Equity diversified funds have had a dream run in 2003 with many of them among the top performing equity funds of 2003

Hundred per cent plus returns were the norm for these funds last year, with fund managers showing an inclination towards mid-cap stocks across sectors.

Templeton India Mutual Fund's Franklin India Prima Fund (177.13 per cent), Tata Mutual Fund's Tata Equity Opportunities Fund (164.23 per cent) and Birla Equity Plan (160.95 per cent) of Birla Sun Life Mutual Fund were the top three performers for the year.

Though a broad-based rally in equity markets helped the managers these funds achieve great results, their performances were also a vindication of their stock preferences.

The Smart Investor spoke to three of the top equity fund managers in 2003 on what made them outperform, their portfolio management styles and outlook for the markets.

While their outlook for the markets in 2004 remains positive, most of them were cautious about the short-term.

More importantly, they warn investors to temper their expectations of astronomical returns in 2004. Excerpts from their interviews:

Sivasubramanian K N; Senior Vice President; Franklin Templeton Investments

Franklin India Prima Fund's objective and philosophy Prima Fund invests in small- and mid-sized companies, seeking aggressive capital appreciation over the long term.

The fund follows an inclusive investing style and given the liquidity/risk considerations of the mid- and small-cap segment, we generally tend to take a smaller exposure over a larger number of companies.

We adopt a proactive approach and aggressively book profits as soon as our target prices are met. Our stock selection approach is essentially a bottom-up one and we will look to invest in companies across sectors, which have good fundamentals and have the potential to turn into tomorrow's bluechips.

Secret of success in 2003

Mid-cap focus: Even as the scheme has been traditionally investing in mid- and small-cap stocks, the market has tended to overlook small/mid-cap stocks as the research on such companies has generally been poor. We have been able to capitalise on this 'under-researched' opportunity through our in-house research.

Bottom-up approach: We adopt a bottom-up approach and sector allocations are a factor of that approach. Given the eclectic nature of our investing style, it is individual stocks rather than sector allocation that play an important role in our portfolio management.

By the end of December, auto and ancillaries, and banks and financial services were the top sectors in the scheme's portfolio. Our portfolio turnover ratio was 103.62 percent as on January 30, 2004.

Market outlook for 2004

Earlier in 2003, Indian equity markets were grossly undervalued on various parameters given the improving fundamentals both on the corporate earnings and economic fronts.

A change in global liquidity, lessening of supply pressure from UTI and increased optimism among retail and foreign investors have led to a sharp rally from the lows hit in April 2003.

Given that the re-rating is over, we expect the market direction to be determined by corporate performance going ahead.

Our view is that while markets are not undervalued anymore, the return on equity of corporate India and the potential for economic growth going ahead should act as positive triggers.

While on a P/E basis, valuations are no longer cheap in comparison with other countries, Indian companies offer one of the highest spreads between cost of equity and ROE, which have increased due to the low interest rate scenario and improved efficiencies for corporate India that have led to better working capital management.

We expect the rally to be broad based going ahead given the various structural improvements that have taken place in corporate India and the economy.

Investors should look to adopt a bottom-up approach and invest in companies with good fundamentals across sectors.

With the economy on the growth path, companies that derive a majority of their revenue through domestic demand should do well and so will companies well positioned to take advantage of the outsourcing trend (like IT, BPO and pharma).

A word of caution: Near-term risks include change in liquidity (impacting FII flows), over optimism, impact of forthcoming national elections on policy-making, protectionist tilts in developed countries and geopolitical tensions.

Given the steep rise in stock prices over the last year or so, investors have to tone down their return expectations to realistic levels and should not get carried away by the recent performance.

Also one needs to be aware that, the recent rally has seen not-so-good stocks also rally on speculative activity and the challenge of research activities would be to identify companies with sustainable long-term growth potential.

One also needs to be aware of the inherent risks with the category which could lead to additional volatility.

Ved Prakash Chaturvedi; Chief Executive Officer, Tata TD AMC

Tata Equity Opportunities Fund's objective and philosophy:

Tata Equity Opportunities Fund has been focusing on bottom-up-driven stock picking. The fund follows our overall investment philosophy and approach.

In the first part, the fund looks at companies from our investment universe and passes them through various filters. These filters include management quality, business competitiveness and market competitiveness.

Only those companies which reach the high watermark in these areas are then tested for valuation and the fund aims to buy companies with a buy/sell price discipline.

Further risk control is maintained through a limitation on exposure in various portfolios. Hence, you will see that normally we do not have exposures to individual stocks beyond 5 per cent of each portfolio size.

Secret of success in 2003

Picking potential value creators: We have worked hard to knock on more doors and turn more stones to identify quality companies which can potentially create value for our investors. Examples of these are in automobiles, auto-ancillaries, pharmaceuticals, oil and gas, etc.

The investment philosophy of the fund is oriented towards buying companies which are fundamentally undervalued. Companies may be undervalued either because they are under-researched or because the current price does not fully discount the potential of future growth.

Our research team tracks a universe of 300 companies on a proactive basis to find ideas which have not been completely researched.

We also research a large number of companies, project their growth potential in the future and look at current valuations. This approach helps us discover fundamentally undervalued companies.

Identifying the right sectors: We were convinced during the early part of the previous year that there is significant undervaluation across a cross-section of the market and our special focus was on some key sectors.

If you look at our portfolio allocation strategy during the year, you can see that we have been bullish on sectors such as auto, auto ancillaries and oil and gas while we were bearish on FMCG.

We have a quality portfolio, with a portfolio turnover ration of 60-70 per cent last year.

We have a 20-25 per cent exposure to the mid-cap sector which includes several companies with attractive valuations and growth potential. It is our view that good quality mid-cap companies will outperform the market.

Market outlook for 2004

The equity markets are a barometer of the performance of the economy as a whole and a cross-section of companies in particular.

At a fundamental level, it does seem that corporate performance will continue and for the moment FIIs seem to be positive on India.

However, global investors will closely watch future trends in the area of economic reforms before putting in significant fresh allocations into India.

Similarly, the next monsoon will also be critical for the agricultural economy. While there will be upsides in some sectors, it is fair to say that all the sectors may not necessarily outperform the market.

The short-term outlook for the Indian equity markets has clearly to be derived from the fact that while fundamentals are positive and corporate performance is good, there has been a significant uptrend in prices and valuations have gone up.

A word of caution: From a short-term investment perspective, great caution should be exercised. However, typically, medium-term (three-five years) investors would create value for themselves if they have the patience to invest systematically.

Given the strong long-term fundamentals of the Indian economy and the consequent growth potential for the corporate sector, longer-term investors clearly stand a better chance of creating value for themselves.

Thus, at this stage of the Indian equity markets, investments in equities should be considered with a longer-term perspective.

Ayaz Motiwala; Fund Manager (Equities), Birla Sun Life AMC

Birla Equity Plan's objective and philosophy:

We have consistently maintained a well-diversified portfolio across a number of stocks in a range of businesses. We have made big gains by being early in some commodity, shipping, automobile and mid-cap pharma stocks.

We also continue to hold onto most of the winning positions and have taken profits primarily based on business prospects and valuations. We have eschewed the temptation to get onto the next big idea while in the bargain end up selling existing names.

We ideally like to buy quality businesses run by ethical and competent people. Our focus is always on the underlying business, its durability and replicability and the price we are paying to purchase those profits.

Secret of success in 2003

Diversification is the key: The fund has consistently been well-diversified across sectors with no individual stock accounting for a very high weightage. We have picked stocks that merit a place in the portfolio and have not taken any single stock or sector bets.

Typically our mid-cap exposure has ranged between 30-50 per cent in the context of investment opportunities available.

However, we are not fixated at a particular market cap. Our approach is to buy businesses on merit at reasonable valuations.

Market outlook for 2004

Expecting returns in 2004 to replicate those achieved in 2003 would be being a bit too ambitious.

The backdrop to high returns in 2003 was a combination of factors like huge undervaluation of corporate profits and local and international developments like declining interest rates, global commodity recovery, domestic economic upturn, etc.

On an ongoing basis we believe investors in Indian equities can expect to make 15-17 per cent nominal returns at current levels of interest rate. However, as one observes from experience, market returns are rarely linear.

Typically, markets behave in extremes, amply demonstrated by the barren period from Mar 2000 till May 2003 and then the 100 per cent plus returns in the last six-eight months.

A word of caution: Investors need to keep these facts in the right perspective on building their return expectation for the next year or over the medium to long term.