Use volatility as a friend, increase allocation to equities: Rajesh Saluja

The managing director & chief executive officer of ASK Wealth Advisors believes that stocks will get re-rated as earnings catch up

Indian equities may not see much action in 2018 given the various headwinds and elections ahead, but, Rajesh Saluja, managing director and chief executive officer, ASK Wealth Advisors, tells Vishal Chhabria that for a 3- to 5-year horizon, he is advising clients to use volatility as a friend and increase allocation to equities. He believes that stocks will get re-rated as earnings catch up, and that’s what equity investors should look at. Edited excerpts:

Indian markets have recently seen a sharp swing – from tailwinds to headwinds. Macro has deteriorated. How bad can it get from here?

There are two aspects that need to be considered. One is at the micro level, where we are seeing an improvement in earnings. Third quarter Nifty earnings growth was at 12.7 per cent. Given various indicators, discussions with managements, etc, March quarter (Q4) Nifty earnings should be around 25 per cent, partly due to a low base effect from Q4 last year. Disruptions related to the goods and services tax (GST) are settling down across various industries and the overall demand is picking up. Even globally, both US and Europe economies are showing signs of improvement. This is getting reflected in improved earnings, especially in the listed space.

However, there are challenges at a macro level. Increase in yields and the introduction of LTCG (long-term capital gains tax) have resulted in a 1-2 per cent increase in cost of equity. This affects valuations and hence we have seen a correction of 10-12 per cent in the Sensex and a much larger correction in the midcap/smallcap space. There is also a fear of slippage on fiscal deficit, given that it is a pre-election year. With state elections and general elections scheduled for next year, the market is expected to remain volatile and edgy. Also, the US Federal Reserve is likely to increase rates three or four times this year. While it shows confidence related to the growth of the economy, it does create a temporary movement of money from equities to fixed income. This will also keep global markets volatile. And let us not forget the trade wars.

As a house, we are neutral on equities this year as micro improvement will cancel out macro challenges. We will have to closely monitor how the government maintains its fiscal deficit or whether it takes further populist measures. We have to also watch the liquidity situation, both domestic and global, and its effect on yields and equity valuations. But, for a 3- to 5-year horizon, our advice to clients is that they should use volatility as a friend and increase their exposure to equities with a higher allocation to quality largecaps. This year will be one of bottom-up approach while investing in equities.

Indian and US government bond yields have moved up. So, won’t debt become more attractive than equities, which are at record high valuations?

You’re right, debt will throw up opportunities, but nothing exciting. India’s 10-year government bond yields are 7.6-7.7 per cent. Debt funds and other fixed-income options are likely to deliver 8-8.5 per cent after tax if held for 3-4 years. So, the money that has an investment horizon of 2-3 years will be parked in such investments. However, for five-year-plus money, we believe equities will deliver 18-20 per cent returns on the back of GDP growth of 7.5 to 8 per cent. Yes, equity valuations could be a concern, but only with specific stocks in the mid-cap and small-cap space. We have to be disciplined and careful in selecting businesses.

Which are these pockets of opportunity?

There are many in the agriculture, technology, non-banking financial companies (NBFC) and banking space. After the correction, most automobiles, tractors and two-wheelers are reasonably priced, given the expected earnings growth. So, on a trailing earnings basis it looks expensive because there has hardly been any earning in last two years, and prices have gone up mainly on hope. But, as earnings catch up, stocks will get re-rated, and that is what equity investors should look at.

As a money manager, do you see investment options as having reduced when compared to the past, given high valuations, headwinds, etc?

There are lots of opportunities even today. In the past 15-20 years, we have had many issues and challenges that have created headwinds, tailwinds, etc, so many times. One needs to be disciplined and focus on quality investments across asset classes with proper risk management. Over the long term, investing in equities offers powerful compounding returns if you have invested wisely in equities or PMS/mutual funds that are disciplined in picking up the right businesses where the size of opportunity is great, return on capital is good, there’s capital efficiency and cash flow, low leverage and companies are run by good management teams. Even in the current market, we are raising money for equities because we are finding value despite the fact that in the short term there could still be some correction.

With US, Europe and other countries threatening trade barriers, how do you see this playing out for India? And are you tweaking your portfolio to adjust for this potential threat?

We will have to wait and watch how this progresses and how much of this gets implemented – and also how other countries react. Even in the US, there is a good amount of resistance within Donald Trump’s own party. Europe and China, too, have been making noises around retaliation, but let us see how far this goes. Clearly, most countries are tending to focus inwards/locally rather than globally, given the challenges around creating employment. Technology is throwing a big challenge on this front. One has to watch which kind of business/segment might get affected – both positively and negatively, and then change the investment strategy accordingly.

How are you playing the banking and financial services space? Would you be looking at PSUs?

Broadly, we have stayed away from PSUs. There is still a long way to go for some of the PSU banks to compete with the private ones and NBFCs. As a choice, we operate in the private space. With yields moving up, one will have to watch the effect on earnings. In the past five years, some of the well-run private banks have demonstrated aggressive growth – Kotak Mahindra, HDFC Bank and IndusInd for example. On the other hand, PSU banks have gone slow in the past 2-3 years because of all the challenges they face. Consumer-facing NBFCs like Bajaj Finance, Bajaj Finserv, Cholamandalam and some microfinance businesses and private banks are great opportunities.

There is a consensus estimate that earnings will grow 18-20 per cent. Given the past track record and current headwinds, don’t you think FY19 will be another year of disappointment?

In the past 2-3 years, the actual number has been way short of the consensus prediction of 15-18 per cent growth. In 2016-17, we were on track, but demonetisation and GST got implemented and threw businesses out of gear. However, Q3 and Q4 of FY18 have been quite good. So, unless there is some major disruption, earnings are in an upward trajectory. There is a much better chance of FY19 hitting the number.

…even as interest rates and oil prices are at elevated levels?

This is the first time that we are seeing a pick-up in demand across many segments (infra aside, which is a result of government spend). We are seeing a pick-up in rural consumption and also exports. While private investment is 12 months away, there is clearly an improvement in demand across sectors, including metals. After demonetisation, there has also been a shift in investments from traditional asset classes to financial ones.

There is a bit of temporary tightening of liquidity, and hence the interest rate move in March, but if inflation is in control, we don’t see any significant changes in rates next year. Ditto for oil, which remains range-bound amid competition from shale. Most of this is priced in.

How does India compare with other global markets? What trend do you see in foreign fund flows?

Most forecasts are talking of India’s GDP growing 7-7.5 per cent over the next 4-5 years. This can be matched by few globally. Temporarily, when interest rates go up, you will see a little bit of money re-allocation across markets. But, can any foreign investor ignore an economy growing at over seven per cent? Highly unlikely. Yes, cheap money may not be there; once interest rates start going up, the arbitrage (cheap) money might not be there from the US markets. But, you still have Japan and many European economies where interest rates are close to zero. So, there is enough global liquidity, including institutional money waiting for stability and value before investing. However, this year you may not see significant foreign flows, given the impending elections. The year 2018 is not going to be easy for equities.

What returns can one expect from debt market investments? Which segments will do well in 2018?

We are not taking a duration call, so no duration funds. There will be lots of new FMPs (fixed maturity plans) launching, and offering 8-8.25 per cent returns for a tenure of about 3-4 years, allowing investors the benefit of indexation. They are good options. Credit/accrual funds will be good options. We will also see a lot of real estate funds targeting mezzanine/debt funding deals where investors can get 10-10.5 per cent returns after tax. So, it will be a combination of these options.

What is your take on real estate? With prices down, is it worth investing in?

Commercial real estate has seen a pick-up across cities like Hyderabad, Bengaluru and Mumbai over the past 5-6 years, primarily in the absence of supply. There are large transactions taking place in the pre-leased space, too.

In the residential segment, investor demand is weak across India, especially for luxury properties. But, in the mid-income housing we have seen a pick-up across most cities except Delhi-NCR. With the Real Estate (Regulation and Development) Act (Rera) in place, quality developers are offering good deals to investors and end users. For the purpose of consumption, it is a fairly good time to invest as buyer is the ‘king’.

In affordable housing, apart from the latent demand, new demand has emerged due to the subsidies made available. Luxury still is and will probably remain down until there is a cycle of sustained wealth creation – this may take 2-3 years. But, in mid-income housing (Rs 4-10 million and onwards), at least in the top 5-6 cities, there is a demand for quality builders with good execution track record.

From a direct investment point of view, however, we always tell clients not to look at real estate because of relatively low returns, the risks involved, and pathetically low rental yields of 1-2 per cent in the residential segment.

But from a fund manager perspective, we have funds and are still raising money because we are finding very good deals with builders with manageable debt but facing challenges on cash flow and sales fronts. So, we approach such builders with Rera-approved projects. At the end of it, our clients get a decent return of 10.5-11 per cent after tax and fees. There are many good opportunities among mid-sized builders.

Prices in top 5-6 cities like Gurgaon and Noida are also down 30-40 per cent. Leveraged investors are also out, more or less. So, we don’t see a further decline or any increase in prices over the next 2-3 years.

Your take on overall asset allocation?

We remain neutral on equities for the next 3-6 months unless there is some significant macro event or if there are signs of a political stability. On fixed income, our focus is on FMPs, accrual and credit funds. We have increased our allocation to alternate investment strategies like real estate funds, pre-IPO funds, long-short strategies (portfolio of equities and simultaneously short on the Nifty), etc. We also recently allocated a small portion to global equities under our first-of-its-kind US Opportunities Fund. The objective is to get geographical allocation for our clients and also get them to invest in businesses you don’t find in India — such as Apple, Alphabet, Netflix, Nike, Starbucks, Visa, Adobe, etc, which are some of the top quality businesses in the US. We expect the rupee to weaken; that will also add 3-5 per cent to returns, over and above the 11-12 per cent on the US dollar from such investments.