India's Best Fund Managers 2019

“Generating alpha is harder without volatility”

Chirag Setalvad says an efficient market can be more challenging than a turbulent one

The best captains don’t steer away from turbulent waters but ride through them with a steady hand. Managing the largest mid-cap fund in India, Chirag Setalvad, believes it is usually easier to outperform during bouts of volatility. This senior fund manager at HDFC Mutual Fund says that, by being consistent, diversifying and understanding businesses you invest in, risk can be managed and even leveraged. With elections around the corner, the market could see dips and highs, but Setalvad believes that the effect of polls is only short-term. According to him, in the long-term, market performance will be driven more by fundamentals. 

While you are the largest mid-cap fund in the market, does your size sometimes become a constraint? 

Not really. Despite the size increasing, we have maintained the same level of diversification, kept portfolio turnover low and retained our mid-cap focus (and have not drifted towards larger companies). At the same time, we continue to construct the portfolio on a bottom-up basis and invest in good quality, reasonably priced companies. So, the fund philosophy has not changed. Thus, size has not substantially altered the way in which we manage the fund.

Firstly, despite being the largest mid-cap fund, the portfolio’s weighted average market-cap is one of the lowest amongst peer funds. The concern with assets under management (AUM) size is that when a mid-cap fund becomes too large, it starts to invest in larger companies. We have maintained the weighted average market cap of our portfolio at closer to or lower than that of the benchmark. Today we are invested about 70% in mid-caps and 30% in small-caps. We have not gravitated towards larger companies. We have ensured that our style has not drifted.

Secondly, we have been consistent in our diversification. We have had about 60 stocks in our portfolio since inception and a larger AUM has not resulted in over diversification.

In addition, keep in mind that the AUM increase has been a combination of price appreciation (the net asset value is 5x in about 10 years) and fund inflows. The size increase has taken place over a reasonably long period of time and hence we have had time to make adjustments. 

Finally, we are very focused on managing risk which is especially important in a large fund in a category where liquidity can dry up. We have a well-diversified portfolio. We normally keep about 5-6% in cash. Most importantly, we are managing fundamental risk by investing in good quality businesses at sensible prices. Risk is much more than just volatility and standard deviation. It is about having a good understanding of the businesses that you invest in.

The mid-cap universe has seen a lot of volatility in the past one to two years. How do you build a portfolio that can weather bouts of extreme volatility?

Volatility per se is not something to be worried about. In fact, it is usually easier to outperform during bouts of volatility which is driven more by emotions and flows than by fundamentals. If you can maintain a steady head in uncertain markets, you can accelerate buying when the market corrects and valuations become more sensible. Bad times do not last forever (for that matter neither do great times) and investing in tough times helps add to long-term return. Thus, by focusing on fundamentals and having a long-term orientation, one can try and take advantage of short-term aberrations. Alpha generation is actually harder when there is no volatility. 

What were some of the under-researched companies that have reaped rich dividends for you? 

Over a period of time we have invested in many under-researched companies. At the time of our investing, the number of analysts covering these companies was low or there was no coverage. These companies did not regularly meet investors or host conference calls. Thus, we had to rely on published documents and alternative research (such as meeting competitors, dealers, suppliers and so on) to frame our understanding of these businesses. Often liquidity was an issue and we had to build up our stake very patiently. However, liquidity does improve once these companies grow and become larger, are discovered by more market participants and improve their level of investor communication.

When we first bought a south based auto ancillary manufacturer, it was a relatively ignored business. It was trading at a single digit price-to-earnings (P/E) multiple. It belonged to a good group but was making a commodity-type product and the stock was illiquid. However, the company was well managed and was making a decent return on equity (RoE) and growing well. So, there was no reason for it to trade at a single digit P/E multiple. As it was an illiquid stock, we had to be patient and buy it for months to build a meaningful position. Today, it trades at 20x. If a stock meets our internal criteria we don’t shy away from going against the grain.

A leading non-banking financial company (NBFC) focusing on consumer finance was a great franchise with strong growth, high return ratios and very good management. Valuation was not cheap on the face of it at 2x book value. However, we felt that the inherent strength of the business was not being recognised. It was not that people didn’t know the stock but the quality was under-appreciated. It eventually moved to 5x book value.

You have a considerable exposure to the chemicals space across the funds? What was your investment rationale when you invested in them?

The rationale was based on improving cost competitiveness, rising product prices, increasing market share, continued domestic market growth and attractive valuation. Firstly, Indian chemical companies compete significantly with Chinese manufacturers. The environmental sensitivity in China has increased, and regulation and compliance have risen substantially. This is increasing environment-related costs for Chinese chemical companies while restricting new capacity additions. 

Additionally, the overall cost structure for Chinese companies is also increasing with wage inflation and other costs picking up. As a result, Indian companies were becoming more cost competitive and product prices were rising resulting in improved profitability.

Global chemical majors are heavily reliant on Chinese manufacturers and were looking for other reliable alternative suppliers. They wanted to reduce their dependence on Chinese vendors not only from a cost perspective but also to mitigate potential geopolitical risks (such as sanctions). Indian companies had strong chemistry skills, good process R&D and low manufacturing costs which could help them gain share with global buyers. Finally, domestic demand for chemicals was also growing reasonably. 

Thus the overall outlook for chemical companies was improving. At the same time, these companies were well managed and valuations were reasonable.

What were the most unyielding times for you and what were your key learnings?

The most challenging period is when the market is running up very sharply. When investor adrenalin is surging, the emphasis can shift away from fundamentals. Businesses of inferior quality, momentum stocks and concept based stocks often do well in this environment. 

Hence, we tend to under-perform as our focus is on good quality businesses and we avoid the kind of stocks which tend to surge in an exuberant market. As relative performance suffers, there is an implicit temptation to dilute ones standards. The challenge is to remain patient and to stick with one’s convictions. This is easier said than done. 

As a fund manager, what are some of the biggest challenges today? 

The market is becoming much more efficient and that is the biggest challenge. There is a lot more competition and increased availability of information. As the market becomes more efficient, alpha generation comes down. The analytical and informational advantages are getting reduced but fortunately the advantages of discipline and good investment character remain. 

After generating a return of over 60% in 2017, the small-cap fund is down 11%. When returns are so divergent how do you manage investor expectations? 

The key is to set the right expectations. Firstly, investor in equities must be reminded to have a medium to long-term perspective. This is especially true in the mid and small-cap categories where volatility can be higher. Investors in these categories should ideally look at a three to five-year time horizon. Secondly, investors are encouraged to invest money in a systematic fashion. This helps reduce timing risk as it averages one’s purchase cost over time. 

What sectors do you expect will do well in the next one to two years and why?

Financials, industrials and IT may do well in the near term. Financials, particularly corporate banks have gone through a difficult time in the past few years. Not only had credit growth dried up but more importantly asset quality had deteriorated significantly. Both of these issues seem to be changing. On one hand, the worst of asset quality seems to be behind us. Slippages seem to be stabilising and recovery rates should improve. On the other hand, credit offtake is seeing an improvement and will hopefully sustain. As things improve, valuations, which are today substantially below their long-term averages, could revert to more normalised levels.

In the industrial segment, there should be an improvement in the capex cycle. Currently, it is mainly the government which is spending money. However, private sector capex should pick up as well. Companies have not invested in substantial capex lately. Capacity utilisation is being stretched and this will push companies to begin investing. In addition, business confidence seems to be improving and the disruptive effects of Goods and Services Tax (GST) and demonetisation are behind us. Needless to say, in terms of our infrastructure, we have a long way to go. Hopefully, commodity prices will remain benign and stable. We particularly like the industrial consumable businesses where the cyclicality is lower and the RoE across the cycle is good and companies have healthy order books. Valuation of industrial stocks looks sensible. 

IT companies are good businesses to hold, especially mid-caps which have the ability to grow faster than the industry. There is a big push to digitisation. These companies are growing decently, are benefitting from rupee weakness and enjoy high cash flows that enable strong payouts and at the same time are reasonable priced.

How do you see the macro environment playing out in the next couple of years? What kind of impact do you expect the elections to have on the market? 

In general, the next three to four years could be better than the past couple of years from an economic standpoint. Commodity prices have corrected and inflation has moderated significantly. Capacity utilisation is rising and hopefully you will see private sector capex picking up. Credit growth is improving and liquidity issues related to the NBFC sector should get resolved. Post GST, the formalisation of the economy should also increase.

Slowing global growth, rising protectionism and tightening liquidity are some of the key macro risks. However, these concerns are more global in nature though they would impact risk appetite and hence market performance in the near term. Longer term, it is important to keep in mind that the Indian economy is relatively insulated as it is not very export dependent. Closer to home, fiscal discipline, asset quality and credit growth are key variables to watch out for.

The upcoming general elections may have some short-term impact, but it is unlikely to have long-term consequences. A lot of economic policies have become apolitical. The economy is a very complex being and politics is a small cog in a very large wheel. Long-term, market performance will be driven more by fundamentals. Thus, the health of the overall Indian economy (and more specifically corporate earnings growth) and valuations will play a much more important role than elections. 

Are there any sectors you would avoid investing right now and why? 

Currently, the valuations of consumer companies appear very stretched. They are trading at 30-50x one-year forward earnings which is at a substantial premium to their historical valuation. While the long-term growth outlook is positive this is more than factored in. As a result there is very little margin of safety and this is one sector where we are significantly underweight.