Opportunity lies in largecap and midcaps: Chirag Setalvad, HDFC MF

In a chat with ET Now, Chirag Setalvad, Senior Fund Manager-Equity, HDFC MF, says it is prudent to be oriented more towards largecaps, that does not mean that the long term prospects for midcaps is not good. Edited excerpts

ET Now: Where do you see opportunity in this market?

Chirag Setalvad: Today, we are seeing greater opportunities in largecaps and midcaps. In the last year or so, a lot of money has come into the midcap category. There's a great deal of interest from HNIs which has held up the midcap part of the market and we have not seen any outflows. So far, dips in the market have been associated with inflows. Midcaps used to trade on an average at 15 per cent discount ton largecaps. Today, they trade at 10 per cent premium to largecaps. Keeping that in mind, it is prudent to be oriented towards largecaps which does not mean that the long term prospects for midcaps is not good. So there we remain very positive. It is more when we are talking about from near term say 1 to 1.5-year standpoint.
ET Now: Let us talk about one of your flagship schemes which you manage -- the HDFC midcap fund. If I scan through the top holding or the key holdings of that fund, you have taken a disproportionate bet in the NBFC space. Pharma space is suffering but you got a decent exposure there. A little bit of exposure is also there in banks. So let us first start with NBFCs. The call has worked for you. But what is the way forward for NBFCs and why do you still like it?

Chirag Setalvad: We are a little bit more apprehensive on NBFCs today. When we bought into these companies, they had very good ROEs which was not reflecting in their valuations and they were growing well with good management. Today, that situation has changed a bit because they have delivered in the last couple of years and they have got a lot of investor interest in the last couple of years. As a result, valuations have moved up from what used to be 1.5-1.8 times book value to now 2.5-3 depending on which company you take. So today, the case for owning NBFCs is becoming a lot more challenging because NBFCs now trade at valuations at par with large private sector banks; both have similar ROEs, which mean over a period of time they will grow at broadly similar paces. So, do you own a largecap private sector bank which is growing at 25 per cent where there is significant liquidity or do you own an NBFC which is also high quality, you will receive similar ROEs which mean, similar long-term growth but liquidity will remain different. So I think between NBFCs and private sector banks, the latter are in favour.

ET Now: Pharmaceuticals are your top holdings and we are not getting into a stock specific conversation but Aurobindo Pharma has worked like a charm for you. Torrent Power is right up there. Pharma space is in complete disarray - a) pricing power is going, b) US FDA clampdown is making sure that these companies have to reboot themselves. What are your thoughts on pharma?

Chirag Setalvad: Unfortunately, we categorise pharma into one block. However, companies have very different profiles. First, we have to keep in mind that different companies have different exposures to geographies including the Indian geographies. So not all companies are equally exposed to India or the US or developing markets. Hence it is easy to paint companies with the same brush but actually their profiles are quite different. Even their manufacturing capabilities, their focus on quality is different. So the good news is that people look at pharma. They see the same concerns and therefore they evaluate companies in a similar fashion. But if you dig deeper, then you realise that different companies have different profiles, different sort of risk, matrix and as a result if you are stock specific, there is an opportunity to pick reasonable ideas. So I think it is not only true for the pharma industry but for IT and industrials as well. They key is in midcaps but possibly otherwise as well. You have to be stock specific because companies have very different profiles in the same sector.
ET Now: So where are you confident of better growth and better days?

Chirag Setalvad: In general, we are quite positive that the economy will turn around. There has been this expectation for almost a year-and-a-half and it has not panned out. But as you see on the ground, indicators have certainly turned positive whether it is in car or cement sales. The economic prospects are beginning to improve. So over a couple of years, two parts of the market will stand out to do better, sectors which are economically sensitive, including banks, industrial products and construction. These segments should do well. I think the other segment which should do well is where valuations are bombed out. Now again that is true for banks and commodities where you see a lot of value on the table, however, this is not so true for industrials.

Hence where you see companies benefitting from the economic recovery or valuations are sensible, these are the two broad areas which look interesting but again having said that the key is to be specifically focus on companies and look at the individual profiles because within banks, there are companies that obviously we would like and not like in a cheap sector. Similarly in expensive sector, there will be plenty of things that we like and do not like. So it is important at the expense of reputation to look at individual companies.

ET Now: But in general, earnings recovery has disappointed even though the macro has been near perfect. We have got rate cuts. Crude prices have come down. The benefits of a decline in commodity prices is visible now. But earnings generally have been slightly slow. Barring two or three pockets, the pickup is not there. So why do you think markets have gone so wrong in assessing the earnings recovery?

Chirag Setalvad: As you said the environment is very fertile. All the ingredients are in place. The problem is that this is not like baking a cake. It is not that you put in ingredients, put it in the oven and you know exactly when to take it out.
ET Now: Do you bake a cake or you do not like to bake a cake?

Chirag Setalvad: No I do not. So I think all the ingredients are in place and the interesting thing about markets is that it is not clear when and how long it will take for the cake to get ready.

ET Now: So for anyone who is waiting on the table, how much more should they wait for the cake?

Chirag Setalvad: In my mind, people that are investing in equity market should have a minimum of three to five years investment horizon. Anything shorter than that is not suited for equities. So that kind of horizon is reasonable and from here on, three to five years later, I suspect investors will do quite well.

ET Now: At a time when interest rates are coming down and since equity return at the end of the day is a premium to the average rate of return, they are premium to the underlying interest rate. So if interest rates are coming down, do you think the equity returns in future will also come down?

Chirag Setalvad: When you look at it from an extended time horizon, a 10-year perspective, those rates of return tend to be quite stable. So longer term investors tend to make approximately 15-17 per cent returns. But in 2-3 years, obviously in one-year bucket, returns are very volatile. We have seen the market giving a 300 per cent return and a minus 60 per cent return since its inception. While one-year returns are obviously very volatile. But the next couple of years should do reasonably well because earnings should pick up. Now will it pick up in the second quarter, the third quarter or the fourth quarter is difficult to say. It is difficult to time it that but the environment is positive. Earnings growth should pick up to bring the averages back to a more reasonable level. Last few years have been at single digits. In the next couple of years barring the next six months, growth will come back reasonably strong and their capacity utilisation is also tightening. So the advantage and disadvantage within India is in building capacity.