Oct 19, 2016 06:38 PM IST | Source: CNBC-TV18

Economy is embarking on strong earnings cycle: HDFC MF

The market currently is fairly valued, but equities will always be volatile in near term, says Prashant Jain, CIO of HDFC Mutual Fund, adding that one must invest into equities at any point the market corrects due to global reasons.

After last few quarters of muted earnings, the economy is ‘embarking on cycle of strong earnings growth for next few years’, believes Prashant Jain, CIO of HDFC Mutual Fund.

The last few quarters saw high stress in sectors like banks, metals and some engineering companies. The stress is reducing now that will push earnings for these sectors, the ace fund manager told CNBC-TV18 in an interview.

Jain added that he was confident that the fortunes of corporate loans-focused banks would turn around as the earnings cycle turns.

HDFC's funds have had high exposure to corporate banks such SBI and ICICI, a position that has hurt them over the past few years but has worked out well recently.

Jain is bearish on sectors like consumer staples and pharmaceuticals.

Below is the verbatim transcript of Prashant Jain’s interview to Latha Venkatesh on CNBC-TV18.

Q: Let me first start with the festive mood itself. I don't want to sound negative but the various CEOs we speak to are not talking about a huge festive buying. Is the economy kicking up?

A: We have to differentiate between the consumer staples and the consumer discretionary because consumer staples have reasonably high levels of penetration if we talk about soaps and shampoos and things like that. So, volume growth rates in that space -- it is logical to expect them to be quite muted for many years. On top of that inflation is low. So, the contribution of price increases to nominal growth is again going to be quite modest in this environment. That is what is probably coming out when you talk to consumer staple companies.

However, if you talk at consumer discretionary whether it is cars or airline tickets or even air conditioners, brown goods, consumer durables, I am sure you will get a very different message. So, low penetrated products will grow faster and highly penetrated products will grow slower. It has got nothing to do with the state of the economy or the consumer sentiment.

Q: Instead of asking you the overall earnings growth where will you see earnings growth in Q3 and Q4? In fact for that matter even Q2?

A: We are now embarking on a cycle of strong earnings growth for next few years in my opinion. What has happened in the last few years is that certain sectors have come under very high degree of stress, these were the corporate banks, the metal companies and one or two other sectors like construction and engineering. These are the sectors which drove down the aggregate Sensex earnings per share (EPS) growth because their earnings fell by half or more than half.

Now what we are seeing is that the stress in these sectors is steadily reducing every passing quarter and these sectors will achieve normalised profitability over the next two years. So, these 2-3 sectors should drive very strong earnings growth and that should lift the aggregate earnings growth for the broader markets as well.

Q: You have long kept your faith in the corporate banks and over the last few days we have seen banks like ICICI Bank absolutely shoot up 10 percent in a couple of days. You think there is more to go for these banks?

A: I am glad that you finally used the word corporate banks because everyone seems to be always saying public and private banks and we have always argued that the challenge is not public sector versus private sector but the corporate banks.

If you look back what is happening is something very simple. The lending by these corporate banks were secured and those secured loans are now being resolved because they are backed by assets and assets are getting sold.

Of course this process has taken longer than what one would have hoped for or desired but finally things are coming around and the resolution of the sale of the Essar Refinery particularly is one of the largest stake sales and it will resolve maybe between 10 percent and 20 percent of the total stressed loans in the system. So, this trend should sustain for the next few years and by fiscal 19, we should see normalised return on equities (RoEs) for the corporate banks.

Q: By what period you said?

A: FY19.

Q: My worry is that yes, all these stressed corporates, whether it is JP Associates or Essar Group or even Reliance ADAG are selling their family silver, their performing assets. How much would the promoters have made in Essar for instance? Probably not even Rs 10,000 crore. Will that be enough to de-stress the stressed areas. In any case Essar Oil was not the bank's problem, it was not an non-performing asset (NPA). Will it be enough to de-stress the money they make?

A: So, in bad times you will get good value on an asset that is not stressed, that is pretty logical. But it is wrong to say that the assets, which are under stress have no economic value or that the stress will last forever. So, steel is a cyclical business. Power demand today is weak. It does not mean that after two years the plant load factors (PLFs) of these power plants will not go up. So, these assets have values, which are much over longer periods. What will happen is this cash will be used to infuse some equity in these businesses and which should help you turnaround these businesses over time.

Q: Your banking sector allocation in several funds especially the big one HDFC Equity Fund is 30.9 percent. What is the split in terms of corporate banks and non-corporate banks and non-banking financial companies (NBFCs) maybe?

A: Bulk of the exposure in this fund would be to corporate banks, bulk of it.

Q: Would you want to increase it?

A: Yes, I don't want to get into that but all I can say is that in my opinion, my judgement our funds are extremely well placed and we have been positioning for this turn of things for the last few quarters and we seem to be quite well placed at this point of time.

Q: You said you are positive on corporate banks as well as consumer discretionaries. What would you not buy in the current state of the market?

A: As I have repeatedly said to you, consumer staples looks pretty expensive to me. Even pharmaceuticals I believe  the earnings expectations on a broad base or across the sector are quite stretched.

There could be individual companies which may do very well but on a broader sector level even pharma earnings are unlikely to be very exciting.

Q: What about market levels itself? We are seeing a repeated resistance at 8900. Do you think the markets have the legs over a one year period or may be even longer - 15 months period to break past 9000, to break substantially past 9000?

A: What is happening in the market is if you look at market gap to GDP of India, it is very attractive. We are trading at near 10 year lows but on PE terms the markets appear to be fairly valued or expensive and that is because the profitability of few sectors is under severe stress. Therefore when you look at aggregate PEs they appear to be not so cheap. However I think as I said earlier we are embarking now on a period of very robust profit growth. I think the aggregate earnings for the sensex may be slightly ahead of consensus over next two years.

So, this market has legs and it should do well. However at the same time the leadership in these markets is likely to undergo a change. If you look at last 5-7 years it is the consumer staples and pharmaceuticals which  have led this market.

I think now we are coming to a very different environment, low inflation, stability in exchange rate, low current account deficit, low interest rates, low fiscal deficit and capex is slowly but surely reviving and peak stress on asset quality is now firmly behind us. So, I think the leadership in these markets will change more towards may be cyclicals, corporate banks, engineering companies, consumer discretionary some or all of these sectors.

Q: What is your sense about NBFCs, that is the one that also has held leadership though they are not index stocks?

A: That is a very good space to be in. That is a sustainable space. They have a good business case and I have personally  missed that move. I think they should continue to grow.

Q: Even at current valuations you think the growth justifies a further buying?

A: It is difficult to comment but I think they are sustainable models. They represent  growing opportunities but they are not cheap.

Q: So, you expect this earning V shaped recovery in Q3? Q2 earnings are still not entirely with us, could we see some signs now itself?

A: I think they were ahead of estimates. Earlier after every quarter the earnings used to be cut. So, that phase is clearly behind us. Now I think we are in the phase of where earnings should see upgrades. If you look at metals, if you look at automobile discretionary companies, if you look at the corporate banks, earnings are seeing steady upgrades after every quarter.

Q: What about IT, never your cup of tea?

A: IT as we have discussed again in the past, I think it is a good sector, it is a globally competitive sector, very high quality businesses and I think it still represents growth. There are many growth opportunities in the world but on this base the growth rates will be more moderate compared to the past. I think multiples are also reasonable, not too demanding.

Q: What have you seen about the behaviour of investors itself. Has systematic investment plan (SIP) got reasonably entrenched? Do you think there is some continuous steam because of probably return of equity as a favoured class?

A: Clearly, we are seeing that and there is a secular underlying trend that because of collective effort of distributors, mutual funds, media, regulators the awareness about the potential of equities as a long-term asset class has been growing steadily for the last 2-3 decades.

Q: It took a setback during the 2009-10 periods?

A: That is a cycle within a long-term secular trend. So, it is a cyclical asset class and I am not saying that everyone is on top of things that people will invest when markets are down but underlying if you see on a secular basis the trend is upwards and within that there are cycles.

So, there is still a tendency to chase returns and people still want to invest in the best performing themes, the best performing funds over last one or two years but now with other physical asset classes not doing well interest rates coming down the flows that we are experiencing in the mutual funds are here to stay and they will grow over time.

Q: I know you don't like to comment on the near-term trends but do you think the market has a fairly firm support at 8,500. We seem to be bouncing off that mark repeatedly?

A: I don't know and I don't think it matters either because the smartest investors are the ones who have been patient. So, there are many funds in the country, which have delivered 20 percent compound annual growth rate (CAGR) returns over 15-20 years and longer periods. So, to benefit from that you need to stay invested.

I would say the markets are fairly valued and equities in the near-term are always a volatile asset class. If there are some global developments, which cause anxiety maybe markets can correct. But as we have said time and again whenever Indian markets fall purely because of global developments and underlying fundamentals are good, use these corrections as good opportunities to increase your allocations towards equities.

Go back and see Lehman crisis, go back and see tapering, go back and see PIIGS (Portugal, Italy, Ireland, Greece and Spain), go back and see Brexit. Each of these events have given good opportunity to invest in the same market, which is at slightly lower levels.

Q: I know your philosophy has been 'I don't care for the near term highs' but nevertheless there is a category of people who do.

A: I do care but I am not able to answer the question. I would love to say today markets will go up, tomorrow they will come down but I don't think either me or for that matter, anyone else in my opinion, is capable of forecasting the near-term movements of the markets.

For that you just have to go back and look at the track record of what has been said at different points of time and you will realise that there is lot of noise around but very little substance.

Q: I agree but at the moment we repeatedly get the scares from the global market. Would you worry about Fed rate hike or for that matter the European banks that seem to be even bigger threat? Can that sustain some kind of a longish down phase in terms of global risk appetite?

A: We have not given any money to European banks so India is unlikely to be impacted.

Q: But they can impact the psyche of FIIs?

A: Sure, that always the case and that’s what I said earlier. When Greece was taking place why was Indian market coming off, we had not given any money to Greece but it was just the sentiment towards equity which turns negative and to use that opportunity to buy more into India, because India fundamentally the economy, the company’s profits are not going to be impacted to any measurable extent by the problems of the European banks.

US Fed rate I think a 25 basis or a 50 basis hike over time I don’t think it will impact us meaningfully, because today our current account deficit (CAD) is very low so we are quite well placed and the growth momentum is with us. Our earnings growth will be very robust so if you are earnings are growing 15-20 percent even if the cost of capital goes up by quarter percent, half percent it is not very significant. But I would again say over the medium term if US Fed rate hikes interest rates go up significant then one should be at least mindful of that.

Q: Do we at least have to tweak our earnings expectations even in the sectors that you are talking about, that you are positive on simply because there is absolutely no help from global growth and even in India people continually talk about slack and lack of capex?

A: Capex has two parts, one if the infra part which is primarily being funded by the government and that is seeing a steady improvement. So, you can look at roads, you can look at power transmission and distribution, you can look at mining. Two year back people used to say we are short on coal, today it is not making headlines. So, we are seeing steady improvement in the railways area but private capital expenditure will still take some time because the capital intensive businesses are either sitting on surplus capacities or they are sitting in very low levels of profitability. So, it will take time to resolve. However I think by end of FY18 or before that we should start seeing signs of revival in private sector capex also.

As far as exports is concerned I have a very different view on this. I don't think for a economy like India the world GDP growth really is a determinant of how our exports will ..... (Interrupted)

Q:  Determinant but an impact.

A: It is a fallacy, it is a wrong impression which people have in my opinion. The global growth varies between let us say 3-4 percent. So, how can a 1 percent lower growth impact you by 10 percent? Bulk of the growth of Indian exports takes place by growing our market share. IT industry has grown from zero percent to USD 100 billion in 25 years, it doesn't mean the IT industry worldwide has grown by that much. We have gained share. So, as time goes by our exports will start growing  again as the currency becomes stable.

Our exports have been growing actually all along but in dollar terms because of the sharp depreciation of currency the dollar revenues of exports were very muted. I think we are going past that phase now.

Q: Finally, leave us our viewers with a Diwali number, what could be the equity returns in one year, in 2 years what can you think is possible under the circumstances?

A: See again I don't think it is possible for me to give you an answer, because I don't know the answer if I wish I had no problems in sharing, but I would say that the Indian economy is looking quite promising. Almost all the boxes you can take at this point of time and people just need to understand equities the right way and just be patience because this is one area of life where patience rewards you more than activity.
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