Global EM funds fuelling Indian inflows: Rukhshad Shroff

Foreign inflows to India has been very strong over the last few months. Rukhshad Shroff, Investment Manager at JP Morgan Asset Management believes that the recent flush of liquidity could be the result of higher asset allocation to India by global EM funds. 

Here is the edited transcript of the interview on CNBC-TV18. Q: Let me start by asking you about the liquidity picture into India because you manage a large pool of money. Have you seen a lot of addition to that over the last many months when reported Foreign Institutional Investor (FII) flows have been very strong or have India funds like you not been the conduit through which these flows have been coming in?
A: I would say that our India dedicated funds have not seen any material inflows. Most of the flows that are coming into India, in our view, are driven by broader mandate. So an Asian fund or a global emerging market fund are the sources of the liquidity that we have seen over the last 15 to 18 months. Q: Has that been the experience of the funds that you have at JPMorgan as well? Have your Asia funds and your emerging market (EM) funds upped India weightages?
A: They may have upped India weightages or indeed they may have maintained the same weight, but the pool of money has increased. So those funds may have seen an inflow and as a result, the allocation to India may have increased as would have to other EMs as well. Q: What would you attribute this peculiar phenomenon to? I mean if people are bullish on India they would also buy India dedicated products?
A: They would and we are seeing early signs of that. It goes through cycles. Post the global financial crisis, one trend that we have noticed is that clients want us, as a firm, to make the asset allocation decision for them. And if they put their money into a dedicated country fund then that allocation is made by them rather than us.
Hence, by giving us an Asian mandate for example, if we don’t like a country or if we like one very strongly, we can allocate accordingly and that gives them increased flexibility and the onus of asset allocation falls on the asset manager.
_PAGEBREAK_ Q: You had a very good year in 2012 like many India dedicated funds. India did quite well, but FY13 has started off slow. Do you expect this year to be somewhat different than the previous year?
A: Calendar year 2012 was not exactly a straight line performance. It is fair to say that volatility will continue. We at JP Morgan Asset Management on the India product tend to take a much longer term view. Our turnover ratios are much lower and therefore, our implicit timeframe is longer. It could be three to five years.
In this current macro environment, with the political backdrop that we have it is fair to expect volatility. But, I would say that we are reasonably positive on the Indian market this calendar year as well. Q: Do you have concerns on growth though? The last few macro growth numbers have been very weak. The last earnings season was not great. Any apprehensions that the run up in the market might actually be a bit ahead of itself given that earnings have still not caught up?
A: The market is usually ahead of the macro data for sure, because it is by definition forward looking. What I would say is of course we have had the fastest and most dramatic deceleration from 9.5 percent to 4.5 percent in the shortest period, as far as I can remember.
That is clearly an unfortunate outcome. In 2011 that had a very material impact on market returns. In dollar terms the market was down 37 percent odd, if you recall. As expectations have changed and reconciled to this slower growth environment, the incremental news flow on growth and its impact on the market is diminishing.
We think that perhaps growth expectations for the economy are close to the bottom. But, more importantly, earnings and corporate behaviour is stabilizing, it has reconciled to a lower growth environment and we do not believe that 4.5-5 percent growth is the sustainable growth rate for India. 9.5 percent was not sustainable and 4.5 percent is also not so in our view.
I think we will gradually revert back to a level of about 7 percent. It may take time. It is perhaps likely to be longer this time around than in 2009. But once we start the process of reverting back to that sustainable level, it should be good for corporate earnings as well in terms of a reacceleration. Q: What would that reversion to the mean be predicated on? So far, we have not seen any pick up in the investment cycle. Would it only be a function of how low the base has become and from here we will expect a bit of a normal bounce, maybe spurred on by some extra government spending or do you think the investment cycle begins to improve from here?
A: While there is a lot of focus on the investment cycle and the dramatic slowdown, let us not forget that there is consumption as well. Consumption is a far bigger component of the Indian growth story than investment. Both need to eventually start a process of acceleration.
My personal view is that consumption will start first and then a slower recovery in investment will take place. Obviously, the challenges on investment are multiple. It is not just interest rates. Consumption is likely to be driven by all those structural positives that we have talked about over time.
Corporate India continues to create jobs. People with jobs will get more income in their pockets and they will spend. We are starting from a low base. The demographic profile in terms of age and income is very supportive over the long-term. These are all well known aspects of the Indian consumption story. Over time, with rates coming down, slight stabilisation and improvement in the policy environment, investment will also pick up.
One thing we know for sure is that this is not an economy where we have over-invested in infrastructure. If anything, we can absorb hundreds of billions of dollars of more investment and while that process is damaged at the moment, it will eventually recover. Q: In your portfolios in India, are you big on the consumption theme or have you seen some signs of sluggishness creeping in the earnings of the last couple of quarters? Have you trimmed some of your positions in consumer names?
A: Yes. Let me remind you that the way we run our India portfolios is a very bottom-up process. It is not sectorally driven. It is not very macro driven. Obviously, we are aware of these variables and it is not necessarily very thematically driven. Every stock that enters our portfolio enters on the merits of that individual company and that individual stock.
 
There has been slowdown in consumption in certain areas. We have cut back on a few names, we have added to a few. But, broadly speaking, in the last six months we have added to cyclicality. We feel that the cycle has bottomed, whether it is earnings or GDP and as a result, there is room for either valuations to improve or for positive surprises on earnings which should boost companies that are more dependent on cyclical variables.
_PAGEBREAK_ Q: When you say cyclical, do you mean sectors like infrastructure broadly or even materials or real estate, those kind of names have come into your portfolio?
A: It includes so many things. It could mean components or areas within the infrastructure space. It could mean consumer cyclicals like auto, cement etc. It is all very bottom-up. It could even mean banks and as you mentioned, real estate. We may have already owned some of these and we are just increasing the exposure and some maybe new names, in most cases being driven by attractive value. Q: What about IT? It does not usually fall into that definition of a cyclical. IT has done very well this year and valuation continues to expand there. I see Tata Consultancy Services (TCS) and Infosys Technologies in your list right up there in the top holdings. You are relatively bullish on those names?
A: Yes. We see a combination of maybe two or three things. One is that we are quite optimistic about the outlook for the US economy. While this sector maybe cyclical, it is not driven by domestic cyclical variables. It has more to do with corporate America to a large extent and to some extent the rest of the world.
We are bullish on that. We think that valuations are not terribly stretched. In some cases they are quite attractive. It is a sector that would be a natural beneficiary of the weakening trend we have seen in the Indian rupee and if that trend continues, this could be a way of either hedging that risk or indeed participating in that depreciation of the Indian rupee. Q: What about cement? Since you look at valuation so closely, a lot of people like that theme, but are not sure about paying. How much do you have to pay to own the ACCs and Ambujas of the world? Are you comfortable with valuations there?
A: We have been quite overweight on the cement sector for a while. A fair bit of our view on the sector has played out over the last two years and right now, it is going through a bit of a correction. The premise there is that valuations are a function of earnings and earnings in this particular case could be driven by a consolidation in the sector, a very large digestion of overcapacity and oversupply.
Therefore, operating leverage which could be very significant, is often difficult to capture efficiently in earnings forecast. We take the view that the earnings forecast maybe revised up and therefore what appears to be current valuations may not be accurate. Q: From the last disclosed portfolio that you have in one of your bigger funds, I see almost a third of the portfolio is in financials. Would it largely be private sector financials? I know it is bottom-up, but would it include any public sector names or you are generally not very bullish on that area?
A: It is fair to say that at the moment it is almost entirely dominated by the private sector. But, I would disqualify that response with one caveat. Even within the private sector, there are a number of names that we do not own. It goes back to my earlier point, we remain very bottom-up in our stock selection process, not just in financials, but across the overall India portfolio. Q: How do you see Indian valuations now? At 14 times odd one year forward, is it okay for the current level of earnings growth or may be a bit better than current earnings growth that you are getting or do you see the prospect of further re-rating from where we have reached?
A: With 14-14.5 times, if you look at it in the context of our own long term history, it is modestly below long term average. That is a good starting point. Secondly, these price to earnings (PE) ratios are now driven by much more convincing earnings. We have greater confidence in the earnings number than we had 18 months ago when we thought earnings were vulnerable to a downgrade.
We think that process has stabilised. Importantly, we don’t invest in the overall markets altogether. What I find very encouraging as a fund manager is when I meet companies, when we do the research on individual stocks we find a whole lot of attractively valued businesses across the large cap, mid cap and the small cap space that we are willing to buy right now given all the known facts, given all the challenges and given current valuations. We are very happy to own certain businesses and that to us is perhaps the most encouraging aspect and the most supportive of our positive stance.
_PAGEBREAK_ Q: What do you hear when you meet companies now because a fair number of companies or chief executive officers (CEOs) don't exude that amount of confidence when we speak to them about the near term turf? Do you get the feeling that they believe things are improving and it will be much better for their earnings in the foreseeable future?
A: Often company managements are not able to predict the cycle. In 2007 and 2008 there was enormous exuberance. It didn’t do very much to buy into that because it was already priced in and that exuberance led to in some cases very poor asset allocation decisions by corporate India who got a lot of money and capital cheap.
Some of those decisions are still being unwound or in some cases, will be very difficult to be unwound without a tremendous amount of pain. It is good that expectations are modest and corporate India has reconciled today that growth is five percent and not eight percent. A year ago, even when the number was being printed at 6 percent in my meetings, corporate India would often say if the economy is to grow at 8 percent, there was a sort of de-link from reality.
Today, I find this pessimism or this conservatism that I see encouraging because that means there is room for positive surprises, there is a lot of unutilised capacity. It also means there is operating leverage and that is good for potential earnings surprises in the course of the next 12 to 24 months. Q: 12 months from now we will be running into elections. Do you think it will have a material bearing on India’s growth prospects or how global investors see India?
A: For 20 years I have been in one way or the other involved in the Indian equities business. Trying to predict an election in India has fundamental challenges. Polls are often misleading. A third of the population that is meant to turn-up to vote doesn’t turn-up. We don’t know who these people are, why they don’t vote?
An interesting statistics that I was exposed to recently is that, about 200 seats in the last Lok Sabha election were won with a margin of less than five percent. So, we are talking about very small shifts leading to very big changes in the outcome. What I have decided to do and have learnt through these years of experience is that predicting the election is not only easy but, it doesn’t lead to any material gain.
Even if you did predict the election outcome, it doesn’t necessarily lead to a better investment outcome. The last government’s term is a testimony to that. It is a much stronger coalition that came to power, on a much stronger economic wicket and the economy and the stock market has had a very different outcome from what perhaps we would have expected five years ago. My view is that elections contribute volatility. If you can, you should try and participate and take advantage of that volatility.
If there is very aggressive correction in the market because of a supposedly unfavourable outcome, you buy into that and eventually you focus on the bottom-up. Corporate India is far more resilient than many other companies we see in other parts of the emerging market world and they manage to do well despite political and infrastructure challenges. Q: Would you even then go ahead and say that in the last six months the policy piece has been a bit more encouraging than what you described as how it played out over the last three years? Could that be a factor for some more re-rating going forward or do you think that is fully in the price today?
A: To some extent it is in the price because we have responded to that as a market and some individual stocks or sectors which have benefited have done better. I think that the new finance minister has taken on board a number of very serious challenges that the economy faces.
The threat of a sovereign downgrade to junk is not to be dismissed and the finance minister has worked very hard to try and impress upon his own party members and the international investment community that it is important. So, these steps are perhaps long overdue and I am encouraged by a few of them. Some of these decisions are tough in an absolute sense. They are even tougher when you are faced with a slow economy with very high inflation and a fragile coalition government.
Things like raising passenger fares on the railways, the attempted diesel subsidy dismantling, are all tough decisions particularly in the environment that we are in, in terms of inflation. If that continues, there is far more room for re-rating and improvement in the earnings and profitability profile of corporate India, certainly in some sectors. Q: What is the general mood on India now from your larger investors because markets have been up and down? But, five years adjusted for dollar, you wouldn’t have returned too much money to your investors, right? No India fund would have done too well in dollar terms over the last five years?
A: You are absolutely right. If I am not mistaken, in the last five years the rupee has lost approximately 35 percent versus the US dollar and that is a very significant component of value destruction. As dollar based investors that is an important consideration. Our current account deficit and the way it is funded is certainly a concern.
At least we have been trying to establish with our clients that the longer the time frame you have, the more likely you are to overcome these risks and the better your return profile. I will give you a statistic, there has been 35 percent erosion in the currency in the last five years, but here is another one which is very compelling. Over the last 10 years the JP Morgan India fund that we run out of Hong Kong has delivered a compounded return of 22 percent in US dollars. That is a staggering return and it is partly driven by the market but, partly by a long term view, a bottom-up approach.
If you adopt a long term view you tend to overcome some of these cycles. From now, you are starting from a base which is attractive. The valuations are attractive, earnings and the economy are depressed in terms of where they are in the cycle and perhaps in some estimates, the rupee is undervalued too. So, we have a combination of variables from a starting point.