Counting On Recovery In Earnings To Lift The Market, Says Anup Maheshwari

It’s interesting because they are presenting contrary trends. Interest rates in the U.S. are rising and we expect interest rates here (in India) to stay stable and hopefully inch lower as inflation comes down. So it interestingly impacts the type of fund flows coming into the market. From a foreign investment standpoint, it is actually negative. As interest rates rise in the U.S., money tends to flow away because it is an indication of a pick-up in the economy. As far as India is concerned, for all of us as local investors, it is a great trend for interest rates to be heading lower, considering it is positive for financial assets, particularly for equities. So I think this slight conflict between domestic and offshore flows is something that we are going to have to get used to for a little while.

The good thing is that if you look at the SIP flow at the moment, it adds up to a potential growth of 10-15 percent in total equity assets every year. That’s the amount of consistent flow. It definitely does tend to affect lump sum investments because people tend to go with the market direction. My actual concern is it should not affect SIPs. Sometimes even SIPs start getting affected if they don’t deliver good returns over a two-year period. We are coming close to two years now since the market has been a bit flattish. So SIPs, we strongly believe, is the best way of investing because you keep using whatever market volatility is there in the short run. Eventually, you get a bull market which covers up for everything. But it is very important to keep the SIP going and that is the message we want to send out to all investors. Lump sums will keep coming and going, but if the SIP flow is steady, funds of course will benefit from that, but so will investors.

The biggest one that has been talked about is the tax reform in the U.S. and that is beginning to become a trend even globally. If they do some fairly aggressive tax cuts in the U.S., some other countries will also have to do something to remain competitive and attract foreign direct investments. We are keeping a close eye to see if they manage to implement these tax changes. We may see some import tax coming through as well...so we will see what they do. The trend generally is for protectionism and tax benefits locally and that is something we will have to think about as well.

Markets are clearly in consolidation mode. There isn’t a very strong upward trend and the downward trend got arrested a few years ago. I would say it is a very slow recovery. But our focus tends to be more on corporate earnings and gross domestic product. At the end of the day, markets and GDP are not exactly correlated, markets are more correlated with earnings. Earnings were still very depressed even though our GDP numbers over the last few years were not so bad. That is what we are really counting on. At some point in time, the earnings will reflect that. The biggest sectors which have been a drag on earnings, that is the public sector banks and metals, have themselves have taken away about 10 percent of earnings growth. If they change, and we are expecting at least commodities to start giving better returns, then that can take earnings growth back up to a more respectable level which we were used to - around the 15 percent kind of range. That will be a stronger guide for markets than where the economy is right now.

This whole demonetisation exercise pushes things back and will create an airpocket of growth for the next couple of quarters. But I think the system will finally adjust. It is a temporary situation, it’s not a permanent structural change and therefore I think, to that extent, the earnings will come back eventually. If its financial year 2017-18 or financial year 2018-19, we’re not exactly clear, only time will tell. But the fact is, it is coming. It is very unlikely that you will see further earnings corrections from here. People have already adjusted their earnings lower, close to the demonetisation. At some point of time there will be an upgrade.

That’s a good question. Expectations have gone up post the demonetisation. Everyone is talking about some sort of tax reforms, tax adjustments and better tax compliance etc. This government has been surprising us from time to time. So I am not exactly sure it will be exactly the way we are thinking but I’ve got to say most of the steps they have taken are considered, thoughtful from a long-term prospective. I think the focus is more on long-term growth even at the cost of some short-term challenges. As long as the budget stays on course, I think it’s a great thing. So we are hopeful that we will get some of these tax changes but we’ll wait and see.

Well it’s a mix, it’s a bottom-up process. Generally when we look at sectors and companies, the sort of of top-down thought process that we run across is whether there is pricing power in the sector. Is that pricing power increasing or decreasing? Wherever we sense that pricing power is coming under pressure, we tend to go underweight on the sector, wherever pricing power is coming back, we tend to be more optimistic. So, for instance, on the energy companies, we have been quite optimistic for a couple of years and we still hold most of our positions. And we have seen that oil marketing companies have been allowed to pass on prices. That’s what we would call pricing power. So that’s an interesting area. To some extent, banks, selectively. it’s a very bottom-up process, but banking and financial services is a great long-term sector to invest in. We are hoping at some point IT revives. As discretionary spends start picking up in the U.S., as the economy comes back, it’s quite logical that it will help pricing power of some IT companies as well. So it doesn’t seem apparent today but it’s something we have got an eye out for. So you got to pick and choose, where there is pricing power. It is pretty obvious actually when you run across a lot of sectors where the pricing pressure is and where the pricing power is.

Textiles and chemicals are two areas we like a lot, and at a very top-down level, I think the big change that has occured in the last 2-3 years, is that China has become less and less competitive compared to India in a lot of sectors where they used to dominate. Textiles and chemicals fit within that. So most of the Indian textile companies are now a lot more cost-competitive, they have very good barriers to entry in the form of some strong clients that they have in the export markets, particularly in the U.S. If Europe opens up at some time, that’s again a great opportunity for them. The same is true for the chemical companies. The basic points, across both textiles and chemicals, is these are both businesses that have fairly good returns on capital ratios, 15 percent or above. They have good growth now, as China is withdrawing from the markets, they have got some decent managements available that you can buy into, and they are scalable businesses. And it seems like a decent runway. This is not something that will change in a year or two, this is like a 3-5 year process. So we find both these areas as interesting sectors to look at.

So pharma, we’ve had a soft spot for a long time, they have been the biggest shareholder wealth creators. You are absolutely right, these have been big challenges for them – both pricing as well as regulatory challenges. The way we see it, the regulatory challenges are temporary, they will come through in another 6-12 months. At the end of the day, Indian companies account for the bulk of generic exports to the U.S. and if they want to keep the prices of drugs down, they have no choice but to buy drugs from India. So it’s very critical to their healthcare system. Which is why, they have to give these approvals eventually. So what will happen is, as the regulatory approvals come through on the plants, there is this big backlog of product approvals that will start coming in. So you will get volume growth coming back. But you are absolutely right on the pricing side. So we have got to pick and choose our names there, but we just like the fact that it’s a sector which is pretty much down and out at the moment but it has got good economics, good managements, and therefore whenever these regulatory challenges start going away, I think valuations will come back.

So it’s the same as deciding when to buy stocks. At a very broad level, the philosophy is looking for growth at reasonable price, that’s the normal way we look at companies. India is a growth market, so we are always looking for companies that are growing above average but are available at a reasonable valuations, and have the right ingredients of management and economics. If you do enough work when you buy a stock, the thing that will get you out of it, or force you to sell, is any change in any one of these underlying phenomena - which is either growth suddenly comes off a cliff, there is some development you didn’t anticipate, bad capital allocation, a change in senior management and you are not very happy with the new management, or there is some regulation that comes in and affects their basic business economics. So if there is anything that punctures the initial thesis of growth and RoE trend, that tends to make you rethink your position.

It is very common phenomena, of comparing investing with being a marathon runner. And the learning from running a half marathon actually is that you need to plan the entire journey. You can’t just plan for a small period of time. For investments also, you need to think through a full checklist of things that you want from a company and ideally plan to hold it through this whole thesis playing itself out and not get too swayed by what happens in the very short run. This is easier said than done. There is a lot of noise in the market which tends to keep putting pressure on everybody, everyone’s human. But we have seen that our best investments are the ones that we’ve just sat through all the short-term noise and had a bit of that long-term marathon approach of understanding where the business is finally heading and just planning through it and building a position through it. So markets are a marathon, not a sprint, that is very clear. We keep reminding investors of that fact.

First of all, it is only a weekend sport so it’s easy to do . I’d heard that when you are aiming a pistol you’ve got to concentrate and that tends to help. My son was very keen that he learns this sport and then I joined up with him. Both of us have been learning it. And I think the concentration that is required around pistol shooting is really very useful to learn in your day-to-day life. It helps in investing. A lot of these little outside activities are required for you to become a better investor over time because they all add some value. So I think concentration, keeping on track...again it’s about not diverting your mind and hopefully makes me a better investor at some point.

So you’ll never catch a fund manager being bearish. I think the key for us – we have had so many false starts in the last few years on earnings growth – we are really hopeful that FY18 is finally a year when we start getting it. We’ve been like a stuck record expecting 15 percent growth every year, the next year, but it is not been happening. So we are hoping that FY18 is the year for us where we do get some growth coming back, thanks to tax reforms, or whatever comes through. This period is just a small airpocket in that journey. But lower interest rates, fairly decent valuations, if earnings come through, there is no reason for markets to not look a lot better next year.

The way I see it is..whether it is FY18 or FY19...a year down the road I may be having the same chat with you but the fact is that as growth comes in..and you’re right, any new tax reform or any new system tends to disrupt in the near term but eventually everyone knows it’s a positive outcome. So the market does tend to see through some of these issues eventually. So we are hoping GST will most likely come somewhere between now and September and it will create chaos for 6 months or so. So you are right in saying that it might get delayed a bit from FY18 as well..possible..but we are hoping that the sectors which will turn earnings growth - commodities and PSU banks - aren’t as impacted by GST, which is why we think, to some extent, you will get earnings growth irrespective.