We are clearly a couple of years away from peak equity valuations

By S Naren
Economic Times
August 02, 2017
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Peak earnings will come in the next few years and worries that a rapid rise in earnings growth could make valuations lose touch with reality

The market has been moving up almost one way from Feb 2016, with the Nifty moving from 7,000 to 10,000. Is the rally overdone?

Actually, we try to look at the market on four parameters, namely valuation, cycle, sentiment and triggers. Today, on valuation basis, we are in a situation where on a price-to-earnings (PE) basis we are costly; on price-to-book (PB) we are above average; on market cap to GDP, we are just above average and if you look at interest rates and take the inverse of interest rates and earnings yields it is slightly above the average. So on a valuation basis markets are not cheap but not extremely expensive in our framework.

On the second parameter, namely cycles, we are clearly two years away from the market top. From a cyclical perspective, the market is at a top when capacity utilisation is high, interest rate cycle has turned and there are only chances of rate hikes. On that basis it looks like it will take two years for the capex cycle to come and for capacity utilisation to be higher than where we are.

On the third parameter, namely sentiment, you have to be careful. Foreigners are investing and domestic investo s are investing with gusto. So sentiment is the most worrying part. In December and January, FII flows were negative, but now locals and FIIs both are investing and locals are investing with gusto.

Finally, on the last parameter, namely trigger, I believe till earnings come we are safe. The moment earnings come, that is the time when you have to be most worried. Earnings growth is the biggest risk to the market. Bubbles get formed when you have excellent fundamentals with irrational extrapolation. So what worries me most is earnings coming quickly. The day it comes, investors will give high multiples on high earnings and make their biggest mistakes.

Where are you allocating money now?

Oil PSUs, power PSUs look very cheap at this point. These are the only few sectors trading at 15x trailing price-to-earnings and with a price-to-book below 1.5. Six months back we were bullish on telecom, but they got re-rated. Some of the corporate banks are in the process of re-rating.We have had four years of money coming in, so there is no cheap bargain. We are not in a phase of risk aversion.

You are in the fourth year of continuous money inflow, so pockets of deep value do not exist. Three sectors have not moved up namely IT, pharma and PSU banks.Each of these areas has its own fundamental issues in the short term. In case of IT, it is growth; in pharma, it is the US FDA issues; and in PSU banks, it is the NPL problems. The one which we like most is pharma, because pharma as percentage of GDP goes up as a country prospers, and we also feel the FDA issues will be resolved over the next two years. However, pharma was very cheap in 2007, but not very cheap now compared to that time.

SBI cut savings rates on Monday. Many of the smaller PSU banks have been hit by NPAs. Can the smaller PSU banks survive?

Indian banks are an unconsolidated industry with a fair amount of competition from NBFCs. Challenge exists for all the smaller PSU banks. Since they are sovereign, it is easier to collect money. Its only on lending they have to do a good job. They have to create a good business model and able to become more local and focus on SMEs as an area and handle them well, it could be a good area. The moment the government supports them and gets them out of this problem of NPLs, there is scope for banks.

Retail investors are pouring money into equities. `4,850 crore is flowing into equities through SIPs every month. What has changed? Can the flow intensify further?

Corporate profit as a percentage of GDP has come down from 7.1% to 2.9%. We believe this 2.9% will go to 4%, which means a 30% growth. There will be a cyclical rebound in earnings. You have high ROE, high PE stocks now in Nifty. Today equity is in a TINA (there is no alternative) factor.In India, investors have a feeling that anything that gives less than 8% is low. Hence you have reached a TINA situation, driving money into equities.

SIPs can go even higher, but it is important for us to communicate to investors, that past returns were high and this may not be replicated in the future. From these valuation levels, threeand five-year returns will not be high and are a worry; while one-year returns will still be high. How to make investors understand this is a challenge. The structural fundamental problem is that there is no alternative asset class. As investors, we would like to see more volatility. We have seen five years without a 10% correction. When we tell investors that equities are riskier than debt, they say show me a 10% correction. We would like to see volatility, as that will ensure investors remain careful. In 2015-16, there was volatility, so people realised the risks. If markets go up fast, people violate risk rules and that causes a correction.

What is your call on the market now? What should investors do?

Invest more carefully as the market goes up. The general perception among investors is that when it goes up, you tend to invest more recklessly.If you take any road signal, you have green, red and yellow. In green, valuations are cheap, now valuations are not cheap, so you are in yellow. Red is when you hit a bubble, we are not seeing signs of a bubble yet. In yellow, you have to look around and be careful, you cannot invest blindly.

We have been marketing our dynamic asset allocation funds which are hybrid funds having a mix of debt, equity and arbitrage. We believe that the equity cycle will peak when capacity utilisation goes up, a few years later. Already the market is accounting for earnings growth. The lesson of every boom is that people forget asset allocation. In any boom, the single rule people should apply is do asset allocation. We are no longer in a phase where we can invest only in equities.

Financials are a large part of the Nifty. Can growth continue there?

One of the worries is that two years from now, it is possible that 40% of the benchmark will be in financial services. That worries us because historically whenever any sector touches 40%, that sector turns volatile. When money goes out of the market in the future, they will have to sell financials and that will lead to a situation where the sector becomes high beta. The fact that 35% of the Nifty is in financials makes it a riskier sector, that is our worry. The near-term situation looks good, but the high weightage makes us worry about the beta of the sector. We had a thesis that while interest rates come down and credit growth does not pick up, financials will not do well. We feel that the inter est rate cycle has only 3-6 months to go, after that the leveraging cycle will start. In that cycle, banks will do well.Hence nearto medium-term outlook for banks is good. One of places where we feel profits will rebound in the next 2-3 years will be financials.This is because NPL recognition has happened, provisioning will happen, it will peak and then come down. So the medium-term outlook is good, and the long-term outlook is dependent on how equity markets move. If equities see a correction, financials will participate in that correction.

What is your biggest worry from the market perspective now?

If people say equity is the only asset class and say we want to invest all our money only in equities and not in other asset class. Investors should follow asset allocation. A lot of the money which is coming in is coming in hybrid funds which have both equity and debt. However, the good thing is that there are no big flows in midand small-cap funds.

How are the macros looking?

In my 28 years of working, I have not seen a better macro picture. You have low fiscal deficit, low current account deficit, low inflation and a concerted effort to reduce wasteful subsidies. I have seen 1991 and now.

You have low fiscal and current account deficits, low inflation, concerted effort to reduce wasteful subsidies, a low credit growth environment. I would want to see a weaker rupee and lower interest rates as these are important to stimulate production and exports. In August 2013, the rupee was at a higher level than today, so the rupee has appreciated since then and there is clearly an inflation differential between India and the US.I believe that $390 billion of forex reserves is more than what India needs.We can have lower foreign reserves and lower debt.

Are you worried about the short-term disruption due to GST?

GST will create a national network.With all the steps the government is taking to speed up logistics, etc the positive impact of GST over three years will far outweigh the short-term problems. India has launched it at a time when it is easier to get an internet connection. It is easier to implement from a technology perspective.

This article was published on August 02, 2017 in Economic Times