Why HDFC AMC’s Prashant Jain Loves A Good Crisis

India is a secularly growing economy. We are faced with changing headlines, locally and outside India. Most of these have little or no impact on the underlying economy. The economy is growing because of certain long-term demographic factors. Certain factors which have to do with competitiveness of country. India’s nominal GDP growth in rupee terms has been remarkably constant between 12-16 percent across different environments. Equities over long period are simply tracking the nominal GDP growth. But for short to medium periods, the stock markets are driven by sentiments. Not so much by economic changes or even by profit changes but by sentiment changes, which is even faster. It is hard to forecast sentiment. The sentiments for oil a few weeks ago were different than today. With Iran sanctions, everyone was worried and suddenly it changed overnight. So, stock markets over short to medium periods are hard to forecast. People have views, but I feel there is hardly any sanctity to these views. However, if you just focus on how stocks are valued with respect to over-valued or under-valued at a general level, then one can take a decent guess on the markets in the next two-five years. In markets today, price-to-earnings ratio appears to be a bit elevated and that is what most people focusing on. But market cap to GDP in India is close to its all-time lows. This divergence is due to an underlying corporate profitability in India is passing through a bad patch. In the last few years, large corporate banks and certain sectors have been experiencing lower-than-normal profitability. In such a situation, even at low price to books and low market-cap to GDP, the PEs appear to be elevated. There is good value in these markets. India is recovering very nicely. Macro economy is doing well, and markets are not overvalued. I am optimistic for the markets with a medium to long term view, but short term is always hard. It is futile to try and guess markets over the short to medium term.

The future is always uncertain. Nobody knows if foreigners will buy or sell tomorrow. In the current year, we have seen one of the highest selling by foreign investors in fixed income and equity markets. Markets have held up very well despite that. Few may talk about oil, but it is hard to forecast oil prices. As for elections, data suggests that every single election year since 1979, the markets have delivered positive returns in any fiscal year when elections were conducted. So, elections are a known event. Markets position themselves appropriately and most often conservatively ahead of the elections. When elections results are out, despite being contrary to your expectations, you realize that the linkage between elections and corporate profits is very weak, at least in the near term. You go back to the next quarter profits and valuations. These are events which cause uncertainty in minds of investors. I think, either these are random events or ones to which we don’t have a clear view of how it will impact the markets.

As to how should investors invest in this position? Equities are a very simple asset class. In short term, they are volatile. You can be down and up 10-20 percent. But, over a longer period, in the Indian context, they are growing at around 15 percent per annum, which is roughly the same as the nominal GDP growth. The Sensex was 100 in 1979 and today it is at 36,000. It is up nearly 360 times in 40 years. It is 16 percent CAGR. In equities, the key is to figure out what is the portion of our wealth which we don’t need for next three years or longer, and what is the portion of the wealth with which we can tolerate volatility emotionally and financially. We should invest that portion in equities. If you want to reduce near-term volatility, it is a good idea to spread your investments over months and years. But, the longer you wait to commit to equities, the longer you miss out on growth opportunities.

For equities, you need more patience than intelligence. A very average level of intelligence, but high degree of patience will work to your advantage. Most successful investors are the most patient investors. 100 has become 36,000. You needed a lot of patience and belief. Lehman crisis, 9/11, Brexit, PIIGS crisis came, tapering, elections came but the nominal GDP kept on growing. All these events came and went away. Markets have kept on compounding. Someone who has a right understanding of equities knows that these events will come and go but the economy is still growing. If one can sit through all the events, noise, volatility, then that person is the most profitable investor.

The U.S. is the largest economy and interest rates in the U.S. will impact capital flows globally. Higher those interest rates go, the more unfavorable it is for recipients of capital like India. The higher the rates go, it is negative in general for emerging markets. In the Indian context, we have seen very interesting development. In the last 20-25 years, every time the foreigners sold, the markets corrected meaningfully. They did not sell on most of these occasions because of challenges in India, but because of issues outside India. India is a fundamentally secularly growing economy. If the U.S. interest rates go up, it means Indian investments or other EMs become little less attractive. But the interesting development in India in the last decade has been the fast maturity of Indian retail investor because of efforts of funds, IFS, banks, media, and regulators. The Indian investor has understood and continues to improve his understanding about the long-term potential of Indian equities. This is why the rate at which SIPs are, they continues to grow despite all kinds of news, market corrections and volatility. First time in the history of capital Indian markets, despite a significant selling by FIIs, volatility was very limited. That is the power of local flows. Even today, a small percentage of local savings is getting into markets. I feel dependence of Indian capital markets on foreign capital would reduce as time goes by. What we have experienced in the last one year is one such good illustration of it. If the U.S. interest rates move up and foreigners sell, local flows should sustain to absorb it. But, if they sell at a pace which far outpaces the local flows, markets could correct. However, such phases should be short lived.

Put yourselves in the shoes of foreign investors. India is the world’s fifth largest economy. It is also the world’s fastest growing economy. Who can afford to ignore this economy? Foreigners may sell in India for some periods, but I don’t think they will shun the markets forever. Even if your cost of capital goes up by 0.5-1 percent, appreciate the gap between Indian growth and the cost of capital is large. It is not like investing in India is unviable. It may become less attractive.

Corporate facing banks are key as they are large businesses. What the banks have experienced in the last few years has impacted aggregate Nifty growth significantly. That is where the acceleration in growth will come from. Many have been saying that earnings will come but they have so far been elusive. When they come, they will make up for the entire period. In India, the corporate net profits to GDP has fallen from a peak of 8 percent in 2008 to under 3 percent.

In India, profit to GDP is near its life-time low. It will do a mean reversion and when that happens, you will see earnings growth catching up and making up for the lost years, too. The biggest reason for improvement will be in corporate banks.

We have come to end of an NPA recognition cycle and are now in the resolution cycle. Provisioning this year is likely to be lower than last year. Next year should be a near-normal year for profitability of these banks. When that happens, the Nifty growth should pick up very sharply.

No viable project which has reasonable equity to be committed is short of debt capital. Private capex is not recovering because the capacity of utilization in manufacturing was sub-optimal. It has improved significantly in the last two years. Infra capex has revived significantly, mainly led by government initiatives. Going forward, private and industrial capex will pick up because capacity utilization is now reasonable. It takes two-three years to put up capacities. One change has taken place in the last cycle and its that many private sector companies in certain areas linked to infrastructure have been damaged beyond repair. In those areas, I don’t think it is the government or its related entities which will have to step in, but this is what is happening. As far as manufacturing is concerned, I think capex will come back whenever there is shortage of supply.

Different people will have different views. Market thrives on diversity of opinions. For every trade, there is a buyer and a seller. The answer lies in sectors which are stressed but are growing. The stressed sectors are corporate banks, companies linked to private capex and industrial capex. These are the two sectors where the net margin is below long-term averages. That is where the biggest increase in profit should come from. There are certain sectors like FMCG, IT which are acyclical and grow at a steady pace. Nothing much has changed there, and nothing is likely to change. Sectors like metals, refining are cyclical. They will grow through ups and downs. Two years ago, the metals were in a bad shape. It has now recovered profitability, but it will always be volatile.

Retail banks are acyclical. Banking in India is acyclical since banks are an accepted way of parking savings. Deposit growth is quite acyclical. The cyclicality in banks comes from the asset side which comes from weak profitability. If corporate profits to GDP is near life time lows, if you have lent to companies, you will experience NPAs. That has brought cyclicality in corporate banks. It will recover along with profits. I don’t think there is any cycle for retail banks.

NBFCs are an important part of the economy. They lend to areas where banks typically don’t lend to like the non-salaried individuals, real estate, or certain structured capital market linked advances. They meet an important need of the economy by providing credit where banks don’t typically venture. However, NBFCs do not have depository franchises like banks. They rely on mutual funds or banks. That is vulnerable to tightness in liquidity or to a heightened risk of perception. We are experiencing one such environment.

For CPs, the key month is behind us. They have matured or rolled over. The regulators and the government is aware of the importance of this sector. This sector should come out fine. However, they will have to moderate or reduce the asset-liability mismatches which some of them are running. That could moderate growth rates for some time in this space.

A few year ago, when steel prices fell very sharply and touched two-decade lows, it surprised me. That has delayed the recovery in corporate banks. In the last one-two years, at least directionally, things have been moving more or less in line with expectations except for the recent sharp fall in crude prices. That took everyone by surprise. It depends on how you were positioned. If there are many hedge funds in the U.S. who have leveraged position in oil and some of them may have lost everything since markets expected oil to go up post sanctions. But, suddenly, few days before the sanctions were due, there were no sanctions. That must have caught a lot of people on the wrong foot.

It is tough to answer. If you look at the index, metals would be at three-four percent. So, metal companies are affected when metal prices fall. But, how much benefit of the lower metal prices is retained by automobile companies and how much is passed on due to competitive forces is something which is hard to forecast. Over longer periods, input prices tend to get passed on to end consumer. So, high metal prices will lead to more inflation.

A very sharp spike in interest rates in the U.S.. It could put some pressure. A spike in oil prices can also add pressure. But the impact will be limited to few quarters. India has experienced $100-plus oil prices in 2008. In early 2000, oil was at $10. So, if if it goes from $10 to $100, many said India will be killed. But that did not happen because the underlying forces of growth are stronger than the negative impact of oil prices. But it will dislocate things in short run.

From a stock market perspective, there is not much to worry since this is a secular economy and you are not overpaying. India’s market cap to GDP based on next year is between 60-70 percent which is low and attractive.

I was concerned about NBFC space as they grew too fast. When something grows very fast with some ALM mismatch and reliance on wholesale funds, it is vulnerable to some shocks. While it is causing us pain today, it is good that it happened today. If this would have happened three years later, it would have been a bigger issue. This stress was building up. I am relieved that this stress has been managed well by the system.

Having no elections is a far bigger worry than elections. If elections are welcome, it makes this country a successful democracy. There is no linkage between election outcomes and corporate profits. In India, we are fortunate that change of governments has not led to a reversal of the reform process. The pace of reforms has changed depending on the type of mandate, and who is in power. We have not had any meaningful reversal of good economic policies. At the time of elections, you may say different things. But, when you get down to doing things, the direction of reforms has been forward. This is not the case in all countries. This makes the dependence of stock markets and corporate profitability weak on election outcomes.

In the long run, if you manage the economy well, you can improve the growth rates. If you don’t manage it well, the growth rates will come down. The impact of change in government could be felt over the medium to long term but not near the elections, as is often the worry of people. There is nothing which we know about the elections and the market does not. It gets discounted. If the election outcomes are not to the markets liking, market may fall 5-10 percent. But will it impact returns after one-two years? I don’t think so. The best investments are made in the worst of times. Worst times could be weak corporate profitability, selling by FIIs, 9/11, Lehman or even adverse election outcomes which the market does not like. These events impact sentiments adversely. Markets do get corrected but over a period of time you realise that the actual impact on corporates and markets is low. These events create an opportunity to buy same assets for cheaper. India is growing at acyclical rate. Just focus on how the markets are valued, if they are expensive, cheap or fairly valued. One must focus on asset allocation and your tolerance for volatility.