Investors with long-term horizon may continue to invest in small cap funds: Chirag Setalvad, HDFC AMC

We prefer to build the portfolio on a bottom up basis rather than from a top down or from a sector standpoint.

While several pockets of small caps have become quite expensive, one can still pick and choose within the large universe of small caps and find well-managed small caps that are still available at reasonable prices. Thus, investors with a long-term horizon and tolerance for volatility may continue to invest in this category, says Chirag Setalvad, Senior Fund Manager-Equities, HDFC Asset Management Company Limited.

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In an exclusive interview with Sanjeev Sinha of FE Online, he shares his views on the performance of the small cap category in recent years, and whether it is the right time to invest in these funds. Excerpts:

When do you sell a stock?

We may choose to sell a stock for several reasons. Firstly, we would look to sell a stock when it meets or exceeds our fair value target. This target is arrived at based upon the investment team’s research and analysis. Secondly, we may exit or trim our holding in a particular stock if we find a better alternative opportunity elsewhere. Thirdly, we may sell a stock from a portfolio risk management perspective in view of managing sector and stock-specific exposure. Finally, we would look to exit or trim our holdings when our hypothesis regarding the investment turns out to be incorrect.

How do you contain volatility in the fund?

Managing portfolio risk and volatility is very important. On the one hand, we focus on good quality companies that are well managed and are available at reasonable prices. This helps reduce fundamental risk from a quality of business standpoint and price risk from a valuation point of view.
In addition, we believe in managing portfolio risk by maintaining a well-diversified portfolio across stocks and sectors which should help contain volatility. The portfolio is usually well diversified across stocks and portfolio concentration is kept at sensible levels. At present (30-Jun-21) we have 65 stocks in the portfolio with top 10 holdings at ~38%. Lastly, while the fund is largely invested in small caps, it does have an exposure to mid and large companies as well.

With your fund’s asset size above Rs 10,000 crore, are there any constraints in managing the fund?

No, we think the fund size does not pose a meaningful constraint. Most importantly, our investment philosophy and stock selection process has not changed in spite of an increase in the fund size. 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 maintained steady diversification over time. We have also had a consistently low portfolio turnover. Increase in fund size notwithstanding, we have maintained the sanctity of the product and stayed true to our investment mandate.

As per the last market cap categorization released by AMFI (Jun-21), the market cap range of small cap companies is below Rs 11,819 crore, with a cumulative market cap of Rs ~25 lakh crore (considering 1,310 companies with market cap above Rs 150 crore). Thus, we have a large universe which provides us enough flexibility in this category.

The fund has remained focused on small cap companies and has not drifted towards large caps. The weighted average market cap of the fund has largely been in line with that of the benchmark. We continue to believe that the current size is manageable. Further, the increase in AUM has to be seen in the context of overall valuations and market performance. One needs to bear in mind that the fund size has grown over time, not only due to periodic fresh inflows but also due to capital appreciation.

In view of the sharp rally in small caps over the last year, is there any merit in considering an investment in a small cap category at this point in time?

It is true that Small Caps have rallied sharply from the bottom of Mar’20 with NIFTY Small Cap 100TRI index yielding returns of 134% CAGR from the bottom of 24-Mar-20 to 30-June-21.
However, what one must bear in mind is that Small Caps had corrected even prior to Covid and had corrected by -22% CAGR from the peak of Jan-18 to Dec-19, i.e. pre-covid.

With the onset of the pandemic in 2020, Small Caps corrected further and eventually corrected by -37% CAGR from 15-Jan-18 to 24-Mar-20.

Consequently, even after a sharp rally of 134% CAGR from Mar’20 to Jun’21, NiftySmall Cap 100 TRI (as of 30-Jun-21) is barely 5.2% above its level of 15-Jan-18 (a return of 1.49% CAGR). Further, as of 30-Jun-21, NIFTY Small Cap 100 TRI had 5 year returns of 12% CAGR, which is close to the long term average of 11.5%. Hence, the Small Cap rally post Mar’20 has to be viewed against the backdrop of relatively sluggish returns for close to 2 years prior to that, as viewing it on a standalone basis can be somewhat misleading.

While several pockets of small caps have become quite expensive, one can still pick and choose within the large universe of small caps and find well-managed small caps that are still available at reasonable prices. Thus, investors with a long-term horizon and tolerance for volatility may continue to invest in this category.

How do you pick stocks for your HDFC Small Cap Fund viz Stock selection philosophy?

We follow a bottom up stock picking approach and identify companies with reasonable growth prospects, sound financial strength, sustainable business models and good management quality. We buy stocks with medium to long-term view in mind and look at buying companies trading at sensible valuations. We aim to minimize mistakes as far as possible by sticking within our circle of competence.

Which are the sectors in the small cap space that you are bullish on going forward and why so?

We prefer to build the portfolio on a bottom up basis rather than from a top down or from a sector standpoint. This is important as individual small cap companies within the same sector are not homogenous and can exhibit quite different growth and return profiles depending on their positioning and the strategy that they choose to adopt. Thus, while a sector’s outlook can be promising, a particular company within that sector may or may not have bright prospects. Having said that, private capex has lagged for several years and should pick up and government capex should sustain and hence the outlook for the capital goods and construction sector appears positive. Financial companies have faced issues both with asset quality and growth and things should improve as the economy normalises.