BS Fund Cafe: Earnings should recover over the next 2 yrs, says MF manager

Hope people are able to realise that equity is not a risk-free asset: ICICI Pru MF ED & CIO S Naren

Five of India’s best money managers say macroeconomic parameters are shaping up well and expect metals, corporate banks and domestic sectors such as cement, capital goods and consumption to lead the next leg of the rally.

What is your view on the equity markets after the recent correction?

S Naren: Historically, August has been volatile. Our view is that valuations are not cheap, particularly on price-to-earnings metric and on other metrics they are just about fair value. The earnings cycle is yet to play out and it will do so over the next two years. While there have been reasons, such as GST among others, which are hurting the near term, the medium-term outlook on earnings is pretty good and that should be a positive. The real challenge has been continuous flows and the fact that individual investor participation is high. I hope people are able to realise that equity is not a risk-free asset.

Prashant Jain: We are quite optimistic and the economy is shaping up quite well. All the macroeconomic parameters, be it the current account deficit, fiscal deficit, interest rates or inflation, among others. People are saying earnings have not recovered because what has happened is that sectors which were doing very well earlier have seen a collapse in earnings or downgrades (pharma, software and to an extent consumer) but sectors which were in pain earlier like banks and metals have actually seen significant earnings upgrades. While aggregates are always important, it is better to look at what makes the aggregate. These metal companies would not be at these prices, which are three to five times from the lows.

How do you see the impact of goods and services tax (GST) on industry?

Sunil Singhania: The early response is mixed — the larger B2C companies are seeing a revival, while the B2B segment is seeing some challenges. Wherever GST has been implemented (globally) it has always been a case of three-six months of challenges. But the benefits are substantial. It completes the chain from the basic raw material to the finished goods, and brings in a lot of efficiency.

What is your view on the economy?

Vetri Subramaniam: If you look at the macro data then this is certainly the most stable macro environment that India has enjoyed in a fairly long period of time not just relative to our own past but in an absolute sense as well. When you have an economy where there is an underlying level of growth which is reasonably high and you combine that with entrepreneurs and access to capital you will get many sectors and more importantly many companies which will go on to create a lot of wealth for shareholders over a period of time.

How much importance do you give to stock picking? 

Subramaniam: That’s a be-all and end-all of what we do and certainly there is always a mix of top down and bottom up approaches we have but eventually if you don’t have your stock picking right, by that I mean not just buying the right kind of company but also avoiding the wrong kind of companies. Both eventually contribute to alpha (excess return over benchmark).

Are opportunities to generate alpha becoming fewer? Is the industry taking more risks? 

Mahesh Patil: In the near term, alpha opportunities have reduced. The alpha generation by diversified funds in the last three years is significantly higher than the long-term average, which has moderated in last year. Going forward, well-managed funds should be able to deliver an alpha of over 300-400 basis points over benchmark for at least large-cap and multi-cap funds. Identifying new and emerging businesses early also improves performance. Mid-cap funds may generate higher alpha because of the bottom-up opportunity.  

Is there a shortage of opportunities today at current valuations?

Patil: Shortage of opportunities came about because there was a period of time when there was no requirement for capex or requirement to raise money. In the next six months with a fair amount of new companies coming up and there are going to be interesting sectors which will be listed like general insurance, so I believe that opportunity problem was more in the past. 

With large fund sizes, higher valuations and strong flows from retail, has the pressure increased?

Jain: I don’t share that view. It is wrong to talk about numerator without looking at the denominator and that is what everyone seems to be doing. People say inflows are large. Yes, but what is the denominator? It’s a $2-trillion market. And we are collecting less than one per cent of the market cap annually, which is not large. To deploy one per cent of capital in a market which is 100 times bigger, where is the challenge?

Does a large fund size prevent you from, say, executing exits?

Jain: There are no funds in the country that are so large that size becomes  a constraint. For the last three years, the biggest funds have turned in a good performance and we are not yet in a place where funds become very large relative to the market.

Do you face such challenges in mid-cap funds in case you want to exit?

Singhania: I will not say the challenge is in execution, but it is in valuation. In a number of cases there is little room for valuations to catch up right now. The challenge is to be a little bit more cautious in valuation rather than execution. 

What would you be betting on right now, large-caps or mid-caps?

Subramaniam: Looking at the valuations at this point there is far greater comfort in large-caps than in mid-caps and there are various theories being bandied about that mid-cap companies have more domestic businesses, while larger companies have significant global linkages or global operations but when you actually drill down on the data you will find that the same is true for mid-caps too.

Patil: In an environment where interest rates are coming down and domestic growth will pick up, mid-cap earnings will be better than larger companies so probably mid-caps will perform in the longer run but the risk reward at this point and looking at the valuations and also looking at the volatility, mid-caps are probably more vulnerable.

Earnings recovery has not happened for three years. Your views? 

Patil: Earnings over the last three years have ended flattish as far as growth is concerned. While it should start to reverse in some time, when it will happen is a question mark but a lot of ingredients are falling in place at this point of time. Factors that derailed earnings include slowdown in the consumption side because of bad monsoons. There is a revival of consumer sentiment at least from the rural side. Lower interest costs for corporate India should help drive earnings, and, again a lot of corporates have started deleveraging now. There is good possibility that earnings should rebound from the second half of this year. With macro picture in place, it is consumption which will drive the growth and as capacity utilisation starts to improve you will see capex recovery happen with a lag, let’s say a year or two later.

Jain: Two years back the challenging sectors were metals, capital goods and corporate banks. Because of low metal prices and high non-performing assets and bad loans, these sectors saw massive de-growth in profits and that was the main reason why aggregate earnings did not grow. Now the reasons are different with pharma witnessing sharp downgrades and the sectors which were in trouble earlier such as metals, corporate banks and capital goods seeing significant to moderate earnings upgrades. The market is aware of earnings, otherwise pharma companies would not be down 60-70 per cent, so I think this market has sound fundamentals.

Naren: Earnings is like a cycle, it will improve in the next two years and so we really don’t worry about earnings. Investors will have to be cautious after earnings recovery and not today when it hasn’t happened. Jeremy Grantham of GMO says that a bubble is created actually out of excellent fundamentals irrationally extrapolated. 

What are the risks, global or local?

Singhania: The risks are always there because any asset whether fixed income or government security and more so equity will have some risks. Geopolitical risks whether it has to do between India and China or US-North Korea you cannot time and if you wait for all these events to be behind you then maybe you will be investing when Sensex is at 60,000 rather than today. The fundamental risk is that recovery has to happen because otherwise investors will lose patience and prices will fall, which is what has happened in pharma and to some extent in software. The next leg of earnings growth will come more from metals, corporate banks and domestic sectors whether it be cement or capital goods.

Vetri, what risks do you perceive?

Subramaniam: The thing about risks is that the risks which do the most damage are those which you didn’t even know existed. So by definition it is very hard to figure out what they are but ones that we think we already know about or talk about are already reflected in prices and valuation. Equity by definition is a volatile asset class, so don’t get too carried away by what you have experienced.

We have seen investors coming in bull markets and getting disappointed. What is the plan to retain them? 

Patil: You would see volatility, there could be corrections, and it’s important for investors to build the asset class over a period of time. The good thing is a lot of investors have realised this looking at past experiences and are coming into the market in a much more systematic manner, not trying to time it. That’s getting reflected in terms of total systematic investment plan (SIP) book which is seeing inflows of Rs 5,000 crore on a monthly basis and growing. Obviously, when the markets are looking a bit exuberant, multiples are higher and it is important to rebalance portfolios and take some gains.

Has investment behaviour changed over the years?

Jain: Education about equities has improved dramatically. Someone mentioned to a colleague of mine, look I don’t want to buy a mutual fund, I just want to buy a SIP, so it shows that SIPs have become a universally accepted way of investing and they have gone beyond mutual funds and are associating equity with long term which is good. 

How do you manage investor expectations of high returns? 

Singhania: The credit has to go to the investor; they have matured in the last 15-20 years, I think the basic acceptance of SIP is a sign of that. The other thing is return expectation has also moderated so when we tell investors that a 15 per cent return is good, they agree. History has also been supportive of the fact that even if you enter at a wrong time, if you stay invested for a reasonable period of time, you have ended up getting the best returns across asset classes.

What is your view on corporate governance standards of India Inc and have mutual funds become active shareholders with an opinion?

Subramaniam: Corporate governance has come a long way since what it was 25 years ago. The mutual fund industry now participates quite actively in the voting process, which is healthy. Today, we interact with companies a lot more on resolutions that are coming up for voting than we ever did 10-15 years ago.

Naren: It is an ongoing process and as Vetri pointed out I have seen continuous improvement. We may not be where we need to be, but the process is on and every year there is improvement over the previous year.

Jain: The fund industry is now a more active participant in all the resolutions, and the information is also available on websites as to what each one of us is doing. Things have improved significantly, the transparency levels, access to information, even media is extremely alert these days so I think we are moving in the right direction.

As fund managers, how are you addressing the disruption that is going on, be it the impact of smartphones, automation, data analytics or artificial intelligence? 

Naren: I have never seen so much disruption happen across so many sectors and the way data growth is happening, a lot of disruption is going to happen. I find that pretty interesting; we have to soon relook at the way we consider stocks and sectors. We have to see ourselves in the shoes of customers and see the changing trends so I think what Peter Lynch wrote on how reality finally shows up in equity will actually happen across sectors. 

Would you invest in Google, Apple or Facebook?

Jain: At some stage it certainly is possible, the laws allow it, and the way we look at things is we must invest where we understand things really well. While each one of us may have a view on some of these companies, so would thousands of others; managers have views on these companies and so I don’t think we have any specific edge when it comes to investing in one of these companies. So our primary focus continues to be to outperform the market and the benchmarks in India and that is where bulk of our efforts are going.

What sectors do you like?

Singhania: We will be more focused on domestic economy oriented sectors be it engineering or cement; all the companies in sectors that the government has been focusing on. We are also positive on metals because of the huge swing a slight increase in prices can bring to operating as well as financial leverage. Finally the consumption theme because disposable income levels are growing, there is definitely a propensity to spend more on better products.

What do you think of banks?

Patil: Despite the challenges in the economy and poor credit growth if you look at the pockets within the banking sector I think there are lot of opportunities. We have the private banks which have been taking market share. In much of the non-banking financial services (NBFC) sector, we have seen a lot of differentiation, NBFCs are able to tap into some segments because of their on the ground presence and are able to even grow the market. So that’s an area where we see good longer term growth.

What about public sector banking stocks? 

Jain: I don’t think we worry about market shares in a fragmented industry like banking which is about low cost  of deposits, it’s about sensible underwriting and it’s about low reasonable cost of operations. And public banks like many private sector banks have very good deposit base and their cost to deposit is very competitive and it’s a very sustainable competitive advantage. I am quite optimistic on not just public but also private sector banks that are in corporate banking. Let us start talking about corporate banks and retail banks and not just about public sector or private sector.

What about software and pharma, which are going through a rough patch?

Naren: As a country prospers, health care as a percentage of GDP keeps going up. And that’s been the trend observed in the entire Western world. So if you look at it from that trend given the fact that the sector has done very badly over the last two years, we clearly see a scope for the sector to do well in the long run after the near-term problems which have already been well-reported. In software, the debate is the kind of growth and profitability you will have. One of the reasons both sectors have done badly is they got used to some amount of rupee depreciation while the rupee appreciated. If you are going to see the rupee appreciate further, I doubt whether the sector can perform. Our call is that there will be some rupee depreciation over the next few years.

Patil: Software looks a good defensive bet because the downside is limited. Growth would be a challenge but there is no variability in that growth, it is around whatever 7-9 per cent or in that range.

What is your outlook on interest rates and what will be your strategy to earn returns? And will it be duration, will it be accrual?

Naren: Our view is that the interest rates cycle has played out well. You can still have maybe a rate cut or so but the primary cycle has played out. Having said that you know at this point of time, a lot of people think that equity is a risk-free asset. So what we actually keep telling people is you have to invest in products which have both equity and debt, debt not for the big returns but for the much lower level of risk you will get. In the last three years we had one of the most exceptional period of returns in gilt funds, we don’t think that kind of return is possible in the future. But debt funds have a big role to play from an asset allocation perspective. 

And in that case what about expense ratios? In relative terms it will be much higher now?

Naren: We have debt products with very low expense ratios, we have debt products with higher expense ratios. And clearly the returns that you are going to get as investors would depend on the gross returns less the expense ratio. And today bulk of the liquid, liquid-plus products have very low expense ratios. And at that kind of expense ratios, actually the industry is working almost free for the investor.