The Indian capital market is facing challenges from all sides. What strategy in terms of stock picking and sector allocation do you have in mind to make the best out of this situation?
We are in a situation where macros are weakening and micros are improving. From the global macros perspective, the ongoing quantitative tightening is having an impact on rate and liquidity, especially in emerging markets. Moreover, the escalation of trade war amidst this tightening cycle is making things tougher. As a result of quantitative tightening, globally the rates are moving up and emerging market currencies are weakening. India is not an exception to this phenomenon. Our benchmark 10 year yields have risen over 120bps in the last one year itself. And the Indian Rupee has been the worst performing Asian currency this year, having corrected ~14% so far. Apart from global factors, Indian macros numbers look vulnerable too. ~95% of full year targeted fiscal deficit has already been reached with GST running materially behind required run rate. Given the sustenance of this super cycle of quantitative tightening and strained government finances,we have built a more defensive portfolio with overweight in IT, Pharma and underweight in Non Banking Financial Company(NBFC), PSUs. Within the sector, our preference has been for market share gainers and steady compounders with relatively better operating efficiency, better capital efficiency and lower financial leverage.
What are the challenges facing the NBFC sector based on the recent Infrastructure Leasing and Financial Services Limited (IL&FS) bond crisis? How should the investor manage this?
In the IL&FS crisis, the company failed to honour its payments to mutual funds on time. The fact that this was a AAA rated paper till recently resulted in the paper being present in many liquid and debt funds. Risk aversion resulted in liquid fund AUM dropping 35% mom and liquidity dried up wherever the book was even slightly suspect. This has especially become troublesome for NBFCs that were running a negative Asset Liability Management(ALM) gap in the shorter buckets implying liabilities were maturing before assets in the near term. This led to a spike in CP rates. Banks may do more securitisation transactions providing some liquidity to the NBFCs. However, if the tightness in liquidity persists, it may result in another credit event. As investors, we have been underweight in NBFCs and have only held positions in NBFCs where the ALM is well matched and those who have managed asset quality cycles well and thus have no perception issues. NBFC stocks have corrected by over 30% in the last few weeks, with rising concerns on liquidity.
I believe expectations on NBFCs may have to be toned down on account of (1) softer margins and (2) slowdown in loan growth rates. Even if one were to analyse the impact of a 100 bp increase in market borrowing rates, and halving of near-term growth rates from current levels, most NBFCs profit estimates for FY20 would fall by over 20%. With slower growth, if one were to factor in lower valuations, then it can be concluded that the recent fall is not capturing the above effects yet.
The growth numbers are clouded for NBFC sector, funding gaps are visible and valuations are still not capturing the same. In a rising rate scenario, owing to absence of CASA, the NBFCs have lower competitive advantages relative to banks. We have been underweight on the sector and still find the risk reward unattractive.
Can policy reforms help avoid the impact of business cycles on the economy? Do they benefit or harm the market? What’s your view from an investor perspective?
A developing economy like India with a per capita income of under $2000, needs policy reforms on a regular basis. A lot of times the policy initiative is good, but the implementation leaves a lot to be desired. The idea of GST was absolutely fantastic, however better implementation could have seen higher collections and smoother transition, thereby contributing to the growth of the country. Policy reforms like Insolvency and Bankruptcy Code are extremely critical for a country like India which has average recovery rate of ~26% in case of default (vs 80%+ for developed countries) and long time to resolution of over 4 years (vs less than 1.5 years for developed countries). Sometimes reforms are rolled back under financial compulsions. E.g. the fuel price deregulation announced in Oct’14 was virtually undone by asking OMCs to partially bear the price cut recently. There is little doubt in the fact the policy reforms make the economy stronger and more resilient, which in turn is positive for markets. However, it is extremely difficult to establish a short term correlation of policy reforms with market impact.
Your large cap fund holds a considerable allocation towards IT and Pharma. Considering the favorable situation on these export dependable sectors, do you have plan to increase the exposure in the near term? What are the hurdles in the short term?
While we are positive and overweight on IT and Pharma, we also note that these two sectors combined have over 35% weight in our Large Cap Fund vs Index weight of about 18% – that’s a significant overweight. Applying risk management prudence, there is little room for me to add significantly more weight from here on in these 2 sectors.
The IT sector is up 27% this year compared to a flat Nifty. Given this kind of run up in such a difficult year, the sector does carry the near-term risk of profit booking. However, on a one-year forward P/E basis, the sector trades at only 2% premium to Nifty vs 10 year average of 9% premium and 7 year high of 39% premium. Hence, we are comfortable with valuations here.
The Pharma sector had been grappling with regulatory hurdles with observations/import alerts by United States Food and Drug Administration (USFDA) seen in the last few years. As a result of these hurdles and price erosion in US, the sector had been a key under performer for last three years. However, with regulatory hurdles abating, price erosion stabilizing and valuations having corrected, we continue to find the risk reward attractive for Pharma. Rupee depreciation is an added catalyst for both IT and Pharma. However, increase in regulatory hurdles and further price erosion in US can impact the earnings growth in pharma companies.
Your large cap fund also holds a high allocation towards the financial sector, especially the private banks. Along with this you have increased the holdings towards the banking sector recently. What is your outlook on the banking sector with an investment period of three years?
Financials have a weight of about 35% in Nifty. Within this, about 25% is weight of Banks and 10% is for other financial services. Against the 35% of Financials, Large Cap Fund has a weight of ~27%, that makes Financials a key underweight. Within this 27%, Banks account for about 22%, NBFCs ~4% and Insurance ~1%. As mentioned earlier, in a rising rate scenario, Banks have the cost advantage vs NBFCs due to presence of low cost Current and Savings Account ratio(CASA). Hence, we prefer Banks over NBFCs in this rising rate cycle. The Banking sector’s credit growth has started improving, now standing at close to 4-year highs of over 13% (having seen multi decade low of 3.7% recently). With the NBFCs now facing liquidity and funding issues, Banks would have an added advantage. Within Banks, we note that private sector banks have been steady market share gainers, have consistently reported better operating and capital efficiency too. Hence, within banking, we are significantly tilted towards private sector banks (zero exposure to PSU Banks as on 30-Sept-2018). Within private sector banks, so far the retail lenders have led from the front. However, we do see attractive risk reward in private corporate lenders too.
What is your outlook on Indian Rupee against Dollar during the next one year and what are the challenges it can exert on an equity portfolio?
As discussed earlier, world is witnessing quantitative tightening cycle unfolding in front of itself. With US leading from the front, it has been hiking its rates and selling its bonds. As a result, we have seen significant strengthening of US Dollar. All emerging market currencies have suffered losses and so has India. A closer look at Indian macro fundamentals reveals that India’s import cover has fallen to nearly 4 year lows of 8.9 months. The June quarter BoP deficit stood at USD 11.3bn – which was highest since December ’11. As long as our import cover is weak and BoP is in deficit, Rupee is likely to remain under pressure against the Dollar. Our portfolio is geared up for this. With over 35% exposure to IT and Pharma and over 9% in largest private refiner, our portfolio would benefit with strengthening dollar.
In current scenario, how do you manage the market cap allocation in your portfolio?Would you shop for more large caps or those battered mid caps to gain higher alpha?
Quantitative tightening + Escalating trade wars = Tough Global Macros
Rising Crude + Expanding Deficits + Weak Rupee + Rising Rates = Vulnerable Local Macros.
With macros remaining under pressure and liquidity moving out, smaller sized companies may find it more difficult to cope with the macro variables going against them.
Moreover, despite the correction their relative risk reward is still not favourable. On a trailing P/E basis, Nifty Mid cap 100 currently trades at a 56% premium to Nifty Index vs historical average of 6% premium.
Hence, we prefer Large Caps over mid / small caps at this point in time. As of September ’18, our Large Cap Fund had less than 5% exposure to mid/small cap stocks.
The auto sector is going through lot of regulatory norms in the recent period along with the conversion of fossil fuel into EV. Further, recent data shows a drop on the sales in this sector. What is your outlook on this sector with a long term perspective ?
The recent decline in sales in auto volumes was due to a few factors: 1) Kerala floods that coincided with the festive season (Onam) hampered sales for many OEMs where contribution of Kerala to volumes is material. For e.g. Maruti and Royal Enfield. 2) Later festive season in rest of India compared to previous year resulted in muted yoy growth in September. 3) Increasing cost of ownership with higher fuel prices and upfront insurance cost for three years in cars and five years in two wheelers. While the first two causes are transitional in nature, the impact of the third reason has been somewhat mitigated by Insurance Regulatory and Development Authority’s (IRDA) clarification that the upfront insurance is mandatory only for third party cover and not personal accident, lowering the upfront cost.
India’s stance on EVs has changed multiple times and there is no formal policy for EVs. Widespread adoption of EVs in absence of supportive policy measures appears difficult. Passenger Vehicles in India is a segment that will continue to see increasing penetration and benefits from premiumisation and uptrading. Commercial vehicles are a cyclical business but room for penetration remains with improving highways. Two Wheelers(2Ws) are a highly penetrated market and hence will continue to be cyclical with some players capitalising on the premiumisation/scooterisation trends. However higher ownership cost has been material as % of vehicle cost for 2Ws due to the upfront insurance. Additionally, prices will increase from April 2019 on implementation of braking norms exerting further pressure on affordability. (by INR 500-700 for less than 125cc and over INR 2500 for more than 125cc)
India 4-wheeler industry is one of the largest in the world with annual domestic sales volume of over 3mn units in FY18. The sector has been growing at near double digits sustainably. Yet, car penetration in India is abysmally low at 2.4 per 1000 people compared to 16.7 in China, 28.7 in EU and 193.7 in US. With per capita income now nearing $2000 mark – its likely to prove to be inflexion point towards discretionary spending, and cars/bikes are natural beneficiaries.
We expect auto sector to do well in India as we attempt to reach a penetration level closer to our neighbours. Hence, we continue to be Overweight on Auto.
In case of a bond default like what we saw in recent past, what portfolio decision should an investor take, and why?
Bond default like the recent one is a rarity. I do not remember a AAA-rated company defaulting earlier. Hence its nearly impossible to predict such six-sigma event. However, the more pertinent step in a scenario like the current one is to asses the credit quality of the remaining portfolio. In these times, one should stay with quality papers and have low portfolio duration.
What should be the ideal allocation towards international schemes, in one’s mutual fund portfolio? Recent performance has been good for US and Europe based schemes.
While I agree that recent performance has been good for US and Europe based schemes, we must note that driving by looking into the rear view mirror often leads to accidents. A small allocation to international schemes for diversification purpose is always welcome. However, extrapolating recent performance to form expectations is not an advisable thing to do. Having said that, exposure to international schemes may enable the investor to participate in themes which are not present in India [like the Facebook, Apple, Amazon, Netflix and Google (FAANG) stocks, disruptors] apart from benefiting from potential rupee depreciation.