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May 31, 2017 01:04 PM IST | Source:

See midcaps correcting; like retail banks, auto: Motilal Oswal MF's Gautam Sinha Roy

In the near term, the government will try to keep the impact of GST least disruptive as possible

The rally in midcaps stocks may end soon as correction in the midcap scrips is on the anvil, Gautam Sinha Roy, Equity Fund Manager at Motilal Oswal Mutual Fund told in an interview to Moneycontrol.

While midcap stocks have witnessed a one-way rally for the last three years, earnings growth has not been commensurate. Roy believes there has been a lot of re-rating. Midcap PEs (price to earnings) are expensive on an absolute basis as well as relative to Nifty as both are at record highs. Therefore, there is a very strong case for correction in PEs, he says.

However, Roy said the timing of correction cannot be predicted but believes that if the correction happens sooner it will be healthier because if the rally continues, a lot of people might keep getting in at progressively higher levels and get trapped.

Roy is overweight on retail-oriented banks, insurance, pharmaceuticals and also on select auto stocks. The fund house is 'hugely' underweight on information technology sector.

Below is the verbatim transcript of the interview.

  1. We have been seeing market touch record highs. What does it spell for fund managers? What is the strategy you are adopting now? Are you sitting on a huge cash pile-up?

The prospective returns for investors coming in to equity market now will be lower than it has been in the past three years. But if you are really long-term investors (with a horizon of 3-years or more) then it is not a cause for worry. We know that PE ratios are high today.

Over the next three years PEs could come down, but if earnings growth in your portfolio is high enough then you would still get decent returns. It might be less than what people have made in the past but it still should be much better than inflation which is the hurdle rate. Essentially, a hurdle rate is inflation plus a handsome alpha over that is obtainable from “select stock portfolios” .

We keep saying that equity is a long-term asset class. If one remains invested over the long term, one gets as much returns as the earnings growth and PE doesn’t matter much.

How are you looking at GST? Some of the rates have been announced. How do you think market would react once GST is implemented?

In the near-term, the government will try to keep the impact least disruptive as possible. You cannot have a hugely disruptive change at a time when things are starting to look up economically. A lot of planning has been going on multiple rates, product by product. The time that has been taken to chalk it out, points out that they have been trying to be least disruptive.

The impact of GST will be more long-term in nature. Because of improvement in the backend tax infrastructure and data, people who were not paying tax will come in to the tax net. This is clearly the focus area of the government and clearly a positive for fiscal health. Other positive is that supply chain / logistical inefficiencies will reduce. These will deliver results in the long-term, with less near term impact.

There is a fear in the market on the rally especially the speed at which it is running. Do you think that’s a point of concern? Also, are you sensing any steep correction in the market?

Yes, especially in the midcap space one would be hoping for a correction because of the one0way rally that has been happening for the last 3 years, while earnings growth has not been commensurate.

There has been a lot of PE re-rating; midcap PEs are expensive on absolute basis as well as relative to Nifty and they are at record highs on both counts. So, I think that there is a very strong case for correction in PEs there.

When are you expecting the correction that you mentioned?

We cannot predict the timing but typically a lot of domestic flows which is coming to equity is going towards midcaps. This makes it tricky to gauge when the correction will happen. The sooner it happens it is healthier because if the rally continues, a lot of people might keep getting in at progressively higher levels and get trapped. That’s not healthy. So mean reversion in valuation is always healthy because it prevents too much hot money from coming in to the system and market getting in to the irrational exuberance mode.

What are the kind of cash levels that you would be sitting on at this point and time?

Hardly any. We are at less than or around 1 percent across funds as of now. Typically, we don’t take cash calls. What we do is, as the market becomes more expensive, we find that fewer and fewer stocks in a portfolio are looking like attractive buys but so far it has never happened that none of the stocks are looking like attractive buys. So, we just buy a set of stocks which are looking attractive.

Which are the sectors that you are betting on?

We have been overweight on retail-oriented banks and insurance, where quality companies are delivering superior earnings growth. We have select auto stocks that we have continued to hold for a very long time. If you see the numbers, growth is happening only in those segments in select pockets in passenger vehicles or in premium two-wheelers. We will also have meaningful position in pharma. Pharma has not been doing very well of late because of concerns with pricing, US regulatory issues, Indian regulatory concerns on pricing etc. Slightly head winded situation continues to prevail in the pharma sector but those are temporary issues.

We believe that companies that we own will eventually be able to tide over and deliver good growth. We also hold oil marketing companies and some gas stocks too. These companies are growing very profitably and the valuation discovery process that has happened to a large extent continues to be on. If you look at stocks in our portfolio and also if you look at where growth is happening in the economy, you will see a good match between the two. The idea is to deliver good earnings growth in the portfolio through owning good quality companies.

Are you avoiding IT stocks considering there is a shift happening from legacy businesses to digital?

Our take on IT companies is that their existing bread-and-butter business that is application development and maintenance is seeing a movement happening away to vendors providing platform-based services or software as a service, on cloud. That migration is taking its toll on growth of the traditional Indian IT businesses.

Most of the growth is coming from the digital side. But digital practices are still small profit contributors for Indian IT companies. These organizations are large and transition will take its time, may be in a couple of years. We will keep a close watch on the sector for growth to pick up.

Are you completely avoiding or underweight?

As a house we are hugely underweight on IT.

What about PSU banks. Now that the government is actively looking to resolve NPA issues, is it time to look at these stocks?

We had some exposure to PSU banks, which we have exited largely. One thing we have realised over the years of investing is to look for quality with growth. PSU banks do not fit the bill currently. If there is a massive change in their prospects then we will look at them. It’s not just the NPA problem, there is also a problem of prospects of profitable incremental lending being low in a subdued credit growth environment. Access to equity capital is also a challenge, which will restrict growth. For NPA problem, it looks like the worst is over but do not expect a very sharp recovery from here on.

What are the triggers for the market?

The main trigger for the market is earnings growth. Earnings growth is expected to pan out in FY18 from recovery in the cyclical sectors including metals, PSU banks etc. This is just a rebound from a low base. My contention is that market PE today is not cheap. It's actually one of the most expensive PEs ever at 23X trailing for Nifty. To justify these valuations, more broad-based growth is required within the economy.

The government is on a fiscal consolidation mode. Investment cycle is weak. Only pockets of consumption and household borrowing are growing. We are watching out keenly for growth to become broad-based, which will be the key trigger for the markets.

What are your expectations on earning growth?

One year there would be some rebound may be not 18-20 percent but more like 15 percent but over next 3 three years with status quo, there would be 12-13 percent kind of compounded earnings growth.

Why 12-13 percent?

Things will change sooner or later, e.g., monsoon and the rural economy can help. Sooner or later there would be more broad-based pick-up in demand. We should be optimistic.

What are the macro factors that you would be watching out for domestically and globally?

The most important thing today would be inflation and hence interest rates. One of the positive factors in India has been low oil prices. Also, other commodity prices and their impact on earnings are important. Global macro stability and return of growth, especially in exports, is another factor.

Within the Indian context we would most keenly watch out for recovery in broad-based demand. It could be domestic consumption driven, where again monsoon will play a major role, or due to states like UP where new government has come to power.  How successful is the government’s policy in affordable housing and infrastructure development in terms of taking growth up.

With government taking steps like affordable housing and Housing for All and RERA, do you think now it's time to look at real estate sector?

Affordable housing and RERA (Real Estate Regulatory Authority), the combination of two, does look promising after a very long time for real estate. Now, how much of that fructifies needs to be seen. We tend to not do hope-based trades but we are watching it closely. It will take time because RERA is a major change for the way the sector will operate moving forward.

In affordable housing, we are seeing some green shoots happening for select companies. We are positioned in home finance in a big way with 3-4 stocks in our funds which are into mortgage financing, a segment which has been growing and should be aided by the focus on affordable housing.

What is your advice to investors?

I would strongly recommend that people should continue to invest through mutual funds because that’s one of the most effective in both cost and consistency of returns that you get. Many mutual funds in India have long track records of excellent results delivery. If you look at allocation to mutual funds as a percentage of household cumulated savings, it is a low single-digit number. There is definitely a lot of potential for it to grow and improve wealth creation of households through superior compounding.
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