Shankar Sharma Flags Two Concerns For Indian Markets
Indian markets will be able to overcome uncertainty as a severe second surge of the pandemic overwhelms Asia’s third-largest economy, according to veteran investor Shankar Sharma. But he sees two other concerns: higher commodity prices and rising benchmark yields.
“You may not see a repeat of what happened in March 2020 [stock selloff]. 2020 was a surprise. A 30% fall was not on the cards but a 5-10% fall was, given the magnitude of the unfolding problem last year,” Sharma, co-founder of investment advisory First Global, said in BloombergQuint’s series Navigating Through Uncertainty. “My sense is the markets will say, ‘okay, we have a script of what happened last year, markets fell, recovered and the fall was almost as if it didn't happen’.”
The NSE Nifty 50 index has gained 5.4% year-to-date, compared with the benchmark index's 15% rally in 2020.
According to Sharma, there are non-Covid factors that may affect the medium-term outlook for the market. While fiscal expansion, even though conservative, puts India on a growth path, it’s accompanied by some clouds on the horizon. The commodities bull market, he said, has come at a “very wrong time, because post the expansionary budget, India would have wanted lower commodity prices so that it can get away with lower yields to be paid on its debt”.
The focus on growth despite the deficit, in the interim, leads to a strain on the balance sheet, Sharma said. And the government’s borrowing programme is already pushing yields higher, not good news because markets typically like low bond yields, he said.
And it’s not about U.S. yields or their impact, according to Sharma. For the U.S., 10-year yields of 1.5% or 1.6% are not high even as these have risen since last year, according to Sharma. Nobody should believe that 60, 70 or 90-basis-point yields are supposed to be normal and even a 2% or 2.25% U.S. benchmark yields would not be anything out of the ordinary, he said.
A 2% bond yield should support a price-to-equity multiple of 50 times for stock markets, and when adjusted for risk, stocks trading at 30-40 times their earnings are not expensive. But investors who have parked money in second- and third-tier tech stocks in the U.S. can get hurt by higher yields.
Why Sharma Prefers Mid-Cap IT
Within India, Sharma is investing in global cyclicals but not in domestic cyclicals as First Global’s risk-adjusted stance doesn’t allow them to buy something that may see disruptions in the year ahead.
First Global is bullish on information technology with a preference for midcap firms in the category. A $100-million deal doesn't move the needle for a Tata Consultancy Services Ltd. or an Infosys Ltd. but can completely alter the growth trajectory for a second- or a third-tier company, Sharma said. Unlike small caps in other industries, mid caps in IT are still very good companies in terms of pedigree and governance, he said.
"The biggest challenge you have with small- and mid caps of other industries is you don't know what's going to happen. In IT, you have companies which are very well managed, with a great system, a great structure, good boards and good accounting,” he said. You will not have a risk that tomorrow they will just blow up in your face like many other mid-caps do."
Watch the full interview here:
Here are the edited excerpts from the interview:
How you see the current scenario, considering that we seem to be on a repeat template with a more severe undertone on the Covid front but there is a vaccine around?
SHANKAR SHARMA: If you look at it on a global basis, U.S., which really messed up on the healthcare front last year, there were a lot of horror stories coming out of the U.S. and how badly broken the healthcare system was, but it seems under the new administration they’ve got a handle, at least on the remedial part— which is the vaccine part. So, now U.S. is I think 40 or maybe 45% coverage of the vaccine which is really staggering considering the size and the spread of the country. So for a large population country it is right up there. They have gotten their act together on the vaccine front... I think just the U.S. just stands out completely in this whole vaccination game. U.K. has done very well too but of course it’s a smaller country but a large country like the U.S., they are streets ahead and nobody’s even close. Of course, China being the home of the virus you can see it is already covered because I think when the virus was discovered or made or whatever happened to the virus, there are many theories at least they have a remedy already in place, the Sinopharm vaccine has been around and is widely used. So, China also seems to be in a good shape. So, two large, populous countries have probably figured out the solution to the problem. The third populous country, there’s one in the middle which is Brazil, which was also in a bit of strife in the last several months and there also the cases seem to be declining. So that also seems to have put some kind of a lid on the problem. The fourth populous country, it’s obviously the most populous but talking to other sequences, India, where everything has just gone south and just keeps going south and what we are seeing unfolding here, beyond the lens of the stock market which I never regard highly from a maturity perspective, but this has become a totally dystopian nightmare. Every day it is reached, everybody’s home. My sister was diagnosed with it a few days back and I have heard the same story everywhere across India. That really should bother all of us beyond just looking at the market and saying the Sensex is very indecisive. I think India is in a bit of a pickle on this without any doubt.
Do you think the markets will worry about it a lot or will the markets look forward the way they did the last time? The only disconnect is that right now the markets are no longer at the valuations that they were when we were at 7,500 on the Nifty.
SHANKAR SHARMA: My sense is that the markets will look through this. Therefore, you may not see a repeat of what happened in March 2020. 2020 was a surprise, although it wasn’t a surprise if anybody was following the news through February, we were not surprised with the fall except 30% was not on the card but a 5-10% fall was definitely on the card given the magnitude of the unfolding problem last year. This year, for one, it is isolated to India. Second, markets are no longer in a surprise mode. The data has been out there in India for the last 15-20 days and is climbing every day. In some sense the surprise element is no longer there, and markets don’t like negative surprises. If it’s something which is already priced in, the markets will look through that. So, my sense is the markets will say, okay, we have a script of what happened last year, markets fell, markets recovered and the fall was almost as if it didn’t happen. I think markets will say why even fall or why even fall so much. So, you cannot rule out a 5-10%. In any case the markets have rallied a lot. There was anywhere room for a fall for no other reason just for the fact that you should have a correction in this kind of a vertical rally but that I don’t think will be a durable fall. I think markets will look through that and markets will rally back. I think markets probably may not even get there by the looks of it. So, broadly markets have a script from the last time, look through the problem. What lies at the other end of the problem is that generally companies which were doing well, will continue doing well. So, I think markets may not react as violently as it did the last time.
You always said that and it’s obviously, maybe to an extent, fairly understandable that the markets will not crack because of unknown-known, which is completely discovered, but it’s slightly a unknown-known hitherto the known-knowns would be Covid cases or the yield and the interest rate issues. What’s your stand there considering that for now that seems to be buried in the background, but you never know where it comes back. Do you reckon it will come back and haunt equities by and large?
SHANKAR SHARMA: India in its union budget for this year, which happened in February, decided to take the path which it has not taken before, which is basically a part of big fiscal expansion. So, India has typically been a very conservatively managed economy. All Indian finance ministers have always been worried about the fiscal deficit and the budget deficits through history with the time I was born. The only comments you heard prior to the budget is that there is no room for any expansionary policies, the fiscal room is limited and all that. That is a stance that Indian budget speakers have had for decades, and that is one of the reasons why India has been able to withstand global macro-crises which come once in a while. So, the 1997-1998 crisis, India managed to sail through that reasonably well. I mean it wasn’t hurt anywhere close throughout the way, Thailand was hurt and the same happened again. The dot com was a sectoral crisis, it wasn’t really a macro-crisis. In 2008 India weathered the storm the best than any other major economy and it actually emerged from the crisis—the strongest of any economy and maybe emerged from it without doing any major stimulus or adding most importantly to debt. India’s fiscal conservatism has helped it through big crises in the past. This time, the policymakers decided that look we have been too conservative and it’s time to basically, at least lessen that conservatism by adopting a stance of growth. Deficits can expand for the interim period, debt to GDP can go up but if we are rewarded with increased growth, eventually all these things will work out for the better. In a way they have borrowed from the book of China or the U.S. in particular. Both these countries which have followed similar kinds of strategies in which they said, go for growth, never mind the deficits, never mind debt and at the other end of the tunnel, if there is any growth slump, you have basically reduced your fiscal deficit because of the increased revenue and debt to GDP because of higher nominal GDP growth. India has gone down that path of China and America. Now, the question is that whether it’s a wise move. That time will tell. In the interim, the Indian balance sheet will have areas of strain and one of the areas of strain will be obviously the borrowing programme which is why you might see that it’s a shoot on the upside which is typically not such a good news for markets because markets typically like low bond yields. I mean that’s like the synagogue of a bull market, low interest rates low bond yields equity look more attractive and equities rally. Inflation is the other end and of course what is not helping is the global rally in food prices. So, if you look at corn and you look at a lot of other agri-commodities they are enjoying a significant bull run right as we speak and of course industrial commodities such as copper, oil and aluminium etc., which are all inputs for a variety of industries are all enjoying a tremendous bull market. It comes at absolutely the wrong time for India when India would have wanted lower commodity prices so that it can get away with lower yields to be paid on its debt, but life is not ideal. We have gone down the path of expansion but guess what authorities don’t know about it and they are rallying like there’s no tomorrow. All these things potentially can cause problems just to remain conservative. I’m a conservative person I’m not a straight-shoot-person-ask-questions-later kind of a fund manager. We as a house is very conservative and conservatism tells us that there are clouds out there which we need to be mindful of.
Even on the global side would you reckon that yields could spoil the applecart for maybe the U.S. equities, or not quite?
SHANKAR SHARMA: The important thing is that maybe 1.5 or 1.6 are not very high in absolute terms. They’re higher relative to where they got last year. I would tend to view that more as a normalisation of an excessively low yield regime which we saw last year. Nobody believes or should believe that 60-70 basis point yields or a 90-basis points yields are supposed to be normal. That’s not supposed to be normal so even a 2% yield or 2.25% yield on the U.S. 10 years, I would not reckon them to be anything out of the ordinary. That’s why we went a couple of years back. So, we just sort of went down and then we’re coming back up to what is still a very low overall and in absolute terms key level and relative to those yields—if you just look at it, normally in a price to earnings ratio, rest everything will be equal at a 2% bond yield should support a 50 times P/E multiple. Adjust for risk it can support maybe 30 times P/E multiple or a 40 times P/E multiple. In that context, U.S. markets are not expensive, at least the non-technology part of the U.S. is not expensive. So, where you can get hurt are with the high-flying tech stocks especially the second or the third tier. Mainland stocks are fairly cheap but old economy stocks will benefit, because they don’t have much valuation compression risk. They’re already at multi-year lows in terms of their valuation multi-year lows even in case of any stocks and sectors in terms of pricing. So overall I think the U.S. is still okay, but at least at the non-technology end of the market. I don’t think that’s a problem. The problem lies for countries with relatively weaker balance sheets and India unfortunately falls in that category when it runs deficits on all fronts. China can run a big deficit on the domestic front, a big debt to GDP on the domestic front because as long as it can find enough savings to fund that debt, which is largely domestic debt, it is okay. India because of its current account deficit has reliance on foreign flows to fund tax. So, India’s situation is a bit different from the U.S. and China, but we are trying to use the same playbook as U.S. and China. Time will tell whether that playbook plays out the way we think it should.
What is your playbook for India currently?
SHANKAR SHARMA: Our playbook is very simple. So, this year, as we speak right now calendar year, we had a blowout in 2020.
But didn’t you guys score very highly on one of the counts, I think, a PMS AIF report, apparently placed you at the top percentile of the performers, if I’m not wrong?
SHANKAR SHARMA: I haven’t seen that report but obviously the benchmark is — us and the competition. So, this current year, year-to-date, I think we are far and away from the number one PMS in the entire industry for the multi-cap. I mean of course small-cap PMS, if small-caps will do well then obviously, but it can go south as well. On multi-cap, we are far away from number one I think we’re up about 15-17%, while Nifty 4 or 5-6%, something like that. But that is coming out of still a very conservative stance, so the point is not returns. I always repeat this that people focus excessively on the wrong end of the market which is returns and returns alone. Investing is about managing risk. There will always be risk to any investment situation. There is no world which is without risk, right? We as analysers and fund managers, we have to decide what is acceptable risk and what is unacceptable risk. Right now, the risks that we see in Indian equities tell us that is no time to be aggressively chasing stocks which derive their businesses from the real economy or the domestic economy which means that banks and financials fall in that category. They are always by nature, highly leveraged. If you were to have a market cut of some kind, you will see the branch falling squarely on the leveraged end of the market which is banks and financials. So, we’ve cut back significantly in the last couple of months on our exposure. We anyway didn’t have much cut back on that we’re quite comfortable with that. Other than that, we are fairly conservatively positioned so that, if the markets were to correct while we might get hurt like anybody else, we will not lose as much money. So, we are being conservative. Now that conservatism might prove wrong and market sails through it but we’re just going to keep going up. Remember, this is a long-term game it’s not a 50 or a 20-over cricket game. You have to make a run on every ball you cannot play investing in that passion and you need a six on every ball. Some balls need to be just played defensively out, that’s what we’re doing right now.