Expect low double-digit returns in 2020: Mukul Kochhar, Investec

Despite the weakness in the economy the market has been charging ahead. Mukul Kochhar, Co-Head of Equities, India, Investec says companies that are benefiting from the disruption in the economy are driving up the markets. In an interview to Samie Modak, Kochhar says this year will be another rewarding year for equity market investors. Edited excerpts:

How do you explain the divergence in the economy and the market performance? 

The market performance is being driven by stocks and sectors which are benefiting from the disruption in the economy. These are companies that are consolidating, gaining market share, and increasing profitability, as competition reduces. Easy, and indiscriminate access to capital in the past had led to irrational competition in sectors, such as banking, cement, steel, and construction. This was not allowing these sectors on aggregate to even earn the cost of capital. As capital becomes more discerning, we see profitability improving across sectors, driving stock performance of the winners. Our research indicates that return on capital started improving across most sectors from 2016-17 (FY17) onwards, even as the risk-free rate has declined. This indicates that companies are adding more value today over their cost of capital than any time since FY11, driving stock performance, even as the economy has slowed.

Do you think the market has priced in a recovery in earnings and economic growth and gains could be muted from here on? What’s the stock market outlook for 2020? 

It is tough to make a general statement on what is priced in for the market, but we do not see much more of a challenge than normal in picking stocks. We are constructive on the market in 2020, and believe that low double-digit returns (compared to the risk-free rate of 6.5 per cent) is possible.

Most global analyses suggest that the environment is favourable for equities. Do you subscribe to this view? 

Last year was a particularly good year for global equity markets. After a solid year, follow-through could be more of a challenge given that some of this return in a strong year is typically generated through valuation re-rating. CY 2019 was no different, as most markets witnessed valuation expansion. This would imply lower returns in 2020, in general. For India, we believe that investors will still be adequately rewarded for equity risk in 2020, on top of good returns in 2019. A favourable equity environment typically translates into positive equity flows, and 2020 should be no different. 

So far this year, we have seen the broader markets outperforming the large-caps after a long time. Do you think the trend is sustainable? 

We are recommending investors to stay very selective when it comes to smaller companies. Capital markets are going to remain very discerning around management quality and governance, which will impede a strong broad-based rally in smaller companies which we saw from 2014 to 2018. Smaller companies typically find it more challenging to hire high-quality management teams, and we believe that the markets will remain more discerning than in the past around quality of management, and capital allocation policies of companies.

What’s the earnings growth forecast for the next financial year? What will drive earnings growth? 

We believe that the consensus earnings estimate of 15 per cent for FY20, and 20 per cent of FY21 are achievable, with potential for modest upgrades. Tax rate cuts have been a substantial aid to the earnings cycle.

What are the key risks for the market? Do you think oil prices could de-stabilise our markets and economy? 

One of the biggest risks to the market is emanating from geopolitics, driving oil prices substantially higher. Leaving aside this obvious risk, if the cyclical downturn in India becomes secular, it will finally start impacting the markets. Stocks are pricing in some level of normalisation in demand, and a secular downgrade in growth will become an issue for the broader market. This can happen if consumer and business sentiment, which has been impacted owing to recent noise, becomes entrenched. This is still not our base scenario since we believe that the flow from structural reforms will eventually start percolating into the economy.

Which sectors and themes will do well going ahead? 

Consolidation and import substation are themes that should continue to do well in 2020.

What’s the outlook for banking stocks? 

Banking stocks should benefit from consolidation, and as the corporate asset cycle recedes this year. We remain constructive and continue to recommend large private banks -- ICICI Bank, Kotak Mahindra Bank, and HDFC Bank -- to clients. We are also selectively recommending some smaller banks, which are well-run, and have the potential to grow from a small base.

Do you think the auto sector is out of the woods? 

(Problems in) the auto sector are largely because of policy missteps -- in a single year, we have added costs from compulsory insurance, adoption of anti-lock brakes, and now BSVI. This would have an impact of roughly 25 per cent for two-wheelers, and 5-7 per cent on the entry-level passenger cars. At a time when other reforms were also impacting the economy, these steps are not helpful. While growth should return in FY21, largely benefiting from a low base in FY20, the market will still have to absorb price increases from the BSVI implementation. There is a real risk that price increase for diesel cars for BSVI may be high enough to make them unaffordable, at least entry- and mid-level cars.