Valuations in India concerning: JPM Asset Mgmt

Richard Titherington, CIO, Emerging Markets at JP Morgan Asset Management said that for emerging markets in general, it has been only a pullback and emerging markets like China, India and Vietnam may have seen a bear market. He said that there is no disenchantment with emerging markets and some confidence is seen in long-term story. There are a few investors becoming risk averse but they are not yet disenchanted with emerging markets, he added. He added that some markets will tolerate inflation and commodity prices better than others.

On the big valuation differences, Titherington said that some companies would appear more vulnerable. He believes that India’s long-term story appears to be good, but valuation has been a worry. According to him, India is on the wrong side of the commodity and inflation story. The oil prices are expected to stabilise and fall in the medium-term, he said. The markets will stay stressful and valuations can fall despite strong earnings, he added.

Excerpts from CNBC-TV1's exclusive interview with Richard Titherington:

Q: What you have seen so far in 2008 would you describe it as a short pullback in a bull market for EM's or is it a danger that we are flirting with a bear market there?

A: I think for EMs in general, what we have seen in 2008 is nothing more than a pullback. EMs overall are only down 5-6%, I think you need to go more to the individual country level where as is always the case in emerging markets we see very big divergences in performances.

Q: Could you say that some of the EMs that you look at could be bear markets?

A: I think some of them have definitely had corrections of bear market proportions when you look at China and India, both are down more than 20% and I think that is a bear market. When you look at some of the smaller markets, for example Vietnam is down nearly 40%. So there clearly have been bear markets where the asset class as a whole has been remarkably resilient.

Q: Has there been any kind of disenchantment for global investors about EMs because that was the dominant theme for the last 4-5 years. Are people questioning the strength of EM performance now?

A: I think if anything the reverse is true - I think there is a lot of confidence in the long-term EM story. What has unnerved investors in the last year is the losses that they have taken in assets that they considered to be low risk. I think that what has been behind the credit crisis. Most investors understand that EMs are volatile and risky will go through periods when they go down, so I haven't seen any disenchantment with the asset class at all.

Q: So you are not seeing any kind of risk aversion with people who are overweight on EM saying we now need to scale down a bit, having burnt their fingers in the first quarter.

A: I think yes you definitely see some investors becoming more risk averse particularly on a tactical basis, but that is mainly people who have been invested in EMs for sometime and have done very well but even those investors, I would not say are disenchanted with Ems, they are just thinking about their overall risk profile.

Q: Do you see significant divergences in performance continuing through 2008 for EMs as a class as opposed to 2005-06-07, where most markets tended to perform very well, some did better than others?
 
A: Yes, I think you will some increased divergence for three reasons. One is as the asset class has become bigger and more complex; there is more room for divergence. Secondly, we are clearly going through a period of some economic stress particularly with rising inflation and rising commodity prices and some markets and economies will withstand that better than others and thirdly, you have seen over the bull market over last 3-4 years, big valuation differences build up and markets and individual companies that appear highly valued are more vulnerable, I think in this environment, than they perhaps were in 2006-2007.
 
Q: India perhaps is a case in point, where it has suffered considerably because of the valuation premium that it got by the end of 2007. Do you think enough of that has been skimmed off or further relative valuation adjustment needs to be made?
 
A: India, at the end of 2007, from a global emerging market perspective looked relatively expensive. The long-term story is very good, but my main worry was about valuation. Given the 25% roughly in US dollar fall in the market, I think valuation is much less over concerned today. But India is to a certain extent on the wrong side of the commodity and inflation story. So where as the economy and the market had strong tailwinds pushing it forward, in the last 18 months, if anything, it’s facing headwinds and a slightly tougher time now. But long-term, I think the Indian story is extremely strong one.
 
Q: How long do you think this trade can continue, users of commodities are suffering because of the spikes we have seen and producers of commodities are turning out to be the favourite markets, the equity markets?
 
A: The cycle could last for several years more particularly I think when you think about food price inflation where there has been little investment for a long time and it will take some time for supply to increase but I do not think that the current trend of rising commodity prices will last indefinitely.
 
Q: What about crude? Food aside, are you in the camp, which believes you are going to 200 or we are somewhere close to the top for crude? What's your own gut feeling?
 
A: I am in the camp where people do not like to make oil price forecast. I do not think that the market will remain as tight as it is today, indefinitely. So, I accept the rising demand story, a lot of which is coming from India and China, I do think over time, oil supply will increase, so I would expect oil prices to stabilize and fall over the medium-term. Could they spike higher? Yes, they could, but I do not see USD 200 is being a sustainable level.
 
Q: What is your biggest headwind for India according to you? Is it inflation, slowing growth or is it still valuations?
 
A: I think it is all three of those together. I think economic growth momentum has clearly slowed, that is inevitable. Even a high potential growth economy has a cycle, so I would expect India's economic growth to slow down on a cyclical basis.

Inflation makes it harder for corporates to turn revenue growth into profit growth as their cost come under pressure that is what you have seen with IT services companies. So I would expect profit growth to be a bit weaker over the next year or so. And the effect of those two things will put pressure on valuations. But I think all three are cyclical practices, they are not structural problems.
 
Q: How long would you expect the market to pause and adjust to all these factors before we can resume some kind of an uptrend in India?
 
A: I would expect 2008 to be a difficult year for the Indian market. If I am right in that expectation then 2009-2010 would look much more positive because valuations would have come down probably to below the levels that we see for the other major EM countries.
 
Q: Would you say the same of EM equities as a basket or not quite for 2008?
 
A: 2008, I think EMs are likely to continue to outperform developed markets.
 
I am not an economist and I am certainly not going to make any forecast for the US economy. But if the developed world, which is primarily driven by the US conditions deteriorate, that has to have an impact on EMs. I think that they can continue to do relatively well, but they cannot rise in isolation with global markets.
 
Q: So, the decoupling theory is being debunked in the first quarter? Has it, or are people still talking about it?
 
A: I think it depends what people mean by decoupling. I think that the decoupling story from an economic standpoint is certainly valid. When I first became an EM fund manager, if you had a US recession, you would have an EM crisis. You are not having an EM crisis. I think it is much harder to argue for financial market decoupling, because global markets are so interlinked and capital flows relatively freely around those markets. So I am less convinced of financial decoupling than I am of economic decoupling. 

Q: Do you see a lot of stress for emerging markets equities for the rest of 2008 because of further problems, or then intensifying in the US or is it likely that there could be some amount of earnings recession or severe earnings slowdowns in some of the key emerging markets?

A: I think that financial markets in general and I will incluse emerging markets in this will remain quite stressful in 2008. But I think your point about earnings is very important. I have more confidence about corporate earnings in emerging markets than I do about corporate earnings in the developed world. So if I am right, corporate earnings will come through for emerging markets and then our issue will be all about valuation. In a difficult environment, valuations can still fall, either PE ratio can fall, but I am quite confident about the earnings coming through.

Q: Do you see the possibility or the potential for some more PE contraction in markets like India and China, which have performed the worst in 2008 so far?

A: Yes, I think we can see more PE contraction. I don’t think it’s something that we need to worry about significantly because we have seen PE’s fall significantly. I think the bulk of the PE contraction has happened, but could it continue? Yes, it could.

Q: Would you say that this is a factor? If there is to be more contraction in PE multiples, would it be a factor of lower earnings growth or a factor of relative valuations, which are more expensive for the two markets we are speaking of?

A: No, I think it is much more a question of relative valuation. I am not really concerned about earnings, I am much more concerned about relative valuation.

Q: You have high confidence in Indian earnings coming through over the next four-six quarters?

A: Yes. My concern about Indian earnings specifically would be more at the company level. Individual companies have the capability to disappoint. I think the markets in aggregate earnings expectations are quite reasonable.

Q: Did you find when 2007 was ending that certain sectors in India had assumed bubble like valuations and if yes, have they adjusted enough in your eyes?

A: I think at the end of 2007, most investors were only focusing on the potential rewards from the Indian growth story were not thinking about the potential risks. There were a number of sectors that were in order to justify share prices everything needed to go well and people’s optimistic projections needed to come true. Whether you would call a bubble or not, I leave it to you. But clearly when we think about the balance between risk and opportunity, people were thinking mainly about opportunity and not about risk.

Q: Have you seen anything in the first three or four months of this year, which

have brought those risks to the fore? Any major earning slippages, unable to execute on the kind of growth that investors were expecting? Have you seen any of that come through?

A: Not major problems. As I said earlier, where India had a tailwind of rising economic growth, stable inflation, positive portfolio and foreign investor inflows some of those things are slowing down and this is a harder economic and profit environment. But I haven’t seen any major disappointments across corporate India and corporate India retains one of its key attractions to a global investor, such as myself in being on a whole very well managed. So my confidence in corporate India is unshaken and I certainly haven’t seen anything that is happened this year to make me reconsider that.

Q: What worries you about inflation because all the emerging markets investors that I have been meeting they are talking about inflation as the key threat for the emerging market equity performance. Do you fear that it might slow growth or do you fear that policy responses which might turn out to be mistakes in many countries including India?

A: There are two things, which I worry about. One is inflation is the biggest destroyer of financial market values. When you look back through history, inflation has been your biggest problem as an equity market investor.

Secondly and more immediately, are policy responses. What has been very beneficial for emerging markets in general and India is a very good example of this. Is liberalization, opening of markets, de-regulation and lessening of government control. Inflation raises the prospect of greater government control, greater interference in the economy and greater regulation. All those things are potentially negative.

Q: Haven’t you seen precisely that over the last few weeks in India?

A: We are starting to see it.

Q: Do you change your view on a few sectors because of what you have seen, some of the commodities etc, where there is more sign of interference?

A:  It depends on how long this commodity driven inflation goes on for and how serious the government intervention becomes. Government intervention is always a risk so something I always worry about. So I am concerned about what has happened recently, not just in India but many other countries. And if you were to tell me that this was to continue for the next 6-12-18 months, then I would be more concerned about it, but I don’t necessarily know that.

Q: What about Central Bank intervention, particularly in India and China? Do you see them being very active to control, in their control fight for inflation, against inflation with the interest rate too?

A: Government will use every tool that they can to fight inflation and Central Banks and monetary will be part of that. So I would expect that to continue. From my perspective, as an investor I would rather governments used Central Banks monetary policy to fight inflation rather than using direct government regulation and price intervention.

Q: Do you suspect that interest rates could harden more in India because that would have a direct bearing on how the equity markets perform?

A: Yes they could do. I think that is a possibility. That’s why we should be concerned about inflation. Inflation is the biggest risk in short to medium term to the Indian story.

Q: Are you underweight on all the interest rate sensitive sectors then because of this specific fear?

A: We look at investments on by a stock-by-stock basis. We obviously have to be aware of the impact of rising interest rates on the companies that we own.

Q: We had two-three or three-four years of close to 9% growth. If growth does slow down to sub 8%, how long does this cyclical phase need to pass before we can get back to that high growth trajectory in your eyes?

A: I don’t see a cyclical turndown lasting more than one or two years.

Q: 2009 you think, we could resume a journey upward?

A: I would hope so. As long as the overall international situation hasn’t deteriorated significantly; I don’t expect that it will do.

Q: What is the single biggest risk in your eyes to the bullish view that you have emerging market equities in general for the next few years?

A: The biggest worry that I have is a reversal of trend towards globalization. Emerging markets have benefited enormously from growing will trade opening of markets and the participation in the global economy of millions of people who were excluded from it in the past. That’s the driver behind the more rapid growth rate of the Indian economy that we have seen in the last decade. If that was to go away then we would to return to the situation of the 1970s and 1980s, then I would be concerned. I don’t think that’s going to happen.