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Satyam issue to make clients more cautious: JPM AM

Published on Thu, Jan 22, 2009 at 14:37 | Source : CNBC-TV18

Updated at Sat, Jan 24, 2009 at 15:45

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Rukhshad Shroff, Investment Manager, JP Morgan Asset Management

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Rukhshad Shroff, Investment Manager, JP Morgan Asset Management, said the regulatory machinery has kicked into save Satyam and this has given some level of comfort. "The progress has been good, but don't know how quickly the Satyam issue will be solved." He feels the Satyam issue will make clients more cautious.

Shroff is not bearish on Indian IT, but finds the environment challenging. "We are underweight on the IT sector, but have some large bets. The main portfolios are dominated by largecaps and larger midcaps. We also see meaningful divergence in individual stock performance in 2009."

JP Morgan AM, he said, has a slight defensive slant. "We have some FMCG and a bit more cash. We don't hold a lot of cash given the current mandate. Our current cash level stands at 4-8%."

Here is a verbatim transcript of the exclusive interview with Rukhshad Shroff on CNBC-TV18. Also see the accompanying video.

Q: The year 2008 was horrific, are you a bit more hopeful about 2009?

A: Yes, I am for two or three reasons. One is of course that 2008 was a vicious year. In US dollar terms, the MSCI India Index close to 65%. If you look at that or if you look at the Sensex over many years, it has been the worst year ever. The second worst year was a decline of 21% in the Sensex. So, in that respect it is down a lot.

The other reason why I am hopeful is primarily because of valuations. The market trades at 9 or 10 times forward earnings. More importantly, those earnings have been cut down to what I think are more realistic levels. Perhaps they haven't bottomed, but much more realistic, and 9-10 times has been the level from where historically markets have bottomed.

Now this environment seems a little different from historical levels. We are finding absolute value in some largecap stocks after a fairly long time. Twelve months ago it was about relative value, and there was very little absolute value. Now there's absolute value. I think we have seen over time valuations play a very important role in determining the outcome of returns.

Q: What is your definition of hopeful though? Would you be happy if you just had a modest return and the market closed somewhat higher than last year, would that be acceptable or are you looking at serious outperformance after the kind of damage you saw in 2008?

A: I wouldn't be looking for a 40-50% kind of return. I don't think the environment is conducive to that. We are clearly not out of the woods in terms of the economic and financial challenges. But a mid-teen to a high-teen return cannot to be ruled out. That would be an acceptable return. When we set ourselves up for a better 2010, then we will hopefully have more support from economic and corporate newsflow.

Q: Is that the right way to look at things right now because a lot of people are still caught up in that 21,000 zone, when do we get back there? That was an aberration, it happened when it did. Right now we start the clock from 9,000-10,000 and see if all successive years from hereon can be mildly positive?

A: If you calculate average returns, very few years actually deliver the average return itself. We have 20% corrections in a year, and we have very big years of positive return as well because a number of factors have to converge - economic, corporate, liquidity, politics. So, many things have to be in place to give you a 60-70% return. I don't think it seems likely at this point that those will all be as favourable.

Q: What about the other way round? Could it be a 25-30% down year you think even from here?

A: In this environment you cannot rule out any possibility. I think the probability of a positive year is a bit higher than 50%, is what I would say. So, the odds are reasonably favourable.

Q: Has India just been lowered to lowest pedestal after the events of first the terror attacks in Mumbai and then the Satyam episode. Are those risks have they lead to a high risk premium or considered a perceive risk premium on India?

A: Both those events haven't helped in this environment. If you look at the events of the terrorist attack, this was entirely unfortunate and somewhat random event. The second Satyam related occurrence that we had I think has raised concerns about corporate governance and has possibly raised questions about governance in India more than I thought it would. Governance framework in India is different from many other countries so there will be exceptions and corporate governance risk in every country. An occurrence like this happens everywhere. But I think India does have very sound framework, there is always room for improvement.

Q: Is it just a perception problem or has your own confidence being shaken as a fund manager a bit. Not for across the board but have you always suspected that some largecap companies numbers are not transparent or you cannot look through those numbers as carefully and would you as a fund manager also become slightly cagey about investing in those companies?

A: Fortunately for us we have been and we have tried and I think in many cases have been successful in sticking with a discipline of what we will invest in and that has helped. There have been pockets when it has hurt us as well because the market is been what I would describe is irrational; it's neglected or ignored risks, its put significant valuation premium on stock that perhaps should not have those and we have managed to stay away from the bulk of them which pains us sometimes but I think our clients base appreciates and takes it slightly longer-term view.

But we will look through things even more carefully. Its not that some of the information is available - you have to look through annual report and you will find several red flags and you have to deal with them and often you don't invest in such companies. We raised these concerns in meetings as well with management and I think we are likely to see that more verbally expressed now.

Q: You had Satyam yourself and you exited after the event but do you think the situation can be salvaged, you don't have any vested interest in that stock anymore but do you think the situation can be salvaged at all?

Shroff: I don't know what salvage means. I think steps have been taken, the legal system and the regulatory machinery has kicked in. I think that does give comfort but I don't know how quickly and how substantially this gets done. The world is watching as well to see how this gets done. I think so far it has been quite good, we will see the outcome.

Q: Has it affected the sector in anyway because you would have exposures to the IT sector generally both in terms of the environment that IT is trading in right now and because of this episode, have you taken or diluted your holdings in Indian IT in anyway?

Shroff: We haven't changed our view on this sector. I do think that there will be some implications. Clients - the IT company's customers - will perhaps think more carefully about with which company they transact and create and establish a relationship which should help some companies and which perhaps may hurt others. As you know it is a very difficult environment, more than half of corporate IT is linked to corporate America or for that matter corporate Europe and both those economies are in very fragile stages of their economic downturn. So, we haven't made any changes to our sector strategy.

Q: Are you underweight on that sector generally?

Shroff: We have an underweight on this sector. We had been underweight on the sector for sometime, but within that we have got very skewed stock positions.

Q: Just want to ask you about earnings because a lot of people perceive that while you can take a reasonable call, valuations should not get much more compressed from here. People are not able to put a finger on what kind of earnings deceleration we might actually have to live with. Some say it will be flat or 5% or 20% lower next year. Is that the central risk to any hypothesis that you have that we may be on the mend by the end of this year?

A: It is an important risk, of course because earnings and growth is one of the key reasons why people invest in India, as they do in China. We have seen growth whether it is GDP growth, industrial production growth, export growth and also corporate earnings growth have all come off. Risk has reduced substantially versus three or four months ago where my interactions with companies or strategists suggested that earnings forecasts were unrealistic. People were still either in hopeful or denial mode. That has come off.

We are in the stages of earnings reporting season. It will come off even further. Forecasts are anywhere between plus (+) 5 to minus (-) 5. Could they be minus (-) 20 or plus (+) 10? Yes, sure they could be. But the good news is that the markets will bottom well before the earnings even appear to bottom. Forecasts I think at this point are behind the curve. It doesn't matter if someone cuts the earnings of a company or not. The market has already taken a knife to market cap.

Q: Do you think all of it is priced-in?

A: No, I don't think all of it is ever priced-in. As more and more companies report numbers some may disappoint but there is always that final cut or that final exhaustion that tends to take place. But in investing it is always impossible to predict a bottom.

So, I am not going to be trying and spending my time and effort trying to predict that. Even without an earnings bottoming out, today we have got companies that we find has very compelling valuation opportunity. Stocks are trading at materially below book but there is a confidence in that book or in the companies outlook, single-digit P/E multiples, reasonable sustainable double-digit mid-teen RoEs.

So that universe has expanded. It doesn't mean they cannot go down more. But it does mean that at some point you have to completely stop ignoring valuations.

Q: The pessimistic view of course is that this is not a garden variety bear market, earnings won't trough out very soon, and we are in for a multi-year demise of demand and it might not recover for a very long time, you just bounce around in a narrow range and lowish range and recovery takes two-three years out. Is that a likelihood or a low probability event in your eyes?

A: In all likelihood. First and foremost, there is an economic environment that most people are reading about from textbooks because that is potentially when the last time it happened. So, the scale and the breadth of this is unprecedented. There is no country that has been spared - emerging markets, developed, west, north, south, India, everybody has taken it on the chin.

Therefore demand destruction has been very strong. Countries will have to - in some cases - reengineer themselves from an export model to maybe a domestic driven model. That could take time.

But that doesn't necessarily mean that demand destruction keeps happening. It could be that demand sort of bottoms out. That in itself with a combination of low multiples could be a source of positive returns.

I could paint a picture for you that suggests that at some point in the next 12 months while growth remains very depressed you look around the world and you find that even in that depressed environment, India and China present a relative growth opportunity, which is substantially higher than other parts of the world.

I am not telling you about decoupling but if you are suggesting that because America and Europe are likely to be in recession, India and China would also go into a recession then I wouldn't subscribe to that view. Will growth rates come off substantially; perhaps even halve? Yes. Could India have a period of 5-6% growth? Yes, it is quite likely.

Q: Your point is taken but will it be rewarded for that growth because the world is in such a funk right now - they say, "When Dow fall everything falls with it." So far we haven't seen any market showing any signs of out performance or tracking its own intrinsic growth ahead of other markets. Do you think that will happen in 2009?

A: In the last quarter of 2008 segments of the Chinese market from their low were up 75%; India wasn't many other markets were not up that much because some people are perceiving China's ability for e.g. to deal with this to be much better and they are right. There are ingredients in place political, economic, fiscal monetary and otherwise that will help some countries differentiate themselves from the other so maybe it's a relative environment, maybe in a down environment some countries either remain flat in terms of their markets or are down less.

So I suspect that will happen. If you look back in 2008 the average Asian index was down about 50% and most markets were down within that number. So the mean had very little divergence or deviation I suspect in this year that may start to change going forward and people will differentiate on the basis of more sustainable attributes.

Q: You run USD 4 billion, so you cannot be running a midcap portfolio in India. Have you churned around things after the 2008 disaster in the stock market because a lot of fund managers I speak to seem to have changed their bets somewhat looking into 2009, they have either become more defensive, they have bought FMCGs and Hero Hondas of the world just to hide for the moment. Are you running that kind of a portfolio or are your big bets still focused on growth?

Shroff: Our main portfolios tend to be dominated by largecaps and large midcaps, but we do have separate smallcap products. I don't think we have seen a material change to our turnover ratio, so our turnover ratios tend to be quite low. I still tend to be about 30% turnover, which means on an average I am holding the portfolio for about three years. There has not been any active decision to churn on that. At individual stock level that is pretty much where we tend to focus rather than sector, so it tends to be stock driven. Of course there have been changes. But whether there have been dramatic changes, I wouldn't say so.

Q: Has there been a defensive slung to it?

Shroff: Yes. We have had it at the margin some FMCG. In 2008, we would have held more cash than we did in 2007 for two reasons. One is that it is an active investment decision. Equally it is a preparation for potential redemptions because in that environment redemptions are a distinct possibility. But at the stock level, I think 2008 has shown and 2009 will magnify that even within sectors there will be a very meaningful divergence between stock performances. Look at Hindustan Unilever and ITC, both defensives, one was up, one was down in 2008. That is a very material difference and they were among the best performing companies. I think that will even become more pronounced in 2009.

Q: In your book what is defensive, is it just FMCG because some people call pharmaceuticals defensive, some used to call IT defensive?

Shroff: I don't actually use the term defensive because if you think back I can dispute a defensive argument. After the event you can say that Hindustan Lever was defensive but 12 months ago, you could have argued that it had very low growth and a very high P/E multiple. It was defensive because perhaps it is under-owned by one segment of the investment community or you can argue that a company is defensive because it has very low valuations and you have seen that attribute play out. The oil refining companies with their earnings decimated, they performed quite well because they are so absurdly cheap in some people's opinion that it gets very strong support. So, the true defensive investment is cash.

Q: Do you still hold a lot of cash in your portfolio?

A: I do not hold lot of cash. We have depending on the fund and the mandate. There are various individual characteristics there are open-ended, closed-ended restrictions on cash itself of anywhere between 4-8%.

Q: Or more than 10% would be considered?

A: Many of our mandates would not allow us to go beyond 10%. I have got mandates that do not allow me to go beyond 5%.

Q: You are optimistic and hopeful because you are an India specialist and you have a large mandate in India so are you looking at it because you have to se the glass is half full or you genuinely have conviction that after the price damage that we saw last year we are supported by valuations and should not crash. We can always crash and then bounce back. But over a sustain period of time we should not be trading at significantly lower level in this?

A: There are two aspects to it. In my position as an India specialist I feel optimistic because there is valuation support. Having said that if you look at or if you speak to an Asian fund manager or a global emerging market fund manager whose universe by definition is larger - his perception will be different. Growth is no longer a driver of flows because growth is declining. So until growth stabilises, it doesn't become a reason to invest in a particular country unless it's a relative call.

Valuations in India are attractive but there is significant value available pretty much everywhere else so there isn't a sector in India where I can say there is no other country offering better value. It may not offer the same characteristics of value of growth. So valuation is an absolute support but India will have to compete much harder to attract that incremental dollar which is shrunk and there are reasons why India's competitiveness is an uphill task especially in the recent environment.

Q: We still have a little bit of valuation premium on an absolute market level to many other countries. Do you see that getting whittled down because of some of the events of the last one-two months?

A: Yes and no; the premium - there is a bold PE multiple; 10 is higher than 8 and so on is perhaps overly simplistic. There are reasons why an Indian PE for the market is higher than in any other country.

Q: Even at an individual sector level. I am not saying Sensex PE higher than Kospi PE and that's too simplistic?

A: Even on business sector level - one sector is dynamic in terms of its growth prospects, capital intensity; its inherent profitability is different from another. A commodity stock or a commodity sector is very vulnerable to very vicious cycles. But each valuation analyses have to be done in a specific to company's attributes which vary from sector to sector and obviously from country. So on an absolute level, it provides comfort on a relative basis I think India will have a much tougher time with growth declining and value available in bucket loads at the moment to compete for that.