. When the interest rates rise, these debt instruments with fixed rates fall in value and so does the mutual fund. As a result these fixed rate funds show a higher return in falling rate scenario and poor returns in an increasing rate scenario

My views on mutual funds can be found here and on debt funds here.

Selection criteria

I had written the following in terms of debt funds

– Mutual funds – fixed income: This is my favored avenue during a falling rate scenario and I tend to invest with well know mutual fund houses such as franklin templeton, DSP etc. At the time of investing in a debt mutual fund, I tend to look at the following factors
o Asset under management – avoid investing in funds with low level of asset as the expense ratios could be high.
o Fund expense – lower the better. Although the indian mutual fund industry typically gouges its customers and charges too high compared to the returns.
o Duration of fund – This is the average duration of the fund. A fund with longer duration will rise or fall more when interest rates change
o Fund rating – 80-90% of the fund holding should be in p1+ or AAA / AA+ securities.
o Long term performance of the fund versus the benchmark

– Mutual funds – floating rate funds : This is my favored approach in a rising rate scenario. In addition to all the factors for the fixed income mutual funds, I also tend to favor floaters with shorter duration.

So based on the above criteria and in view of the possible rise in interest rates, I was able to find the following funds

Some selections

Templeton Floating rate retail growth – The fund has been around for 5+ years, has beaten the index by around .5% and has 425 crs under management. Majority of the fund holding is in AAA securities. The major downside is that it charges 1% as management fees.

Birla sunlife floating rate LT retail growth – This fund has been around for 6 odd years, beaten the index by around 1% and invests in AAA securities. An additional point is that the fund charges .44% as management fees which allows the fund to deliver better returns to the investor compared to other floating rate funds. The downside is that the fund does not have as much asset under management (around 150 crs)

HDFC floating rate income LT – This fund has been around for 7 years, has beaten the index by around 1%, and invests in AAA securities. In addition the fund charges only .25% as management fees and has fairly high asset under management (around 850 Crs). This fund clearly seems to be better among the lot.

ICICI prudential LT floating rate B – The fund has been around for 6 years, has barely beaten the index and charges 0.85%. In addition the fund is fairly small, less than 100 crs in asset.

Kotak Floater LT G – This is one of the largest funds with around 18000 crs in asset. The fund has beaten the index by around 0.6%. In spite of its large size, it charges around 0.5% as management fees.

The above list clearly shows that the variance in the performance between the funds is low as expected. As a result, it is critical to choose a low cost fund which is difficult as all the funds clearly charge too much compared to the value provided. If one nets out the cost, the return is almost same as the index for most of the funds.

Conclusion

The conclusions are obvious

• If you want flexibility and ease of transaction, select a low cost fund such as HDFC or kotak.
• If you have the time and can put the effort of going to a bank and don’t need the liquidity, then it makes sense to buy short duration fixed deposits with good banks and keep rolling them. As a result when the interest rates rise, you will be able to take advantage of the higher rates.

What am I doing ?

I am using option 1 for myself and option 2 for my parents.

The last one year has been a value investor’s dream. Analyze and find an undervalued stock, buy decent quantities of it and voila!, in a few months time the market has recognized the undervaluation and corrected it. As a result most of the stocks in my portfolio have corrected substantially and I am looking at decent gains.

This has been the experience across the board and I don’t think it is proof of my or anyone else’s special genius or abilities. Now, before we start considering this as a normal state of affairs, let me point out an experience I have had for the last few years. This experience is not unique and has happened to me several times, but I am giving this example as it is recent and ongoing.

I read and analyzed Merck in Aug-Sept 2006 and found it to be substantially undervalued. The company had a growth problem, where due to the limited portfolio of products, its topline was more or less stagnant. However the company was able to improve its bottom line by 50% during the same period by cutting costs. In addition the company had almost 350 Crs in excess cash and was thus selling at 4-5 times its earnings.

So here was a company with great ROE, moderate growth and high cash balance selling for a song. I decided to start building a position and started buying the stock slowly. I eventually built my position for 2 years with the stock dropping during that period. The net result of the position was a loss of around 15% by the end of 2008 including dividends.

Was it a bad pick?
Now a valid argument could be that the stock was bad pick in the first place. In investing, it is important to remember that decision need to be made looking forwards and not backwards. My approach to investing is to compute intrinsic value with conservative assumptions and buy at a discount to this number. This approach may not work everytime, but works surprisingly well most of the time.

The company had a decent performance in the past, was reasonably well managed and had quite a bit of cash. During the period 2006-2008, the company was able to grow the topline by 30% and the bottom line by 10%. Not exactly a blowout performance, but pretty decent. In addition, there were a few things happening below the surface. The company started investing heavily in sales and marketing during this period due to which the topline started accelerating at the cost of the net margins.

The turnaround
The turnaround in the price finally came in Q2-Q3 2009 as the topline growth started flowing through to the net profit in terms of growth. At the same, the market was also in a mood to correct undervaluations and price most stocks closer to their fair value.

Whats the point?
The point is that undervaluation and fundamental performance alone are not sufficient triggers. A lot of times it is the market mood which decides when the undervaluation will correct and you will make your returns.

Now, one can say that if it all depends on the moods, then one should wait for the mood to turn and buy the stock before the turn happens. Well, on that please leave me a comment if you know some logical approach of figuring that out without getting into mumbo jumbo.

The point of the post is that an investor cannot control when the market will correct the undervaluation, but he or she can look for sound companies selling below intrinsic value, buy them and hold a portfolio of such companies with patience. Some of the holdings may take time, but over the course of time the portfolio as a whole will do reasonably well to be worth your while.