The Hindu Business Line : We're still optimistic on mid-caps' prospects

In a close-ended product you are not subject to constant subscription/redemption pressure and are able to take a more long-term view. — CHIRAG SETALVAD, SENIOR FUND MANAGER, HDFC MUTUAL FUND

Traditionally quite an active investor in mid-cap stocks, HDFC Mutual Fund recently rolled out a new closed-end fund — the Midcap Opportunities Fund, that will focus mainly on mid-cap stocks. Chirag Setalvad, Senior Fund Manager at HDFC Mutual Fund, takes a few questions on this new fund.

The valuation gap between mid-cap and large-cap stocks has narrowed in recent months. Does this leave room for price appreciation in the former?

Yes, despite the fact that mid-caps have recovered a bit in the last few months, we are still optimistic of their future prospects. Our approach is very stock-specific and we still find a large number of mid-cap companies that are available at reasonable prices when evaluated in the context of their business prospects, growth opportunities and management quality.

It is generally believed that the earnings performance of mid-sized and small-sized companies will lag large-sized ones in a rising interest rate environment. Given that the lag effect of the interest rate increases of the past six months may yet be felt on earnings, what is your view on the outlook for mid-sized companies?

In our view, sensitivity to interest costs is a function of the extent of leverage and the debt servicing ability. This, in turn, is a function of the nature of the business (capital intensity, etc.), growth plans (both organic and inorganic) and management's risk appetite. Many of these factors are not dependent on market capitalisation. Thus, a large company operating in a more capital-intensive business is more at risk than a mid-cap company which is in a less capex-heavy business. Even for companies in the same industry, it depends on a company's future plans and risk appetite. Finally, you have to keep in mind that most companies have significantly reduced leverage in the last few years while at the same time cash flows have improved materially.

In recent weeks, we have seen some very sharp single-day moves in mid and small-cap stocks, with prices often moving 10-15 per cent on a single event/development or earnings report. Doesn't this kind of volatility make timing a very important factor in selecting mid-cap stocks?

Volatility is particularly difficult to manage in an open-ended structure. In a close-ended product such as the HDFC Mid-cap Opportunities Fund, you are not subject to constant subscription/redemption pressure and are therefore able to take a more measured and long-term view. In an open-ended product, when the market rises and inflows swell, you are under pressure to invest in a more expensive environment. At the same time, when the market falls and redemptions follow, you are forced to liquidate at cheaper prices. A close-ended product gives you much greater control.

Though the universe of mid-sized and small companies has expanded considerably, the market in such stocks continues to lack depth. How does your fund intend to manage impact costs? Will you select fundamentally good stocks and hope for liquidity to build up subsequently, or will your portfolio choices first be put through liquidity filters?

Of course you need to consider liquidity when managing a portfolio. However, it is less of a constraint in a close-ended fund. You are able to build a portfolio on a more stock-specific basis and don't need to consciously build in liquidity to the same extent.The level of liquidity is often a function of the extent of awareness on a particular stock. If you identify a high quality neglected stock it is only a matter of time before it gets more attention, leading to greater liquidity. But, you do need to be patient. Naturally, this is subject to a company's overall market cap and shareholding structure.

(The NFO closes on June 8. Investors are requested to compare this offer with existing funds of a similar genre before investing).