Chirag Setalvad was all of 25 when he started his stint as an analyst at HDFC Mutual Fund during its inception. Two years into the fund’s existence, he managed his first fund, HDFC Tax Plan 2000, which had a corpus of Rs.1.5 crore. He left in 2004 to join hedge fund New Vernon Capital, only to come back in 2007. Today, he manages four funds with a corpus of Rs.14,066 crore. The straight shooter readily admits that a fund manager may not always be the smartest person in the room. Then comes the caveat. “It is not always the smartest guy who turns out be the best investor. The guy who is hard-working, afraid of losses and who sticks to common sense is the one who is more successful,” says the 41-year-old. When Setalvad is not making his investors richer with this simple philosophy, he is spending time with his toddler son.
Tryst with stocks
It was during Setalvad’s first job with ING Barings in the investment banking division from 1997 to 2000 that he started reading up on stocks. “I wasn’t doing much back then and the organisation wasn’t doing much either. But they had all the resources — a high-quality database, extensive collection of research reports and a solid research team.” Setalvad didn’t need to count on too many people for inspiration or to seek guidance after moving to HDFC Mutual Fund. After all, he had Sanjoy Bhattacharyya and Prashant Jain — two of India’s smartest money managers — as his immediate bosses. “I have been very lucky to work with both. Bhattacharyya gave me a great introduction to the business and taught me the most basic principles of investing and stocks. Jain is a tremendous investor and thanks to his great track record, I got a rare opportunity to witness the rigour and discipline inherent in the process. Both have different styles and I was fortunate to learn from them. You had to be an idiot to not absorb a lot after working with them,” he laughs.
His early bosses not only helped shape Setalvad’s investment philosophy, but also the fund house’s philosophy. “This is what we practice across for all our funds — to buy good quality companies at reasonable prices, hold them over a period of time, buy during adverse times and stick to our circle of competence. All fund managers are going to say this. No one is going to tell you that we buy bad businesses at high prices. But the proof of the pudding lies in the portfolio,” he says. While performance could move up or down depending on the market, the RoCE and RoE of the portfolio has been 1-3% higher than the benchmark, while the P/E of the portfolio has been 5-10% lower than the benchmark on an average.
Making the right assessment
Setalvad explains that before investing in a business, he looks at how the company has performed over a period of time. “I look at the variability in the margins over a period of time, which gives me a sense of profit and loss in connection with the balance sheet. I also look at how efficiently the management has deployed capital, look for some stability in the return generated on capital and how the company has fared in comparison with its peers. We like companies that manage difficult businesses well,” explains Setalvad.
He cites the example of Supreme Industries. “The company is into plastic processing and it is not an easy business. It has a 30% operating margin business with consistent return on equity and capital employed. The company has a great brand and distribution and it sells a product we all understand. This is the kind of business we like to own.”
In the case of the plastic processing company, what helped it stay ahead in a commoditised business was its product selection. The company chose to stay away from the B2B and B2G segments and supplied to individual consumers instead. “Supreme Industries could have chosen to sell sewage pipes to the government, but it is so much harder to sell to the government or even to sell canisters to businesses, since this is a commoditised business. It also has a packaging business that is doing extremely well,” he adds. Amara Raja Batteries, Bayer Cropscience and Grindwell Norton were some of the other stocks that checked all the boxes for Setalvad.
What sweetened the deal in the case of Supreme Industries and Amara Raja is the fact that the fund house managed to buy the stocks at reasonable valuations. “It is not enough to buy good-quality businesses — you have to do that at reasonable valuations. Supreme Industries was perceived as a commodities business, so we got it cheap. Similarly, in the case of Amara Raja, the market was more enamoured with Exide, which was quoted at 13-14x. Amara Raja, on the other hand, was quoted at 8-9x because it was perceived as a weak competitor. All that has changed now,” he says. Vesuvius India, which supplies refractories to steel companies, was another quality business the fund managed to get for a bargain. “It has technology coming in from the parent company and its Indian operations are efficiently managed. So, we were getting global technology at Indian costs and the company was doing really well. However, the market perception was that it was a commodities business since it was supplying to steel companies.”
Apart from a thorough check of all the parameters of a company’s business, what Setalvad also prefers to do each time is set up a meeting with the management. One such chance meeting with officials from Bajaj Finance, the largest holding in Setalvad’s mid-cap fund, changed his perspective about the company. “I was aware that it was a good business, but when you go ahead and meet the senior management, you see the passion that is at work across the company. You can ask the officials directly, say, what the cost of distributing product A in region C was and how it has changed over the past two years. They will know all the details — they live and breathe the business, after all. I came back very impressed after meeting them,” he explains. Apart from its great understanding of the business, Bajaj Finance has very good MIS systems and is great in execution and cross-selling products.
Although quality mid-caps help you generate a higher alpha compared with large-caps, some of them come with execution risks and have little to show in terms of track record. So, how does one mitigate execution risks? “There is a lot of misunderstanding that execution risk, overleverage, poor management quality and corporate governance are issues faced more by mid-cap companies. I strongly disagree because you have some of India’s most dishonest managements running some of the biggest companies. There are incredibly difficult execution risks in larger companies as well. Leverage is a function of the nature of the business and the decision of the management, not a function of the size of the market cap,” he says. According to Setalvad, as long as the fund house sticks to the basic investment framework, it needn’t worry about execution risks. “For us to understand the risks, we need to understand the business. We do a lot of channel checks with suppliers, customers, ex-employees and dealers. We also speak to other investors and look at companies overseas and unlisted companies in the same space,” he says.
So, does he take the risk of owning a business that he doesn’t understand? “I have never owned too much of real estate, as the cash flows in the business are opaque. Commodities is more of a global business, which is difficult to understand sitting here in India. Across the cycle, I am not clear of how much return of equity it generates. It is much harder because you have to get the cycle right. Personally, I find telecom also a little difficult to comprehend. There’s a lot of regulation and competition. It is a tough business,” he says. But even such sectors end up providing valuable lessons. And Setalvad says he has taken his mistakes and missed opportunities as a learning platform to do better.
Learning from mistakes
When the going is good, mid caps get more than their share of attention from the market, but the reverse holds true as well. But managing volatility has been no hurdle for the fund manager. Why is this? “Market volatility is something everyone has to deal with. While one just needs to ride out volatility, the pressure to get out is more when the business starts turning adverse. In a large portfolio, it doesn’t matter if five to six stocks underperform, because the problem actually arises when a large part of the portfolio doesn’t do well. Though we haven’t had too many challenges in the past seven to eight years, today, we hold a lot of PSU banks. They have done badly and asset quality has gone to new lows. We are holding on to them and only time will tell how it will work out.”
Commenting specifically on some of the promising opportunities that his fund ended up missing out on, Setalvad says, “Oh, that would be a long list. If we had zeroed in on every opportunity, our NAV would have been Rs.93, not Rs.33. We missed some opportunities in pharma stocks, especially Glenmark and Cadilla. Before Sun Pharma turned to mega-cap, we had the stock in our portfolio, but never held it in size or duration. We missed out on IndusInd Bank and didn’t own enough of HDFC Bank. In the case of Sun Pharma and HDFC Bank, we felt the stocks were expensive and got swayed too much by the price. But because they compounded so well, the stocks did extremely well over a long period of time. What we learnt from this was to pay a little more if you find a good business. As Buffett would put it, “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” HUL went all the way to Rs.85 and we still didn’t buy into the stock. We didn’t want to own something at the bottom of the cycle. That was a different kind of mistake. Things looked difficult back then and sometimes you forget to consider that things eventually normalise and you end up not owning the stock,” he adds.
But with the market getting ever more efficient over time, Setalvad says finding quality companies at reasonable valuation is becoming a difficult task. “When we started out, we didn’t even have the luxury of quarterly reporting and it was easier to dig deep and find these rare stocks. Now, we have 51 analysts covering Infosys and the market will continue to be more efficient over time, meaning that we have to work harder.” But Setalvad says he remains optimistic about the market over the next three years. “Improved earnings growth and reasonable valuations should result in higher stock returns. We expect earnings growth to be driven by a recovery in revenue growth and better operating leverage. Operating margin will also be boosted by softer commodity prices and lower interest costs.”
He expects the economy to be in better shape over the next couple of years on the back of cyclical recovery, increased government investments, better consumption and a better regulatory environment.
So, Setalvad is bullish on economically sensitive sectors such as financial, industrial, infrastructure and energy spaces. He also feels that a falling market is a great opportunity to buy into good companies at reasonable valuations. No wonder, then, that Setalvad is smiling a bit more these days. For him and his fund, the great big discount sale is on, and he plans to make the most of it.