Meanwhile, in case of PSU banks, he said that they could lose market share despite recapitalisation.
Even as doubts emerge over the short term prospects for emerging markets like India, Sukumar Rajah, MD & CIO, Franklin Local Asset Management told CNBC-TV18 that on a long term basis, investors prefer exposure to India.
In the near term though, it may not be the case. India lacks earnings momentum and we are not looking at stocks on a PE basis, he added. The parameters include a combination of discounted cash flow and implied growth rate.
Speaking on financials, he believes that we are still in a sweet spot with respect to private banks. “The market is expecting 15-20 percent growth for private banks over next 10 years and currently have 30 percent market share,” he told the channel.
Meanwhile, in case of PSU banks, he said that they could lose market share despite recapitalisation. He also highlighted that neither do they have competitive advantage nor solid analytics. Having said that, he expects corporate facing banks like SBI to hold on due to their deep relationships.
Below is the verbatim transcript of the interview:
Q: How are things right now? We have had a good year for Asian equities, for Indian equities. Do you worry about valuations or are you constructive as we at end of the year?
A: Valuation for a broad market is not a big issue. There are pockets of overvaluation in different markets. It can be different category. As far as emerging markets are concerned, they have more headroom; they have still been underperforming compared to the developed markets. The current PE multiples are lower compared to the long-term average which is not the case for the developed market necessarily. So I think emerging markets have more headroom to go and beyond that there is an opportunity for bottom up stock pickers. The market themselves might not give great returns but there is a lot of opportunity for bottom up stock pickers, they can still generate good returns even after the valuation gap is bridged.
Q: What do you hear from large global investors now because a couple of year back, in 2014-15 when we spoke to global investors, there seem a lot of scepticism about whole emerging market theme but this year we have seen quite a bit of inflows. I think USD 70-75 billion has come into emerging markets. Do you think that impression has changed that emerging markets will flatter to deceive; they will not generate the returns we are looking for?
A: The biggest change is the outlook on China. There was a lot of scepticism on China, a lot of US portfolio managers were betting that China would implode. That comes from not very deep understanding of how China works because the Chinese model is different from the rest of the world and so they were excessively pessimistic on China and when China didn't implode then there was a huge change in outlook towards China and consequently to emerging markets because China is the driver of emerging markets.
So my view is that the outlook of Western portfolio managers on China fluctuates; it goes from highly optimistic view to a very pessimistic view but the reality is always somewhere in between and to understand that is very important if you are an emerging market portfolio manager or an investor. So China, I think now there is stability but stability should not be confused with great economic outlook. I think the economic growth is still going to decelerate but it is not going to create collateral damage to the rest of the world but China stabilising changes emerging market outlook. If China was going to go down, obviously the risk associated with emerging markets was going to be high. Now with stability coming in China, the perceived risk of emerging markets is going to be much lower and even within Latin America some of the markets where there was a lot of concern; things have proved to be much better than what people were expecting.
Q: What does that mean for the commodity complex because that is one space which has done remarkably well from stock market perspective. Do you expect that to continue, the whole global material space?
A: The demand will continue to decelerate because China is the biggest consumer of most of the commodities and the Chinese demand for metals and generally materials is going to decrease because the capex as a percentage of gross domestic product (GDP) is very high and that will decrease over a period of time as they rebalance the economy. However, the positive news is that there has been more supply discipline in China which was lacking till 2015 and because of supply discipline the profitability of the commodity producers is going to be better than the pessimistic expectations but I would warn that people shouldn't become too optimistic because the demand environment is still going to be weak and they are not going to cut supply more than what is required if the profitability is not too bad. I do not think there are going to be further supply cuts but demand might continue to decelerate for a longer period of time.
Q: To takeoff from the point that you made about interest coming back to China. What about India because the anecdotal evidence seems to be that maybe a year-year-and-a-half back global investors were overweight on India and that overweight stance seems to have diminished through the course of this year, of course stock markets have done well because of local money. How do you explain that and what do you hear when you talk to people about India?
A: There are different types of investors. People would take a very long-term view. I think they continue to have a lot of exposure to India because that still seen to be the best long-term story and on bottom up basis there are a lot of companies which have delivered from a long-term point of view and sustained growth and profitability. On a more tactical basis, obviously India lacks earnings momentum whereas China and Korea, there has been very good earnings momentum which has forced people to shift to some of these markets in the recent past and when that changes you can expect some of them will shift back to India but when you look at the numbers that are coming on in terms of flows, people cannot differentiate between what is the motivation for the shift. So I do not think there is any change in view of people who are looking at the very long-term and their investment process is oriented towards buy and hold from long-term point of view.
Q: You, for many years, have seen domestic money and the interplay of that through mutual funds and you now sit in Singapore but Franklin Templeton Asset Management Company in India must have been the beneficiary of lots of flows this year like most of the asset management companies. In your eyes is this a cyclical shift that we are seeing of the likes that you have seen in the past or is there something structural as people are making it out this time?
A: We are seeing a structural increase in allocation towards equities. We are still, if you are looking at percentage of total savings, it's still in single digits and there is no reason why it cannot be 15 percent or 20 percent over a period of time and the savings pool itself was increasing. So I would expect that equity assets with mutual funds would triple every cycle and that cycle would typically be anywhere between five to seven years. So the domestic assets should continue to grow though. It might not be entirely smooth but it is also becoming less volatile compared to before because the systematic investment plan (SIP) has got on whereas earlier most people did not invest through SIPs, so the volatility was higher because of higher usage of SIPs the volatility is going to be lower.
Q: When you look at your India portfolio of the mutual funds there and when you see it as an important part of your Asian exposure, how do you gauge valuations relative to your earnings growth expectations?
A: We are not necessarily looking at stocks on a PE basis. When we are looking at structural growth companies we are looking at a combination of discounted cash flow (DCF) and market implied growth rate. So we do a reverse analysis based on the current price what type of growth has been imputed by the market and so we make up our mind as to whether that is achievable, whether it is pessimistic, it's realistic or optimistic. So that gives us good indication at many points of time.
Q: What does it say to such analysis about the growth that the market is pricing in?
A: It varies from sector to sector, for example information technology sector, we were one of the earliest investors there and we were one of the earliest to decrease our exposure. So we were looking at market implied growth rate; when the market was implying in double digit growth rate, we thought it was unsustainable three or four years ago because there are two major drivers of excess growth of Indian information technology sector compared to the IT spending. One is, higher amount of IT spending goes into outsourcing companies and within the outsourcing companies Indian companies gain market share. So there were two levers which were helping Indian companies to grow much faster compared to the spending on IT and we thought both the levers were going to weaken and so there was excessive optimism there. In the case of private sector banks we are still in a sweet spot. The market is expecting anywhere between 15-20 percent for the next ten years.
Q: It will come through, you think?
A: Yes because if you look at the market share of the private sector banks, it is still 30 percent and within private sector banks we have the higher quality ones and we have the lower equality ones. So the higher quality ones, there is no reason why they cannot grow at 15-20 percent because credit growth itself should have reached 10 percent. So compared to the system they are growing 5-10 percent faster which should be easily achievable considering that the market share is so low and the state owned banks especially are going to give up market share.
Q: You think still after getting capital as well?
Q: That doesn't change anything?
A: Not from a medium to long-term point of view.
Q: Why do you say that? It is a subject of debate back in India on whether public sector banks now get back into the game and whether private sector banking growth will slow down because now they will have competition which they did not have for two-three years?
A: When you look at their lending, for the retail they do not have the same use of technology and they are not attracting the type of retail clients especially the mass affluent etc, were going to the private sector banks. So they do not have any competitive advantages in the retail lending and nor do they have very solid analytics and information technology big data and so on.
Q: On the corporate side?
A: When you are looking at the corporate, there are some banks like State Bank of India (SBI) who can hold on because they have very deep relationships and they are a very big part of the consortium but if you look at the average state owned banks, they do not have either deep relationships because there has been so much of change of senior management of these banks and many of the companies which used to borrow from these banks' traditional clientele, they are not worth lending to; their family businesses which were not well run and they are all going down the tube. So from corporate lending point of view they do not have any competitive advantage, so if they speedup their lending, they might end up in a mess.
Q: So you won't be optimistic on public sector banks. Would you?
A: No. Except for State Bank of India; I think there is some rerating potential. So, on the average public sector undertaking (PSU) banks - no, not at all.
Q: The imputed growth point that you are talking about which you say that is sustainable for private banks, what the market is pricing in today, would you say the same of the expensive NBFCs where the market might be imputing 30-40 percent growth in some cases for the next 8-10 years?
A: There is a bubble there because many of them don’t have a differentiated processes and so they have been benefiting from the lack of lending by the state-owned banks and they are willing to take high risk but at some point of time some of them are going to implode. I am not saying all, some of them might be in niches where they have strengths in terms of it might be something to do with consumer durable lending where they have deep relationships with the dealers or things like that.
But for those exceptions, the average NBFC – there is no reason why they will be able to sustain these type of margins and credit quality.
Q: Where do you stand on this affordable housing theme, which has become very popular one in India with - lots of sectors have been rerated on the back of that, do you buy it?
A: There is a huge opportunity but to get it going is not that simple because we didn’t have large developers. If you look at China, there are so many large developers, each of them can develop so many times more space than our biggest developers. They are used to that. The land procurement mechanism is very rare, the provinces allocate land. So in India I think procurement of large tracks of land is a challenge. The ability of the builders to scale up is a challenge and then the pricing to be right is a challenge but I am sure the government is working on resolving some of those issues.
I do expect progress but I think the momentum to build up is going to take at least two-three years.
Q: One question on the capex cycle and how to approach industrials back in India now, what would you say is the right approach?
A: This is the problem I have with most of the people who have been complaining about capex. One thing they don’t understand is the basket of spending is changing. You and I – if we get more money, we are not going to spend on the same thing that we are buying 10 years ago. If we have automobile, we are still going to have an automobile, it is a slightly better quality automobile but I think the biggest change is in things like electronics. I just counted the number of Apple products I had at home and then in a family of three, we had 10 Apple products. There is going to be demand for that. If we can manufacture in India, there is going to be a huge capex opportunity and this is exactly what I was pointing out to the Finance Minister as well.
We need to have a programme, the Make in India programme, that should focus on what people need and electronics is something which people are going to need more and more. Both he consumers as well as the corporates. There is going to be more automation in every factory, it is not just the cement plants that we need, yes, we do need a little more of them, we do need a little more of the steel plants but I think the biggest opportunity is going to be in areas like these.
For these we have to solve many problems to have capex in these type of areas and when we solve them, there is going to be a big opportunity otherwise there is going to be some pickup but it is not going to be that big unless we get into areas like these.
Q: You spoke about a contrarian call in IT a few years back. What is your highest conviction contrarian call today in Indian stocks, either on the expensive side or where you were betting against or the ones which people do not like but you are happy to go out on?
A: At this point of time, it obviously depends on the price of the stocks. So the way the market is pricing in stocks in our India portfolios, our portfolio managers are underweight IT because when we look at the services companies, we do not think that the current market price is still overestimating the growth potential for most of the companies.
So we have made some beginning in property. We think it is going to be a big opportunity over a period of time, but traditionally, the corporate governance of the property companies was pretty low. Now there are a few companies which are trying to differentiate themselves. They should see a lot of opportunity. That is a space that we would like to watch out and invest more if more viable business models emerge. Retailing can be a big opportunity. There were a few failed retailing companies because they were too optimistic and they did not have very robust models but there are more companies which are going to try and test various models and some of them have successful formats which are pretty profitable and they are expanding. I think there is going to be good opportunity in retailing. There is going to be good opportunity in healthcare, but not necessarily selling the same type of medicines. It is going to be in terms of services, differentiated products, etc. So, these are areas that we are watching. Yes, private sector banks are among the large sectors.
Q: What about telecom? Are you willing to take a contrarian approach to that?
A: We took a view that there will be consolidation. For a while, we were right and then it did not work because one large corporate stepped into that field and then everything changed. Yes, there is going to be consolidation. Now it is going to become a three-player market, clearly. But, the extent of pain can continue for quite some time because when we look at Reliance which has entered, they are not going to be satisfied with the current market share. So they are going to play for higher market share and as long as they are playing for that, I am not sure whether the pricing can allow good return on capital. So I think there is a longer term opportunity, but it comes with a lot of risk and pain.
Q: For people who are buying stocks today, you mentioned in passing that maybe return expectations need to be moderated. Do you think it is a given that when people walk into mutual funds today expecting that the long-term return would be close to 15 percent a year, do you think that is being optimistic from this kind of entry point or should one set one's sights a little lower?
A: When we are looking at the world and India, equities are still very attractively priced compared to other alternative investments. So we are looking at the implied equity risk premium. In the long-term the equity risk premium is about 5 percent that means equity investors, to come into the equities, they were looking at 5 percent extra returns compared to fixed income. In most parts of the world, now it is 7 percent and India is also close to 7 percent at this point of time compared to the long term average of about 5 percent.
Q: The risk premium is 7 percent, so we should be expecting 7 plus 7 fixed income, 14 percent?
A: 7 plus 6 or whatever, so I think the implied cost of equity in India is about 12-13 percent. So, I think there is enough margin of safety in the current valuation in relation to debt, so if the cost of debt keeps going down, equities will become even more attractive compared to debt which means that there has to be a higher allocation towards equities. So I think equities are still globally and in India, very attractively priced in relation to debt and probably much better than real estate in any case.Disclosure: Reliance Industries, the parent company of Reliance Jio, owns Network 18 that publishes Moneycontrol.com.