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Valuations Do Not Justify Where Markets Are Today: Andrew Holland

Most small and mid-sized companies are not prepared for GST implementation, says Andrew Holland

Valuations Do Not Justify Where Markets Are Today: Andrew Holland
Motorcyclists ride through a market in Ahmedabad, Gujarat, India, on January 11, 2017. (Photographer: Dhiraj Singh/Bloomberg)

Even as benchmark indices approach lifetime highs, Andrew Holland, the chief executive officer of Avendus Capital Alternate Strategies says the Indian market is already over-priced.

This week on Thank God It’s Friday, Holland says India is still on the path to recovery from the demonetisation pain, and then there’s the impending Goods and Services Tax (GST) roll out which will disrupt the economy further, for at least 3-6 months.

Here are edited excerpts from that conversation.

Markets Richly-Priced?

Indian equity benchmarks are moving towards lifetime highs. Broader markets are already at life highs. When does one start worrying about valuations?

I think we have been worried about valuations even when the market was 5 percent lower because earnings haven’t been catching up with the valuations. Most analysts are saying 20 percent earnings growth for financial year 2017-18. They have saying that for the last three years. I don’t think we could do 20 percent in a year. Valuations are at a point now where the risk is to the downside rather than to the upside. Our market has been dragged up by two things – one is global markets, but it’s not because fundamentals have changed in India but because global markets have been moving up. Second, you had a series of one-off events - whether it is HDFC Ltd. in terms of the (FPI investment) limit, talk of Axis Bank Ltd.-Kotak Mahindra Bank Ltd. merger, Reliance Industries Ltd. on Wednesday, and TCS Ltd. or Infosys Ltd...all of these are heavyweights on the index and helped dragged the market a little bit further along with global markets. But valuations are not justifying where we are today.

Earnings Trajectory

Adapting to Goods and Services Tax (GST) is going to have its own pain when it comes to earnings. Most of the downside of demonetisation has already played out. When does an investor start seeing robust, high double-digit earnings growth?

You said demonetisation is over, but meeting companies, there are some areas where they have got back to where they were in terms of trade since last year in November. But most industries are saying it is starting to pick up but it’s not V-shaped, it’s more U-shaped, they are nowhere near the levels they were at prior to November. And it’s going to take a gradual rise. And by the time they finish that, it will be time to implement GST. No one’s ready. The large companies are going to say that they are ready but I can assure you that the mid-sized, small companies are not ready. There are a lot of systems that have to be put in place. So this has real potential of halting the economy again...minimum three months. Possibly up to six months, but minimum disruption of three months. So what you are going to see is companies saying, ‘I’m not sure how the system is going to work’ and you’ll see de-stocking throughout the chain, to see how things start to move. You are not going to say ‘I’m going to buy all these cars on the basis that everything is going to be smooth.’ That’s another potential problem. I don’t see double-digit earnings growth depending on when GST is implemented. Let’s say it is implemented July 1. It won’t be until the January to March quarter in financial year 2017-18 when you start to see recovery in earnings.

Global Factors And The Rupee

We have some indications of what Donald Trump has in mind with respect to trade policies, but we are also looking at elections in Europe, specifically in Germany, France and Netherlands. What is the importance of these elections to Indian markets, if at all, and what does it mean for the rupee?

I’ll start with President Trump. Next week is an important week; he’ll be making a speech at the U.S. Congress which outlines what he will do over the next 4 years or so and that would include his big tax incentives. So, it’s a big week next week. The U.S. Fed came out last night and said ‘we are fairly sure we will do something’ without really telling us when.

In France with the election end of April and results in May, Marine Le Pen said, if she wins, that the French franc will come back, meaning France will go out of the European Union. I can’t say it that’ll happen, but let’s say it does, does that mean that Germany will go to the Deutsche mark? And then what’s left in the euro (zone)? Euro is probably going to Portugal, Italy, Spain, probably someone else. And the disruption that has for the weaker countries is huge. We have to watch the opinion polls as we get closer to see if the change that we saw because of Brexit, the change that we saw because of President Trump being voted in is going to play out in France as well.

Tepid Fund Flows?

India has been some recovery in foreign flows in February but it’s not as robust as the previous year. Will foreign fund flows remain tepid and could we expect them to taper going forward, when it comes to India?

One of the things we’re more excited about is the move away from monetary policy towards more fiscal policy – so fiscal spending – and alongside that lower cooperate and personal tax, that’s a global factor. That means that global growth will start to pick up. Rather than throwing money in and getting 2-2.5 percent global growth, with fiscal spending and lower tax, you could get 4 percent growth. India, from the foreign portfolio flow viewpoint, we are at the back end of flows. If I’m an emerging market fund, I’m going to buy South Korea or Taiwan, warrants on worldwide growth, because they are exporters. India is a domestic-driven economy so we are not going to benefit from that. So flows will go to those countries. We will get some because emerging market funds will have to have some weightage but it’s going to be a trickle. And also because valuations are so high and it’s difficult for foreigners to say ‘India is cheap’ because it’s not.

Transmission Of Rate Cuts

How much of the interest rate cuts can the banking system pass on, especially now that the RBI has changed its stance from accommodative to neutral?

Think about two things. One is that yes, banks are sitting on a lot of cash, so they can also bring rates down to corporates. But it’s not as though capacity utilisation is running at 80-90 percent. We are still at 60 percent. So, you don’t need to build a new plant; so there is no need for anyone to rush out and start borrowing from the bank. It might be more working capital. But the problem is this – PSU banks still have a huge problem on their books. So even if they could do deals - if you talk to some companies they say ‘we wanted to sell some assets but the banks don’t want to take a haircut’. So you are in this Catch 22 situation. The banks are not saying ‘okay, I’ll just take it off my books’ because now it’s going to be a problem for them in terms of capital ratios. So, the problem with the banks is the centre of this problem and no one is doing anything about it.

It’s evident that you’re not in favour of PSU banks as much as you’re in favour of private bank but how would you pitch that as against non-banking financials?

The non-bank financial companies will continue to do well. Here’s the thing, private banks will take market share from PSU banks, partly because of technology and strength of their balance sheets. Non-banking financial companies will start eating into their business as well - working capital loans and whatever else that PSU banks are trying to do. So they going to keep losing the market share unless they very quickly reinvent themselves, which doesn’t look as though they are going to.

Consolidation In Telecom

We are looking at a lot of consolidation in the telecommunications sector. We have Bharti Airtel-Telenor, Reliance Jio and Idea’s merger talks with Vodafone. It is a pattern that mergers could be to a certain extent beneficial for the sector but consensus ratings and target prices are not very encouraging. What is your view on the sector?

I am going to address the last part of what you’ve said. Most analysts were so negative because of Reliance. They just had no expectations of anyone making any money and therefore the target prices were quite low. Now all of a sudden we like what Reliance is doing and the market likes what Reliance is doing. This has been going on for a long time and it’s not that we have woken up to something new. And the consolidation is like two and two equalling four-and-a-half. I am not sure it is going to equal three. You are trying to put together very big companies and then they are going to say, ‘what do we do next. Then the battle begins again. So the battle might be over in the short term but war has not been won. Reliance will look at some of these mergers if they do happen and say ‘we need to something here to increase market share’.

When you’re merging, a lot of pain can be helped in terms of pricing and as the merger goes through you try to put in more cost to compete because you have got two companies out of which one is not doing well because of the competitive nature of pricing. As you try to merge and merge two different companies, two different ways of working, and then you still got pricing pressure, it’s the way that you manage to get market share and hurt competition. I am not sure I want to be ‘all is over for the telecom sector. It’s like saying consolidation is the best thing. If this was the case, then every sector should have consolidation.

View On The Information Technology Sector

What are the other areas in the market that you like right now?

I have been very negative on the information technology sector for a long time. One things that I said repeatedly was that the only thing that will start to excite me...see the valuations of IT companies, even before the recent run up, were too high, for what I believe is a commodity-type business. They are trying to reinvent themselves too in a changing world and it has not been working. You see volumes and revenues and margins increasingly under pressure.

So what would make me more excited are two things – if they increase the dividend yield and/or do some buybacks because you have not been able to do anything with yourself. We saw that with Cognizant and we saw that with TCS. TCS is probably more beneficial for Tata group. So this where Infosys and Wipro will probably have to do something. At the end of the day, when you look at companies where that decade of growth is gone, you ask ‘how do I value them now’? Now they got very strong cash flows so becomes like a utility. And no one pays dividend like the utility does. So there is going to be a switch. The reason for me to buy is if you are going to give me something, is it either dividend yield or growth or buyback. Now you can’t give me growth like you used to. So now give me yield.

Sectors To Stay Away From

Which are the areas that you would like to go short on?

It is increasingly becoming difficult. But, what I would say commodities have had a great run. I am not overtly negative, but I think there could be a little pain coming in the commodities industry. While we are all saying that global growth would pick up, I think there has been a lot of speculation on the Chinese market with commodities. I don’t see that strong a demand. They might have been oversold at one point but I think they are all very extended. So, I think commodities would be an area which requires hedging. Also pharmaceutical in that case, the important point is that a large number of pharmaceutical companies are not investing in pharmaceutical products due to lower prices. So is the border tax coming or do some of our pharmaceutical companies have to manufacture in the U.S.?

These are the things I think the market did not look at and decided to take the rosy part which is lower prices so I think it is going to be good for Indian companies.

Consumer Discretionary Versus Consumer Staples

A lot of people prefer consumer discretionary versus consumer staple because consumer staple is simply very expensive. But when you look at the valuations you see that it is not very different from discretionary either. So if one has to choose between the two, where would one stand?

It is a crowded tray of consumer discretionary and I am thinking that this is where I am supposed to be. But something has changed which made you think about what has changed. So I would say that Hindustan Unilever Ltd. was massively overpriced and that case had been for some time but may be after this they will have to look at things differently and how they are going to rationalise the businesses which will flow through to India as well. So maybe there is an extra leg of margin for growth here for Unilever going forward. That is the kind of thing that could make me more positive. Again, they don’t pay high dividends and they don’t do any buybacks. So something is going to change for me to pay that kind of a multiple. But this change could be the kind of change I’d look at and if Unilever is doing it that I can say that Nestle and others can also follow.