Current valuations don't reflect underlying economic reality: Ambit Capital

Interview with Saurabh Mukherjea, chief executive officer, and Prashant Mittal, strategist, at Ambit Capital

It was a roller-coaster week for the markets, amid talk of a fiscal stimulus by the government. Saurabh Mukherjea, chief executive officer, and Prashant Mittal, strategist, at Ambit Capital tell Puneet Wadhwa the recent flows into equity mutual funds are largely speculative in nature and pose a risk of reversal. Edited excerpts:
 
Your recent report expects economic slowdown to worsen. Will you change your view after the government’s stimulus measures?

Mukherjea: In the first quarter of 2017-18, government spending grew 30 per cent. So, the government has — correctly, in our view — already tried to stimulate the economy. Despite that, gross domestic product (GDP) growth in the quarter was well below expectation. It is hard to see the government being able to maintain this blistering pace of spending growth. Hence, as government spending growth moderates, we reckon the economic slowdown will be accentuated.

 

How will the markets take to a higher fiscal deficit for propping up growth?

Mittal: We saw the rupee depreciating and equity markets crack a bit in the past week, in the wake of growing expectation of higher fiscal slippage. However, it would be a bit premature to say this is the start of a deeper correction, given that domestic liquidity has remained strong even through the past few days of correction. However, if foreign institutional investors (FIIs) continue to sell meaningfully, like they’ve done since August, domestic inflows led by retail investors could start drying, too. The Indian retail investor has usually followed, rather than led, FII action.

 
Do you see a reversal or slowing of domestic flows?

Mukherjea: What’s interesting is the make-up of flows into equity mutual funds. These have come to be dominated more and more by lumpsum investments, rather than by systematic investment plans, over the past 15 months. We think these flows are largely speculative and are chasing spectacular returns generated by equity markets over the past year. They pose a big risk of reversal in case equity returns were to taper.
 
How concerned are you about market valuation at this stage?

Mittal: Very concerned. Our analysis of the top 500 companies by market capitalisation suggests the Indian markets currently trade at price multiples close to (or even higher in some cases) the ones seen in 2006-07, sans the corresponding earnings growth. With the consensus sharply pegging down earnings growth expectation, year after year, current valuations do not reflect underlying economic reality. The divergence seems likely to get resolved through a deep correction over the current financial year.

 
Your expectations from the coming results season?

Mukherjea: We believe goods and services tax (GST) adoption-led volatility at a time when the economy remains weak (weak corporate capex, black money crackdown and lack of job creation) should continue to throw plenty of negative surprises in the coming earnings season as well. We expect GST adoption to lead to significant consolidation in the wholesale channel as non-tax-compliant wholesalers shut shop.

Further, while we see revenues recovering to mid to high single digit growth, margins are likely to remain under pressure as fast moving consumer goods (FMCG) companies give higher margin to support wholesalers and defer price hikes to avoid the anti-profiteering clause.

 
Sector preferences at these levels?

Mukherjea: We remain concerned about the housing finance space, where valuations appear surreal. HFCs show some early signs of stress, where gross NPAs (non-performing assets) and credit costs have surged for many of them in recent quarters. Also, recent events suggest homebuyers in the NCR (National Capital Region) are considering stopping EMIs (monthly instalment payments) for delayed projects. We believe in the overall system, gross NPAs in home loans could increase by 70-170 basis points (bps) if 30-70 per cent of the borrowers default. We are selective buyers in information technology and pharmaceutical stocks, which have seen prices plummeting over the past year.

 
Your reading of the bond markets and interest rate trajectory? What’s your advice to an investor in the debt segment, given the road ahead for the rupee and interest rates?

Mittal: We expect a 25-50 bps cut in rates by end-FY18. However, our concerns for the bond market emanate from the risk of NPA infection spreading to it. As credit quality continues to deteriorate in the economy, a default event can lead to a major correction in the bond market. There is a risk that such a correction could drive the cost of capital up, further slowing capex and cutting off a source of financing (from non-bank finance companies) for the beleaguered SME sector.