What is the real market? The one we saw in March was painful and really cheap or the market which is staring right now which is elevated and a bit stretched? Where would it finally settle?
Both the pace of fall and the pace of recovery have been violent. I think markets are indicating that perhaps the war is not over till the time you find a medical solution to Covid-19 but still the worst is over. What was not right was the March drawdown because at that time there was a lot of anxiety and unknown aspects of pandemic but as things are sort of settling, people are getting a grip on the data points and there is also a view that the welfare cost of lockdown is greater than the benefit. More importantly, the recent spike in infection is accompanied by low fatality rates and from an investment angle, the Covid episode has damaged the cash flow for one or two years.
If you do a DC evaluation of a business, the value does not fall by more than 5-10% but the damage to the price during the violent fall in March a significant 40-50%. The realisation that the price drop for an event which will impair the cash flows for a year-year and a half is much more than the inherent value of the business and price and value have to be breached.
Also we should not see the pandemic in isolation. We will have to see what is happening globally and in India in terms of the response to the pandemic. Worldwide we have seen a massive unleashing of liquidity both by the government and central banks. The real yields are permanently suppressed and to that extent, the market today is about 6%-7% YTD down, which is a reasonable zone. March clearly was unwarranted and to that extent it has nicely come back, taking a more longer term picture of the damage to the cash flows and again retracing that closer to reasonable valuations.
Do you think markets are looking stretched now because of hope and hype?
Entering the pandemic pre-Covid, we were going through a bad phase and it wasn’t that corporate India was doing extremely well. They were coming out of a recession so the PAT to GDP was 2.5% after the tax cut. There was a recovery which was about to happen so the base was in that sense favourable for earnings to improve.
Secondly, let us not dissect too much the earnings for the current year. It is very erratic. If you look at PE multiples, FY22 is talking about 18-19 times for the Nifty and this we think is reasonable for two reasons; one is earnings even in FY22 would be suboptimal to the longer term potential. If the longer term potential is say 4.5% of GDP, we have to be still significantly lower than that. Second, this entire PE multiple should also be seen in the lens of lower interest rates that reduces the equity risk premium.
So I do not think that PE multiples at 18 times FY22 which is also slightly sub normal earnings are expensive in a low interest rate regime.
Lastly the better way to look at value businesses in such a dislocation where one year cash flows and earnings are very erratic is to look at Nifty price to book which is around 2.4-2.5 times next year and is closer to five year mean. It is not that markets are exorbitantly expensive. I would say it is reasonable and some pockets are cheap or some would probably be closer to the pre-Covid level and may be slightly on the higher side.
The grey area in the market right now is financials. In your declared portfolio, you have a very large exposure to financials — about 25-26% weightage which is almost in line with what the benchmark. What convinces you to have such an exposure to financials which is very large in nature?
You are absolutely right that financials have been laggards in an otherwise strong market. They are still down 20-25% YTD and we clearly see value in this bucket because long term some of them are winners particularly the stronger franchises and near term destruction is only impairing the cash flows. The anxiety on loan loss provision is only for a year or so and that is one.
There are multiple factors why we are positive on financials. First is these are very strong franchises and will get much more consolidated. like in many businesses and pandemic also came along with certain events like what happened to Yes Bank or PMC. So to that extent, there is a bit of consolidation on the liability side. There will be a few strong franchises which would come on the other side of the virus and that is one.
Second is that the moot point is not the credit growth because that would recover over time as that is a function of the GDP growth. It is more to do with the asset quality. We entered the crisis when the corporate book was looking bad and there is not much of a problem on that side. It is perhaps to do with retail and the business loan where we have to observe how the delinquency pans out.
It is too early to say because the moratorium is over and the restructuring guidelines have come in and these are much more pragmatic and our view is that overall stress and loss given default would not be significant. The ballpark for a well managed franchise will be a maximum one year of the provisioning operating profit. Many of these banks have very strong balance sheets, high capital base and low cost liability franchise. They have sufficient capital raise and provisioning buffer. All in all, it is a classic case where near term is impaired and by near term I mean one year and longer term is intact. The valuation is in our favour and that is the reason we remain positive and overweight on retail oriented banks.
Are markets telling you that the focus is on global recovery which is going to be better than the domestic recovery?
There is no secret sauce but it has a lot to do with the processes and I would like to emphasise that the approach is more team and process driven and performance is more an outcome of the rigors of research and the process associated with true aspects.
One is on stock selection and the is on portfolio construction. On stock selection, the important part is to buy good quality franchises up to a reasonable valuation. The idea is to avoid two extremes. One is anything which is sub-optimal franchise or lower ROI business, lower growth business, suboptimal management should be avoided.
The other extreme is where everything is good and valuation is not in favour and we try to avoid that too. I case of longer term opportunities, you buy in a disciplined manner.
And the second aspect in terms of where the drawdown of the portfolio is, in bad times that is not significant on the portfolio construction side. It is very important that the portfolio should avoid big mistakes in construction. We believe that no sector, stock, style or theme should have a disproportionate divergence to benchmark. If I were to give an analogy from boxing, it is said that it is not how hard you can hit the opponent, it is more to do with how hard you can get hit and constantly keep moving forward.
The point is mistakes are integral part of stock selection. Important aspect is to construct a diversified portfolio which can handle mistakes and yet deliver decent risk adjusted return. These are some of the qualitative aspects of the investment approach which we have followed across the mandates and the past returns have been fairly satisfactory.
On one side of the market there are PSU banks, metals and also a stock like ITC. All available at throwaway prices. On the other end, there are IndiaMART, Jubilant Foodworks, DMart stocks — trading at PE multiples of 100 plus. Why do you think we have two extremes in the market?
Yes, we are grappling with this sort of divergence but it has been blurred. Healthcare has been re-rated. One other sector which was not doing well was the small and midcap and that has got significantly re-rated. If you see the divergence, if you look at BSE 500 companies, YTD almost 225 companies have given positive returns of which 128 companies have given more than 20% return. So it is not that polarised. But certain sectors are at deep end in value. They were deep in value even at pre-Covid times.
We see it as an opportunity but the important thing is the business should have longevity and secondly when looking at a value stock, it should not be pure value without a basic growth and a trigger to that. So triggers are very important in unlocking value.
For example, you mentioned some PSUs like oil marketing companies. In the next six months or a year, a very big trigger could happen which is a strategic sale of one of the entities. If that is the event, then definitely it would re-rate and it will have an impact on re-rating in general of many PSUs, So the value debate continues. Within value one has to filter that businesses should have double digit growth and there should be some trigger for the businesses to turnaround in terms of cash flows. We see this polarised sort of market more as an opportunity than debating why it is so polarised.
Stock market is the only place where some would argue that gold is available at the price of silver in a bad market and similarly, gold trades at the price of diamond in a very overbought market Right now, is silver available or is diamond available?
I would say the relatively Covid proof sectors like IT, healthcare are in the reasonable zone. They are not dirt cheap but they are not expensive either and so they would compound in sync with the earnings growth. It is not that 20 time PE multiple for the IT sector is very high given the fact that what would happen as some of the events related to the adoption of digital by the enterprises accelerate. The things are actually quite positive for the next three, four years.
But that does not mean that you have to buy it. If you already own the IT sector for quite some time, it is a good hold zone where it would compound in sync with the earnings growth. So PE expansion may not take place in both the sectors, but we are seeing a revival in earnings for the next three, four years and that should be the expectations of earnings in both the sectors. There are specific cases which can always be a sell case and there could be some attractive buys also.
You are managing $6 billion. What should investors expect in terms of returns now because frankly finding good companies in India is always a challenge?
I have to correct. $6 billion is spread across nine products and each has a different mandate; the largest product is about $2.5 billion largecap fund which is managed by my colleague and so there the challenge of liquidity size is much less because we are probably half of what the largest fund in the country is and otherwise also, the top 100 companies are very liquid.
So we do not think that at an aggregate level, size will be a challenge. Of course other things remaining the same, if it were a small cap fund or if it was a more midcap oriented fund and if the size is large, then it can become a challenge. In our case because it is spread across nine products and all the products have flexibility to invest in larger companies. For the next 250 companies, I do not think size is a bigger challenge. If it were to be challenged in any of the products, we would take proactive action in terms of soft closing the product which we have done in one of the products about three years back.
Where do you think the economy is headed in terms of large cap concentration because each sector has a few leaders? If there are few leaders in each sector then what will happen to mid and small cap stocks?
YTD if you look at the rally, it is not skewed towards a few stocks. Almost 60% of the market is about 200 day DMA and as I said almost half of the BSE 500 stocks have given positive returns. So it is not a skewed few stocks’ rally. A lot of companies in the midsize businesses — agrochemicals, chemicals and pharma companies have generated good returns.
That said, it is not to do with size but it has to do with some qualitative aspect of how the business is positioned. Earlier there were events like demonetisation, GST and now a pandemic which is such a large dislocation, once in a century event, it is not only the quantitative strength of the balance sheet, it is the softer aspects of the management which comes to the forefront.
The thought leadership of the management should have the ability to steer the challenges and probably use this as an opportunity to grow organically etc. So there will be consolidation across businesses but that will have more to do with the qualitative aspects of the company’s management rather than only size.
The consolidation will also happen because some of the weaker names will not be able to sort of survive. That consolidation would happen but it will also happen in midsize businesses. Many are mid-sized businesses in agrochemicals, chemicals, footwear and many of the names are in manufacturing also. So there also consolidation will happen but that will have more to do with inherent strength of the business and that is the reason it is very important for investors to avoid the weaker ones and stay put in the stronger names which will come out winners on the other side of the virus.
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