Too much pessimism over IT; pharma still not cheap: UTI MF’s Subramaniam

Pessimism over the prospects of information technology companies may be overdone, feels Vetri Subramaniam, Group President and Head of Equity, UTI Asset Management.

In an interview with Moneycontrol, Subramaniam says the industry is not in dire straits as the market is making it out to be.

“The growth (in IT) rates have come off, but for most companies, the return on capital is high compared to other sectors and the cash flows are strong,” he says, adding, “the real challenge for the companies is how to deploy the cash flows; should they acquiring other firms in an uncertain business environment or be returning money to shareholders.”

Once the darling of money managers and retail investors alike, stocks of IT companies now figure way down the pecking order on buy lists. Revenues as well as profit margins in traditional offerings have shrunk dramatically, and it will be a while before the new business lines are able to offset that.

Over the last one year, the BSE IT index has risen a measly 1 percent, compared to a 18 percent rise in the Nifty 50 index.

“What we have observed in the past is that a new wave of IT spending in a domain or sector would help them overcome the challenge posed by the ebbing of growth in an earlier wave. You saw that with offshore development, Y2K, ADM,BPO,ERP, IMS….now there is no wave to lift the sector, or rather, the new wave is taking time in building up,” Subramaniam says.

But Vetri feels there are good bargains in the sector if one were to look carefully.

“Valuations are cheap, so the downside risk is low. If one has to choose between companies with high ROIC (return on invested capital), healthy cash flows and cheap valuations, and companies with low ROIC, weak cash flows and expensive valuations, the choice should be pretty obvious,” he says.

The other sector where he feels investors are being overcautious is pharma. Pharma has fared even worse than IT with the Nifty Pharma index declining 15 percent over the last year.

“The twin challenges for the sector is quality issues and deflation in generic drug prices,” Subramaniam says.

“Deflation is de rigueur in the pharma sector when it comes to prices of generic drugs. The only way you can offset it is through new product launches. But quality issues have reduced new launches and have limited the ability of companies to do that,” he says.

The key difference between the IT sector and the pharma sector is that most pharma shares are not cheap in absolute terms, he feels.

“Unlike IT shares, which are cheap in absolute terms, pharma is a case ‘cheaper’ than historical metrices. The stocks are certainly cheaper compared to their highs, but not as cheap as IT in absolute terms,” Subramaniam says.

And while there are decent bargains in both IT and pharma, Subramaniam says that investors need to analyse the companies rather than taking a sweeping call on the sector.

“The challenge in stock selection is that when the cycle turns (for the better), the new leaders may be different from the existing ones,” he says.

At the broader level, a slowing economy and muted corporate earnings growth are the key worries for investors at this point. Following the steep decline in the June quarter, many leading agencies and broking firms have trimmed their GDP growth forecasts for the current fiscal to below 7 percent.

Subramaniam feels the latest readings of high frequency macro indicators like steel, cement and car sales raise hopes that a gradual recovery could be underway.

“For the economy the challenge remains growth acceleration, given that the two main engines—investment and exports—are not firing,” says Subramaniam.

“Consumption growth is a strong feature but it is good if jobs, income are being created and people have disposable income to spend. Consumption driven by borrowing alone can support the economy only so much,” he says.

The government is in a bind, as the fiscal deficit has already reached 96 percent of the full year target. To stick to the 3.2 percent of GDP target, the government will need to cut back on spending. Already with corporates reluctant to invest because of debt problems and weak demand, a reduction in government spending will further aggravate the slowdown. At the same time, the RBI has warned the government against announcing a stimulus package to get the economy moving.

“That (Infra) is also the only sector right now which is capable of creating jobs in a big way. Unfortunately, infra investments are largely tied to government finances, and the government does not have money to spend,” Subramaniam says.

Strong inflows into mutual funds have helped offset persistent selling by foreign institutional investors. But that is also raising concerns that retail investor money is fueling a bubble in the market at a time when valuations already look expensive.

Equity mutual funds attracted over Rs 80,000 crore in April-September this year, a three-fold jump compared to the inflows during the same period last year. Market watchers feel there is a gradual shift underway in household savings away from traditional asset classes like real estate and gold, into financial markets.

Subramaniam feels fund flows are being “over analysed” because eventually fundamentals will decide the stock price.

“Equities as an asset class is still under owned in India,” he says. “Entrepreneurs need risk capital to drive new investments- where are you going to get that from, if not from the equity market.”

Also, he feels that there is a marked difference in investor behavior this time around compared to the previous bull markets.

“In 2000 and in 2007, you saw investors put in a big chunk of money at one go in tech and infra schemes or even diversified schemes. When the market corrected, mutual fund investors saw their returns suffer for many years. But this time, a lot of money has come through the SIP route.

If you stay with a scheme for five years through the SIP route you will be catch both the highs and lows of the market valuation cycle. This enables you to better handle a correction in the markets as opposed to making a single investment at a single point of time; often at very often at high valuations. The latter has been the cause of big drawdowns and negative experiences for investors in the past,” he says.