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‘Post-correction, mid & small cap companies now once again trading closer to long term averages’

Author: Kumar Shankar Roy/Wednesday, December 26, 2018/Categories: The Finapolis Conversation

‘Post-correction, mid & small cap companies now once again trading closer to long term averages’

The view from the top is often unique. HDFC Mid-Cap Opportunities Fund is the biggest scheme in its category with over Rs 20,000 crore investor assets. With a stellar track-record since inception in 2007, the equity fund has generated over 23% annually for the last ten years. However, midcaps have corrected this year and naturally such funds are down. Is it a good time to buy midcap funds or wait till the storm passes? Kumar Shankar Roy caught up with Chirag Setalvad, Senior Fund Manager - Equities, HDFC Asset Management Co. Ltd. to discuss the fund’s investment philosophy, current mid cap valuations, investment universe and whether the fund’s huge size is a constraint. Read on to know the veteran investment manager’s insights.

What is your investment philosophy of HDFC Mid-Cap Opportunities Fund?

Investment philosophy of HDFC Mid Cap Opportunities Fund is based on the premise that stock prices reflect their intrinsic value over long term. Our investments are driven by fundamental research with a long term view.

Further to create wealth over time, the key is capital protection and therefore we emphasize on the price of purchase greatly. Key tools to achieve this objective are:

  1. Target a margin of safety,
  2.  Effective diversification in line with the mandate and
  3.  Limit investments to companies of acceptable quality.

We also believe that it is possible to achieve higher than benchmark portfolio returns through active management over long term.

What are the kind of characteristics should a stock have for it to become a part of your portfolio?

The aim of our strategy is to predominantly build a portfolio of Mid Cap companies which have:

  • Reasonable growth prospects
  • Sound Financial strength
  • Sustainable business models
  • Acceptable valuation that offers potential for capital appreciation.

What kind of stocks are not a part of your portfolio?

We follow a bottom-up stock picking strategy, avoid stocks where valuations are not in sync with growth prospects and where management quality and corporate governance is below desired levels.

What are the key reasons for good performance of your fund in recent years?

Our outperformance in recent years can be attributed to the following factors

  • Quality research with long term focus and aim to better understand the businesses that we invest in.
  • Investment discipline of aligning strategy with fund mandate at all points of time.
  • Not compromising on sanctity of the product or mandate under competitive pressures.
  • Avoiding assets where risks involved are not understood.
  • Less emphasis on short term underperformance, if medium to long terms prospects are promising.
  • Portfolio construction based on medium to long term fundamentals

Do you take cash calls?

The scheme maintains cash at minimal levels. Average cash levels from Sep 2015 to Sep 2018  is 3.5%.

Is there any tactical miss you regret?

There will always be stocks that we would have liked to own more (our big winners) of or those that we missed entirely. That is integral to investing in equities in general and in midcaps in particular. There would also be instances where we would have liked to exit faster than we did.

Prior to standardization of funds what was average % of midcaps w.r.t. fund AUM?

HDFC Mid Cap Opportunities was launched in June 2007 as a Mid Cap fund with at least 75% of the Net Assets being invested in Mid Cap Companies. As defined in erstwhile Scheme Information Document (prior to scheme rationalization) “Mid Cap Companies are generally those companies that are either a constituent of the NIFTY Free Float Midcap 100 Index or companies that have a market capitalization of Rs. 500 crores or more; but does not exceed the market capitalization of the largest constituent of the NIFTY Free Float Midcap 100 Index.” In April 2018 (month prior to scheme rationalization), ~ 96% of Net Assets was invested in Mid Cap companies as per erstwhile definition.

Post scheme rationalization, HDFC Mid Cap Opportunities continued as a Mid Cap Fund. As of September 18, ~65% of Net Assets is invested in Mid Cap companies as per prevailing definition of mid cap companies in SEBI circular (Consisting of 101st to 250th company in terms of full market capitalization).

What changes have been made in investments due to standardization of funds?

As mentioned above, HDFC Mid Cap Opportunities Fund continued as a mid cap fund post scheme rationalization. The Definition of Mid Caps universe changed pursuant to scheme rationalization and the scheme realigned its portfolio to the extent required to adhere to minimum Investment limit in Mid Cap companies i.e. 65% of Total Assets. To align with new definition, we have bought/sold some stocks in line with the scheme objectives.

How do you view current mid cap valuations? Please elaborate

The midcap (Nifty midcap 100) and small cap (Nifty Smallcap 100) benchmarks have corrected significantly since January 2018 by about 20% and 35% respectively. In addition to the price correction there would have been some earning growth in this period as well and thus the correction in valuations is a summation of both the price fall and earning growth. Prior to this fall, the valuations of small and mid caps appeared stretched - midcaps were trading at a premium to their long term average valuations and at a premium compared with largecaps. Post this correction, a lot of this excess has been rectified and these companies are now once again trading closer to their long term averages.

With Rs 20,000 crore in assets, you have the largest asset size in the mid cap space. When do you see the fund's huge size affecting investment and returns?  

It is important to keep in mind that the fund size has grown both due to NAV appreciation as well as fresh inflows, which have been spread out over time. As per the last market cap categorization released by SEBI, the market cap range of mid cap companies is ~Rs 10,000 crores to ~Rs 30,000 crores with a cumulative market cap of about ~ Rs 25 lakh crore**. This definition provides the fund with enough flexibility. Despite the increase in AUM, we have not changed the manner in which the fund is run.

We continue to focus on companies of reasonable quality that are available at sensible valuations and build the portfolio on a bottom up basis. We have held a similar number of stocks and steady diversification over time. We have also had a consistently low portfolio turnover. Lastly despite the increase in AUM, the fund has remained focused on midcap and small cap companies and has not drifted towards large caps and the weighted average market cap of the fund has been regularly lower than that of the benchmark. Hence we continue to believe that the current size is manageable. Further increase in AUM has to be seen in the context of overall valuations and market performance.

With the Sebi categorization, midcap funds have to choose stocks between the 101st and 250th stock by Market Cap. Do you feel this is a constraint, given that mcap may not always be a true reflector of the potential and size of business?

While the SEBI categorization does restrict the investment universe by mandating that at least 65% of total assets of Mid Cap schemes should be invested in companies ranked between 101st to 250th in terms of full market capitalization, it still is a reasonably large universe for active stock picking. Further, mid cap schemes do have the flexibility to invest up to 35% of total assets in large caps and small caps. SEBI categorization provides a common definition and improves transparency and consistency amongst funds.   

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