 "Up to India to turn this crisis into opportunity: Sanjeev Prasad")
After falling sharply post the Brexit event, markets have recovered much of the lost ground. Sanjeev Prasad, senior executive director and co-head, Kotak Institutional Equities, tells Vishal Chhabria that India should be prepared for a period when the markets might not perform. He says the market is not cheap and will look attractive if it falls 10%. Edited excerpts:
Post Brexit, how do you see things shaping up from here? Do you see the market trending lower from here?
There are two parts — economy and market. The market reaction has already played out. The economy impact will play out over a longer period of time. The world should be prepared for a period of lower economic growth. Unfortunately, global GDP growth has not been good with recent economic recovery being fragile even before Brexit. And Brexit will only increase uncertainty.
Firstly, will other countries also start to look at exiting the European Union (EU)? Secondly, there is lot of anger and frustration among middle and lower income households, which are linking the pressure on their incomes to failed policies of governments. Thirdly, we need to see if this extends to a debate on immigration, globalisation, etc, which may result in less globalisation and higher trade and other barriers. The political class has to review its thinking about their economic and social policies of the last seven years post the global financial crises. Monetary policies that were designed to bring about financial stability post the global financial crisis in 2008 have failed to deliver economic growth.
Global markets, however, are going to respond to how the global economy will perform over the next one or two years. Market’s initial response to the Brexit event is behind us, but we should be prepared for a period wherein markets may not perform. We would highlight that global bond and equity prices have been supported by low yields, engineered by central banks. High asset prices do not reflect the confidence about growth, but low yields.
India though is in a far better situation due to its better macroeconomic position and reforms undertaken in the last two years. It is not hugely integrated with the world economy, so Brexit doesn’t really impact it meaningfully. If the GST bBill is passed, it should send a strong signal to global investors. And if we get the FDI equation right, India could actually stand to benefit as it is one of the few large economies that is still growing strongly.
So, it is up to us now as to how to turn this crisis into opportunity. People still want to invest in growth markets like India. We might get disproportionately more foreign capital if we play our cards right.
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But, already FII/FPI money flow has been weak. Do you see money flowing into India?
Exactly, it has not been very strong in the last few months. So, it is important that India does the right things for it to stand out among emerging markets. For example, how do we direct household savings into financial savings instead of it going into gold? Do keep in mind that gold prices have gone up sharply in the past few months because of low global GDP growth concerns and now Brexit. This could result in households looking at gold more seriously once again, which could affect domestic equity inflows. So, it is important that the government responds appropriately.
Global data including that of US, China are not encouraging. Do you see any risks emerging on this front?
This has been the problem for the last several years now. The first response of global central banks post the global crisis to bring down rates, infuse liquidity and revive the global economy was correct. But, economic growth didn’t pick up in many parts of the world as accommodative monetary policies were not backed by reforms, which could have addressed the structural problems in EU and Japan or resulted in higher productivity. So, the political class needs a rethink in terms of how they want to manage the economies. Until then, we should be prepared for lower global economic growth.
Given the backdrop, how do you see earnings growth for India Inc in FY17?
FY17 earnings growth should be good due to the low base in FY16. Between FY14 and FY16, the net profit of the Nifty Index has hardly changed, at Rs2.7 lakh crore, as a number of sectors have seen low growth or a decline in net profit. Five big sectors including autos (due to Tata Motors), banks (private banks have done well but public sector banks’ profits have collapsed), oil and gas, metals and mining, and pharma, have seen their profits being stable or declining over the past two years. We are looking at 16.5% growth for FY17 currently; may be there could be 1-2% cut to our current forecasts.
The real issue will be FY18, where we are projecting high growth and building in economic recovery. The latter is still uncertain. We see some reasons for optimism on growth due to good monsoon, pushing up rural economy, 7th Central Pay Commission payments both for central and state government employees and ex-employees, which will sustain consumption for the next two years. The government is also spending on infrastructure, but we still have to see private sector investment pick up.
How will you play this economic recovery?
You can divide this into consumption and investment plays. For consumption, one can look at autos, retail-focussed private banks, consumer durables - basically large domestic stories.
Most autos companies will do really well, given good monsoon in FY17, 7th pay commission payments. On top of that, GST implementation, assuming it happens, will lead to a lower tax rate of about 18% compared to about 24-37% currently on autos. Consumer staples and durables, however, are quite expensive, but they are fantastic companies and they will grow at about 12-15% earnings growth for the next several years. The challenge is rich valuation of over 30 times FY18 earnings for most of the stocks.
On investment side, one could look at a combination of industrial and infrastructure companies. However, since most of the infrastructure assets are owned by governments (central, state and local) and will continue to be owned by governments, the opportunity to participate in the creation of infrastructure in India is quite limited. One can look at companies that provide equipment or do construction for infrastructure assets.
What about power — where you have the UDAY scheme, etc?
UDAY is a powerful scheme for sure. And if it plays out well, it can significantly improve the financials of state-owned power distribution companies and their inability to buy sufficient power. In transmission, Power Grid is a good story, which will give you good return in the next few years, and the stock is available at about 10 times on FY18 earnings, and in generation there’s NTPC, which is also available at similar valuations. If the government is able to address the problem of unviable PPA (power purchase agreements) which many private generation companies have entered into with distribution companies, some others may become more interesting. We will have to wait and see how the situation plays out over there.
How about capital goods, cement or metals?
The underlying global supply-demand balance in most of the metals is not very good. Barring zinc, there is massive over-supply in all others, especially aluminium and steel. If China slows down, supply-demand situation could worsen further. Also, China is creating new aluminium capacity and as much as 2.5 million tonnes per annum of new capacity will come up over the next six months
Cement demand will grow in India for sure but the sector is terribly expensive. I don’t feel like paying 20 times PE for a cement stock which is already discounting a fair amount of recovery in profitability.
How will you spread your investments? And would you look at midcaps?
It’s largely autos and banks that make up 50% of our recommended model portfolio, followed by outsourcing stories such as IT and pharma at low 20%. We have some defensive names in oil & gas and regulated utilities. We have made our portfolio fairly defensive over the last two months as we do not find value in most sectors and stocks now.
Among midcaps, we like certain segments such as agriculture productivity enhancement companies (agrichemical companies) and niche lending companies (NBFCs). However, valuations of good-quality midcaps are quite high. One needs to find the right companies which will participate in growth of the economy and are available at a valuation discount versus large caps in the same space.
Indian market is still trading above its long-term average levels. What's your take?
That is the whole challenge and that’s why we have made the portfolio more defensive. The market is trading about 18 times FY17 basis. So, even if it comes down to 16-17 times, still it will not be really cheap. However, investors still like India given its decent medium-term growth prospects and given the lack of investment opportunities elsewhere, Indian market may hold up. So, the market may go through a period of time correction.
There could also be some downside to global markets, if investors start getting concerned about global economic and earnings growth. The problem globally has been that a lot of the rally in equities over the past few years has been supported by lower cost of equity and not by higher earnings. Investors have assumed that global economic growth and earnings growth will eventually recover but growth expectations have been belied year after year for the past several years and central banks have been forced to respond through more and more unconventional monetary policy interventions. There is a natural limit to what central banks can do in terms of reviving global economic growth and at some point in time, markets may start worrying about high valuations and low earnings growth.
What levels would you be comfortable in buying at?
Historically, the Indian market has largely traded in the range of 13.5 to 16.5 times 12-month forward earnings basis. However, with its stronger macroeconomic position now and better quality of governance, I am willing to give a slightly higher multiple of up to say, 17.5 times. So, the market still needs to correct 10% to offer a great buying opportunity. Or one could stay invested and expect returns of around 10% on a March 2018 basis. That is the way we see the market playing out, time correction for several months.
Do you think the worst is behind for public sector banks, and would you start selectively picking stocks there?
NPA is only one part of the issue. Overall governance and management practices in PSU banks need to improve. The government has the right intentions, but let us see if governance and other practices can be changed to get the right outcomes.
Currently, NPAs are about 17-18% of banks’ total loans as per our assessment and will peak out by September 2016 quarter. But, we’re not sure on the recovery rate – 30%, 50% or 70%. This means we don’t know how much write-off banks will have to make, and hence, how much capital they will require. The government has done a lot of good work in terms of improving the operating conditions in some of the sectors, like the UDAY scheme for power, MIP and safeguard duties for steel, funding for textiles, putting in place the insolvency act though it still has to set national tribunals. The real challenge is that we don’t have a very good understanding of the capital requirement of PSU banks as it is linked to loss, given default figure, which itself depends on several variables. If the capital requirement is going to be very large, which is quite likely, a) whether the government is prepared to give that much amount of capital and b) should one be investing before the government injects the capital? If the government is going to invest a large amount of capital at below book, then the book will get diluted significantly. We might as well wait and see how the government fixes the governance and immediate capital requirement issues.
Many believe that good monsoon will lead to better rural demand, but given that the last 2 years have been very bad, what kind of improvement do you see?
There will be some improvement in rural economy, but not immediately. One good monsoon may help increase output to earlier (FY14) levels, but the pricing part of the equation shouldn’t change much. In the non-agricultural part of the rural economy, economic activity has been fairly subdued. Thirdly, earlier, a lot of consumption in rural areas was also supported by high land prices. So, one monsoon will not change things dramatically, although it is welcome. So, we expect some recovery in agriculture input, chemicals, seeds, and also basic consumption items like consumer staples. But income level will not improve dramatically.
Recently, inflation has moved up, and commodity prices have risen. How do you see that trend for the rest of FY17?
It is going to be a challenge. We expect inflation numbers to soften a little starting July-August as food prices begin to come down from current high levels. But beyond that, inflation is again going to go back to 5% by end-2016 or early 2017. So, the scope to cut rates is quite limited, not more than 25 basis points, in our view. Hopefully, with this Brexit event, we will see commodity prices cool off a bit. The RBI’s 4% target for inflation for January 2018 will be a challenge. I think it we will be around 5% only, and this is without considering the impact of pay commission.