Funds with a concentrated focus

By Kavitha Krishnan |  03-12-19 | 
 
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About the Author
Kavitha Krishnan is a Senior Research Analyst on Morningstar's Fund Research team. She has over 9 years of experience in the Financial Sector. She would like to hear from you, but cannot give financial advice.

We recently looked at two Equity Focused Funds and assigned a Bronze to SBI Focused Equity and a Neutral to Sundaram Select Focus.

Sundaram Select Focus oscillated between a diffused and a concentrated approach, and is currently mandated to run as a 30-stock concentrated portfolio with a focus on large-cap stocks. Fund manager Rahul Baijal runs a concentrated approach with a meaningful investment in two or three sectors.

SBI Focused Equity roughly sticks to 30 stocks, with the top 10 accounting for around 50% of assets. The fund follows a benchmark-agnostic absolute return strategy that hinges largely on the execution capabilities of fund manager R. Srinivasan. 

SBI Focused Equity Fund

The fund manager focuses on parameters such as ROE and ROCE to uncover companies that are capable of generating growth on a sustained basis. The approach acquires an edge thanks to a qualitative overlay; R. Srinivasan relies on his research bent to uncover competencies such as technological prowess, cost margins, or a brand equity that gives the company an edge over its peers.

Srinivasan doesn’t mind investing in richly valued stocks for the incremental growth, but he also scouts for value buys. His value buys typically include companies that trade at a significant discount to their intrinsic value. While stocks like Procter and Gamble Hygiene Care and Elgi Equipment typify his value bent, stocks like HDFC Bank remain despite high valuations.

Srinivasan has been increasing his large-cap allocation; this segment currently constitutes around 50% of the fund. That said, he runs the fund with a lower average market cap compared with peers. Despite his ability to quickly exit stocks that don’t meet his criteria, there have been instances where he has held on to a stock that has underperformed over the short term based on his conviction levels.

This benchmark agnostic approach and concentrated portfolio give the fund a unique flavour and lead to this being a differentiated offering. Yet the portfolio is not without risks and could underperform in a momentum-driven market.

In keeping with the fund’s "aggressive" label, R. Srinivasan constructs a portfolio of roughly 30 stocks, with the top 10 accounting for roughly 50% of assets. Though the fund bears little resemblance to its underlying index, a few benchmark stocks like HDFC Bank and Kotak Mahindra Bank have remained long-term holdings.

Conventionally, large caps accounted for roughly 15%-30% of the fund, but this has changed since our last review. The fund currently invests up to 50% of assets in large-cap stocks, and this lowers liquidity risks in the portfolio.

Over the past two years, a large-cap stock like HDFC Bank has been contending with a mid-cap name like Procter and Gamble Hygiene Care for the top position. Another area in the fund’s makeup is its allocation towards small caps, which traditionally accounted for over 55% but currently constitute only about 5% of the portfolio. Over the years, value picks such as Emami and Blue Star coexist with growth stocks like Kotak Mahindra Bank and Avenue Supermarkets; bearing testimony to Srinivasan’s professed investment style.

Sundaram Select Focus

The fund has oscillated between a diffused and a concentrated approach, and is currently mandated to run as a 30-stock concentrated portfolio with a focus on large-cap stocks.

As a result of the recent SEBI categorization, the fund now falls under the focused funds category.

The manager uses the sector-based model portfolios prepared by analysts as its initial reference point when choosing stocks. Analysts combine absolute and relative valuation techniques, using discount cash flow models and quantitative ratios such as return on equity, EV/EBITDA, P/E, and price/book value, among others to make investment recommendations.

They look at the business in terms of sustainability, growth prospects, and company management, and interact with suppliers and customers to get a better understanding of the business. The presence of an economist helps, especially from a top-down macro perspective. Normally, themes are clustered around a few sectors, leading to sector concentration. The manager looks at investing in high-quality companies that have differentiated businesses.

The coverage list is built by taking a long-term view on the business (about three to five years) and looking at the overall sector opportunity, any underlying themes that will play out over the long term, the position of the business within the sector, and the company’s size.

The fund’s bias for large-caps is evident in its portfolio, with large-caps accounting for 80%-90% of the portfolio versus 70% for a typical peer. While the fund earlier held 40-50 stocks, the number of holdings gradually dropped to around 30 in 2018. The fund has historically been run with a concentrated approach and continues to do so since the recent change in the fund’s mandate.

Top-10 stocks constitute about 60% of the portfolio, in line with the fund’s current proposition of running the fund as a 30-stock concentrated portfolio with a focus on large-caps.

The fund uses a combination of top-down sector selection and bottom-up stock selection to generate alpha. Given its concentrated approach, the fund can deviate significantly from the benchmark. Off-benchmark positions are based on the manager’s conviction and expectations of growth.

Rahul Baijal has been constructing the portfolio around three key themes: domestic cyclical recovery, discretionary consumption, and government reforms. We think the portfolio’s construction is robust and has the wherewithal to withstand market downturns across market cycles.

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