'What happens to index has no bearing on stocks'

SMART TALK: Ajit Dayal

. Edited excerpts:

What is your outlook on the equity market?

If you talk about the index, we believe that it is over-valued. The reason is that some of the heavy weight stocks like ICICI Bank, Reliance Industries, L&T, ITC, TCS and Infosys have done extremely well and seem expensive.

However, beyond the index there are hundreds of stocks that look like an attractive buy. Our preference has always been towards buying value stocks irrespective of the index.

For example, consider Zee which was removed from the index about a year ago. The stock has more than doubled ever since. So what happens to the index has no bearing on the stocks.

Can you share with us some of your investment strategies?

We seek value, which means higher earning power at a lower price-earning ratio. One can also define value in several other terms such as price-cash flow, price-book and dividend yield compared to its peer group. So, let us say, when we look at the banking sector, we will first look at the history, the management, how they are going to generate business and try to understand the business model of the bank.

Then we will apply the valuation criteria, for example we like to buy PSU banks when they trade at about 1-time P/BV. And when the P/BV goes close to 2-times we tend to step away from the stock because we think that at higher P/BV the risk of going wrong is more than the return. This is also called as the bottom-up approach.

Besides, there are certain valuation methods which are applied to particular industries and stocks. Let us take the example of the cement sector. While analysing a cement company we will use the enterprise value per tonne. In India, it costs about $90-95 per tonne to create a new cement plant. So if a cement stock is valued at an enterprise value (EV) of $150-180 per tonne, it would seem expensive to us.

The logic is simple. In the hope of getting a premium valuation of $180 per tonne, there would be enough reason to create new facilities as the cost of building a plant is much lesser. But if every one does this, then valuations will come down due to increased supply. In turn, it will also bring down the cement prices and profits of companies.

How do you evaluate companies which are in the growth phase and investing in new capacities?

Ideally, profits can either be paid out as dividend to the shareholders or can be invested into expansion in the hope of higher growth. But expansion can sometimes be damaging.

For example, between 1988-98, L&T kept on increasing its cement capacities which hurt its return on investment (ROI). Although it has got its pay-off now, it would not have made sense to be a L&T shareholder in those days.

Here again, we do not own any cement stocks largely because the new capacity coming on stream in the next twelve months may depress prices. And to that extent, companies are not getting the rate of return that they deserve given the risk taken to build the additional capacity.

How will you compare a company with high growth and minimal expansion with one that promises growth but also a high capex?

Its a question of valuation. You need to pay a different multiple for buying a business that is steady. This is why companies in the commodity arena such as steel, cement and sugar, which move through the different cycles and show high price volatility, command a lower multiple.

We have a combination of different kinds of stocks in our portfolio "� some which are steady in nature, while others are expanding big time. Tata Steel bought Corus; that is a huge jump; but does not scare us. At a certain price we would like to buy it. To give you another example when the Jet Airways issue came out in January 2005 it touched about Rs 1200 per share. Despite the fact that we liked the business, we did not buy it considering the high price.

But when it fell below Rs 600 in May 2006 we started buying Jet. We tried to find out the risk and return. We looked at the valuations, traffic growth, competition and also looked at all the risk associated with it. A lot of negatives were factored into the stock but we asked ourselves as to how bad it could get. Could it go to zero? Not likely. Could it go to hundred? Not likely again. From Rs 600, it could possibly go down to Rs 450 or Rs400. On the higher side, it could go up from Rs 600 to Rs 1200 in three to five years time. Ultimately, investment is a combination of common sense, discipline and patience.

How do you view equities in the backdrop of a rising interest rates?

Studies around the world have shown that equities over a long period of time will give you a greater rate of return than government bonds or any kind of fixed income instrument. In 1994, the BSE 30 index was 450 points, now it is 14000. It is a return of 23 per cent compounded annually.

In India we believe that a return of 15-20 per cent per annum can be expected from the markets over the next 5-10 years. If the GDP is growing at 8 per cent per annum and inflation is 6 per cent, the nominal rate of growth in corporate earnings should be 14 per cent.

Considering this how do you look at the property price situation in India?'

We believe property prices will collapse by 30-40 per cent depending on the location of the property. The reason for this - property prices have gone up and interest rates, too, have increased. Although disposable income has also increased, the cost of housing has effectively gone up six times.

The affordability level in our opinion has crossed the highest level witnessed in 1994-95. Affordability Index is the number of years of income you need to own a property. According to HDFC data, in 1994-95, the affordability index was close to ten years, which meant you required ten years of income to buy a 1000 square feet property at that time.

But the market collapsed dramatically from there. However, the boom since 2003 has pushed prices beyond 1994-95 levels. That, to us, stretches the limit of who all can afford it. Ideally, we would like it to come down to five years of income, so either the income has to double or the prices must come down to half.