On Thank God It’s Friday this week, we spoke to veteran independent market expert Ratnesh Kumar on the current market setup, the key triggers that will move the markets now and whether India will continue to attract more than its fair share of fund flows.
India In Early Stages Of A Bull Run
You have been associated with the Indian markets since the early 90s. Through your career, you have probably seen a lot of business and economic cycles. Which phase of the business cycle. Which phase of the business cycles currently India is in?
So one of the beauties about the market is that even if you spend a lot of time you don’t necessarily get any wiser. You have to keep learning; every day the market has new things to teach us. I would call the current phase as a bullish one. First and foremost, it’s not that the valuation is excessive. We have seen bull markets go haywire when the valuations become excessive. We are nowhere close to that. India has had its run, but so have most markets in the world.There are rainchecks happening on whether fundamentals are good enough, which is a healthy thing. But we are in the early-to-mid stages of a good bull run in equities.
Current Valuations Sustainable?
The Nifty is trading at a valuation close to or even above the valuations of some developed nations . Do you think current valuations are sustainable? Do you see an upside from there?
So valuation as a concept is never an absolute. It has to be looked at relative to our own history or relative to other markets – be it developed or emerging markets. Valuations are also a function of what sort of growth the market or companies can give. Right now, the long-term average valuation for Indian markets is around 15-16 times. Maybe we are about 10 percent ahead of that. It would not be right to compare some of the developed markets’ valuations to India’s valuation because the growth paradigm is entirely different. In India there is strong belief that the economic growth is there and hopefully, that will translate into better corporate earnings growth in the years ahead. So what I would say about valuations is, yes, it is above mean, our own historical mean. But we have also seen phases where valuations based on estimated earnings. We have seen estimates go wrong on the downside where the actual corporate performance turns out to be worse than the estimation. But we have also seen time periods when the actual performance turns out to be better than estimates. That 10 percent or so extra valuation which is there, eventually better than expected corporate performance, as the economy turns around, will make up for that. I won’t be that concerned about the valuations. Even in comparison to other emerging markets, what you do have currently in the world is paucity of growth...paucity of economic growth, paucity of corporate growth so the world money and markets are all fund flows are all co-related markets are globally co-related globally the equity liquidity is trying to find growth opportunities. India is one of them. Hence we are seeing good flows and that is supporting valuations.
What Will Drive Markets Higher?
Where do you see the next set of triggers that could drive the Indian markets higher?
So one beautiful thing about triggers, which can drive the market is, if I know the trigger applying some hypothesis, everybody would know that trigger as well. So it will not really be a trigger. So it’s a very usual thing that all of us discuss triggers. We also discuss it. If you look at the current situation in the market, the biggest triggers for the markets would come from where the surprises would come from, which is where I would look at not the immediate 3-6 months, but in 1-2 years, better than currently forecast earnings – that will be one trigger. You also have quite a bit of pessimism in terms of certain segments of the economy which are not doing so well like investment cycle etc. What you have seen is that the government sector has been investing but the private sector does not have the capacity to invest. So as and when the private sector enters the investment phase, that will be a trigger. It is a bit uncertain right now given the leveraged balance sheets in the private sector but as and when that happens that could be a trigger. But that would come after 2-3 years.
India’s Share Of Fund Flows
What is your view on liquidity which could affect fund flows in India? Will it be sustainable in the coming few years?
So liquidity from the market perspective has two components – domestic and foreign liquidity. Globally there are negative interest rates. On and off you hear concerns about when the U.S. Fed will start to raise the interest rates. But if you look at the past 100 years’ history of Fed hikes, in the initial phase of the Fed hikes, markets actually do better simply because why will the Fed hike? Because the economy is doing better. So then companies begin to do better. So there is empirical evidence that the initial phases of central bank rate hikes would not turn the tide away from equities, in fact, it will be helpful. It’s only towards the second half of Fed hikes, that’s when equities begin to suffer.
Within that context, as I mentioned earlier, there are very few growth pockets in the world. So India will continue to attract its fair share of, maybe better than fair share in the context of emerging markets, simply because we are in a phase where our growth is better, economically, and corporate earnings growth will come back. Domestic liquidity is an equally important factor. What you have seen in the last few years is that domestic liquidity, money coming into mutual funds, insurance..all those things have started to play a bigger role. At the end of it all, less than 10 percent of India’s financial savings go into equities. So for me, that is still a long process – of greater and greater domestic liquidity coming into equities. To give you a context on the other extreme, in the U.S., 60 percent of financial savings from households go into equities. We are at sub-10. So we have a long way to go. The mutual fund popularity which you have seen will only keep getting better. Over the next 5 years, so far as domestic liquidity is concerned, barring a few phases of ups and downs, I expect a secular trend of strong liquidity, rising liquidity over the next 5-10 years.
Earnings Cycle Bottomed Out
Next week will mark the end of the first quarter earnings season. Has the earnings cycle bottomed out and has anything particularly stood out in this quarterly numbers, in terms of positive or negative surprise?
Earnings have bottomed out. When and how much they will recover can’t be said for sure, but I believe it will be sooner rather than later. The forecast is that the earnings recovery starts this year. In the recent results season, there wasn’t much of positive surprise except the auto sector. But otherwise, a broad-based recovery is not visible because some large sectors like banks and commodities, which make up a huge percentage of the Indian corporate sector’s profitability, those numbers are down. Commodities are coming off a low base of last year so we can get to see better performance going forward, and for banks the expectation is that much of the baggage of non-performing loans has come through and may not worsen further. And that would support earnings. If we look at 3-4 different factors for earnings – one is the domestic cyclicals, domestic consumption areas like auto or construction, they begin to deliver better-than-expected earnings and some of the really worse-off areas like banks or commodities are coming off a low base so they will begin to deliver. So putting all that together, I am hoping that in the next 3-4 quarters, we are back to mid-teens earnings growth.
With the benchmark indices at close to lifetime highs, do you see pockets of value which still need to catch up?
Lifetime high is not a hindrance for me. If I have an asset and if it also grows even 5 percent every year, it will make a new lifetime high every year. But 5 percent return is not good enough for me, especially in an equity asset class, if I have to beat inflation in the Indian context and beat real growth in the GDP context, which means I must compound every year at 12-13 percent. So even with market volatility and ups and downs, a stock should be hitting life highs every year and crossing life highs. At this level of the market, we might still be at half the valuation of the previous bull market peak in 2007. That’s the beauty of earnings compounding. So I am quite optimistic. We have had a good run. It is a phase of consolidation where questions will be asked on valuations and earnings recovery support and if companies are able to deliver according to forecasts. But my belief is that eventually this will get sorted out and then when growth comes back, it will also come back as strongly as it went away.
IT Sector ‘Relative Laggard’
At the start of this financial year, you seemed to be positive about the IT space. A lot of questions have been raised on the growth outlook of this sector. What’s your view on the sector now?
So I believe IT stocks are looking less attractive because developed markets are a big chunk of IT companies’ business and it’s a good business but it has some growth headwinds right now. What would also happen in the short term is that political noise will extend maximum up to the end of this calendar year due to the U.S. elections. So we have seen in IT the phase of relatively lesser growth. In the domestic context when the economy is going up from the trough, domestic sectors tend to perform better initially till they catch up with other sectors that have done well. So IT has done much better vs domestic sectors in the last 4-5 years. So I would think that in the first 1-2 years of recovery, IT services will be a relative laggard.
The Consumption Story
What’s your view on consumer discretionary sector?
Consumer discretionary is a relatively smaller sector. Logic says if there is more money in the hands of the middle class, and you have pay commission and monsoons, this sector will pick up, but you will struggle to find too many stocks. So most white goods stocks are not listed but most of them should do well. The entertainment sector should do well and I consider it to be a part of discretionary stocks. Pockets of the auto sector will do well – two-wheelers and the affordable four-wheeler segment. The other part of consumption to look at is banking and financial sector. We have already seen retail credit is quite robust – whether it is housing finance or other areas. So as people’s income levels improve, that segment will continue to do well. So that’s another segment one can play on the consumption theme. As people’s incomes go up, they will feel better. Those who have equity will feel even better. So my proposition will always be to have more equity participation in India.
PSU Banks: Playing Catch-Up?
PSU banks have run-up much ahead of Nifty and even the Bank Nifty. Do you see any shorting opportunity there or PSU banks were just playing catch up in terms of valuations?
Earlier, PSU bank stocks fell too much. So if 80 percent falls and only 20 percent remains and then a 10 percent increase looks like too big jump. These banks have underperformed for a very long time in terms of share prices and that was for a variety of reasons. The NPL problem has been very big and it hasn’t gone away. The expectation now is that with the economy bottoming out, and with strong, decisive actions by various managements in terms of provisioning, that is making the market believe that a lot of clean-up is underway and hopefully things will begin to look better from here and on that basis, you see the stock price performance of PSU banks. And as of now, that is not discounting the improvement in operating and growth parameters. So if the growth and operating performance comes back, they would continue to perform positively from here also.
But if you had to choose between investing in a private bank and a PSU bank, what would you choose.
Let’s say, a year ago, I would have said 100 percent to private banks. But now it is at a stage where I would say maybe two-thirds to private banks and one-third to PSU banks simply because there are possibilities of improved performance and NPL cycle not getting worse. And valuations in that space are one third or maybe lower in some cases, so you have a valuation pick-up also. So now that is the way the mix would change.
Asset Classes Beyond Equities
Let’s talk about some other asset classes, if you’re talking about portfolio allocation, which other asset class other than equities should figure in a person’s portfolio?
The country as a whole, our current allocation for equities seems to be 10 percent and that is still only a percentage of financial savings. A majority of the country’s savings goes into physical asset classes like gold or real estate. So maybe of you look at the whole asset class, equities being currently accounted for, India’s allocation to equity for all their savings is probably just 5 percent. That is dismally low. So one of the things which I would definitely recommend to people is that it is very hard to time the market and equity is a fundamentally a long-horizon asset class so people at whatever stage of life or career they are in on a state-wise basis, they should continue with these allocations in equities and it is also a very liquid asset class. Now obviously other asset classes are getting liquid in terms of futures but real estate is not a liquid asset class. Beyond the house in which people stay so equities have a very strong case against all other asset classes. I would say my view is that for most people asset allocation depends on their own objectives and their savings and expenditure and it’s hard to say that how much anyone should allocate but one should have at least 50 percent of their allocation to equities.
So coming to your investment philosophy, who are the icons? What are the influences that you bring in your investment philosophy?
The world over you have a lot of icons. So the good thing we follow a lot of people. So its not just Warren Buffet but we have icons in India also. One hears from them a lot of wisdom, a lot of things they have learnt. One of the things that I follow very religiously is that ultimately, equity you are buying for the future. And the future is created by the management. Numbers that are there today are reflected in the present. Managements create numbers for the future. So the most important variable in equity investing is assessing the quality of management when it comes to its ability yto do well, its ability to work efficiently cost wise as well as capital efficiency and many times all of those things get reflected in a simple number called return on equity (ROE). There a lots of studies which suggests that a company which generates an ROE in excess of its cost of capital which means its not constantly asking for money or it’s not a capital guzzler, generally you find good sustainable returns from these kind of companies. That is one of my mantras so to speak. The management quality often times gets hugely captured in ROEs. Look at the ROEs, look at how the company has been able to sustain the ROEs for the last four to five years through ups and downs and that will result in a selection of good companies.
The RoE Threshold
So would be a good ROE threshold?
So in India let’s say your risk free rate is 8 percent or 7 percent which is your government bond rate. You add certain element of risk premium for equity. So an ROE of 15 percent or above is good. But in the whole market, there are plenty of companies with ROEs of over 20 percent and if you can find them at good valuations, those are the companies to buy over a period of time as an investment strategy.
Getting To Know Suspect Managements
So you partially answered my next question about how to find out if a management is good but how does one decipher if the management of a company is suspect and that we should stay away from the company or exit?
So nowadays especially for people who are good on the net and everything, there is plenty of information available for everybody to decipher where the management has made the right moves and where not. When the management quality is not good, the valuations are sometimes reflective of that. Remember that equity is not a mathematical balancing equation. So just because a company has a lesser valuation does not mean it is a better buy. So it needs to be investigated. Sometimes there could well be an opportunity or mispricing of a share but sometimes there are some factors which are evident behind the value.
Making Exits And Churning Stocks
So there is another question we get asked very commonly. People often know how to get into stocks but seldom do they know how to get out. So my first question is: do you believe in churning or do you believe in remaining in a stock for a really long t9me? Or if you are in favour of churning, how does one decide when is a good time to get out and move into another one?
I would equate that with the fact that all of us want to have a long healthy life. Even when one is thinking of living for an xyz number of years with family etc, you do have regular health check-ups. So even if there is a holding of good quality stocks, periodically it is good to do a health check-up as in what I thought about the company is actually turning out to be true. One of the most important thing to know in the market is I do not know everything. Market knows everything but I don’t know everything. So hence this periodic health check-up is I would say is good and every couple of quarters see what the company is saying and maybe it is not up to expectations but if the company is good and that is what your health check-up is suggesting then why would I want to exit? Then it makes sense to not get just because something has gone up by x percent of y percent. Whereas at the same time if something has not gone up by x percent and gone down by y percent then my thinking is not coming right what I assume then also sometimes there is a tendency is that if I did invest at 100 then I will only get out when the 100 comes back. That is a wrong strategy because sometimes there is a wrong decision made at some point in time despite all efforts then the best way to correct is to go for other opportunities in the market.
Most Admired Business Leaders
Since you have said that management is one of the most important factors in selecting stocks, just wanted to know if there are there any business leaders that you have admired over the years?
There are companies in India which have really done well over the years so you have the Tata group led by Ratan Tata. Then you have the IT services space where you have Premji, Narayan Murthy and they have created a lot of value and then you have the Reliance group. At the end of the day you have different phases for different groups but along the years they have demonstrated that they have different abilities to do well, fantastic vision, great execution with sustainability. These three-four names that I gave you, have delivered not just here but also in the world. And now there is a lot of entrepreneurial vigour which is in the e-commerce space so there are lots of people who are doing commendable stuff. Let’s see who ultimately gets where. So there are lots of people to admire there but let’s wait a few years. Being an equities man I have a longer horizon and let’s see how that shapes up. But What you find in India corporates in general, some of the parameters of quality are better than any emerging market. From your Bloomberg screens if you compare India’s ROE with Korea, China, and Russia or some other markets, you will find that we are much better. I just took some names that off-hand came to my mind but there are many more.