Shares of Indian software services firms could decline in the near to medium term because of likely weak profits, feels R. Sukumar, MD and Chief Investment Officer, Franklin Asian Equities, Franklin Templeton Investments.
Shares of Indian software services firms could decline in the near to medium term because of likely weak profits, feels R. Sukumar, MD and Chief Investment Officer, Franklin Asian Equities, Franklin Templeton Investments. In an interview with CNBC-TV18, he said growth rate of the IT sector is tapering due to stiff competition. Companies were lowering their prices to win orders and that in turn could weigh on profitability, said Sukumar.
On Tuesday, Nasdaq-listed IT services major Cognizant indirectly guided for a 16 percent revenue growth in 2013, by saying its senior executives would get their entire performance-linked stock units only if the company’s revenues rose that much. In 2012, the company had initially guided for 23% and then lowered it to 20%.
Indian IT shares have been under pressure for a while now as slower revenue growth offset much of the gains from a strong dollar. So far in 2012, the CNX IT index has been flat, compared to a 27 percent rise in the Nifty and a 35-54 percent gain in sectoral indices like pharma, FMCG and banks.
On the broader market, Sukumar said the the government will find it tough to revive the investment cycle. A lethal cocktail of policy paralysis, fuel shortage and high interest rates have weighed on project investments for nearly two years now.
Sukumar, however is hopeful that the earnings growth will start picking up next year onwards and would be in the region of 15 percent. This along with a reduction in interest rates would drive sentiment in the equity market.
Sukumar is not excited about the realty sector, despite depressed valuations, as he feels it is a struggle to find companies with good corporate governance.
Metal shares may also underform as weak demand from China could weigh on global metal prices, says Sukumar.
Catch the full interview transcript on the next page.
Below is an edited transcript of Sukumar's interview on CNBC-TV18.
Q: Have you been a bit disappointed at the way retail and HNI investors have approached this upmove in the market? All we have seen is redemptions and continuous selling by most asset management companies (AMCs) and mutual funds?
A: While this is not necessarily very pleasant, but it is not surprise either because local investors have tended to come into the market after there has been a significant rally. So that has been the historical trend. So it is not a surprise that we are not seeing too much of local inflows into the market.
Q: Any change though after the market’s performance through November and December?
A: If you are asking whether we will see insignificant inflows compared to what we have seen in the last few quarters, I do not think there has been a distinct trend to say that we are going to see much more inflows.
Q: There has been quite a bit of caution about IT as a sector over the last few days. Lots of global brokerages are sounding captious. How are you approaching it for 2013?
A: We do have some exposure to the IT sector. Our view has been that the growth rates are tapering down, because the penetration of Indian IT companies is already pretty high and the growth rate of offshoring will come down compared to what we have seen in the last four or five year and also the margins are under a bit of pressure because there is increased price competition between the top tier players. So because of these reasons we think that earnings growth is going to be lower compared to what we have seen historically and so to that extent we have to value the companies differently.
Q: What kind of approach are you taking going into next year; do you believe it is going to be the bedrock for a fresh bull run for the market or a trading kind of market with ups and downs through the year?
A: My belief is that generally equity markets are undervalued in most parts of the world. The implied risk premium is too high so the market is factoring in some combination of a big margins squeeze and deflation and both of them look like unlikely events so there could be big move into equities over a period of time and the more promising market like India will benefit. We do not know the timing though when it is going to happen whether it is going to happen in one quarter or two quarters or in one year. So we are positive on the prospects as such.
Q: Most funds have been quite underweight on the metal space or global commodity space throughout the last year-year-and-a-half. What have you taken away from recent news flow from China, do you think the cycle could be turning as well?
A: As far as metals are concerned we have to look at what is going to be the trend in terms of fix asset investment in China. Fix asset investment growth in the last ten years has been way higher compared to the GDP growth in China and its has probably come to unsustainably high level so it would be fair to assume that the fix asset investment growth going forward would be more modest and China accounts for bulk of the global demand for most of the metals and if the Chinese demand is going to be weak then its fair to assume that the global demand growth would also be in the low single digits for most metals and there has been planned supply increase for a number of minerals and metals based on the historical demand growth that has been witnessed in the last few years. So it’s quite possible for many categories the supply growth might exceed demand growth and might lead to weak pricing.
Q: The markets been enthused by the efforts from the government over the last few weeks but the jury is still out on whether they will be able to restock the investment cycle on which a lot hinges. What are you expectations on that front?
A: I think it is going to take a while. I think the multiple issues and many of them have to be addressed, that’s point one and point two is even after they address there is going to be a lag between they addressing all the issues and the investments starting. So for government action to translate into increase in investment spending is going to take quite sometime and having too high expectations there can be damaging.
Q: On earnings performance though are you feeling more confident going into next year that the kind of downgrades we have seen have troughed out, new sectors can start performing now?
A: We do expect that earnings growth will come back to normal levels. I think normal level for India should be upwards of 15 percent and we have seen single digit earnings growth over the last three years essentially because of margin decline, the margin decline has been because of excess competition and also increase in input prices and so on. We think that there is going to be a consolidation in a number of sectors which would help the improvement in the margins and with the improvement in margins we expect that the earnings growth will trend higher over the next few years.
Q: What are you views on telecom? Do you think the worst is over for that sector?
A: It looks like. There were uncertainties essentially with regard to the government policy and the possibility of some big industrial houses entering the market again creating price disruption. Now most of the regulatory uncertainty has been cleared and there are probably more than 15 players in the telecom industry and only three players are reasonably profitable. So the prices have to go up and there has to be consolidation because many of the players cannot survive in the current form. So we think with the improvement in pricing the margins for the already profitable players should look up meaningfully.
Q: Would you start making purchases in either real estate or infrastructure? Basically, would you bet on high beta next year?
A: Our issue with the sector has been for corporate governance. We are long-term player. We can buy into good quality stocks during downturn provided we believe that the long-term fundamentals are good. But in many of the sectors we struggle to find enough names which pass through the quality filters.
Q: Last year has been good for equities but the last five years in aggregate have not returned too much for equity investors through mutual funds. Do you think with 2012 that may have started changing that you are entering a multi year period where equities will once again outperform fixed income?
A: It’s highly likely. We have three levers; PE ratios and multiple on various matrixes are lower compared to historical averages. The earnings are depressed, the margins are depressed. So the earnings growth can accelerate substantially and also when the interest rate decline the cost of capital might go down and making some fixed income instruments more unattractive. So it’s because of all these levers there is a very high probability that the equities will outperform fixed income by a huge margin over the next few years.
Q: What is the best way to reenter the market to your mind for a retail investor, go with a Nifty fund, a vanilla fund, start playing some of these thematic stories or bet on the midcaps because they are the ones that have been even more compressed than the frontliners?
A: We look at stocks on a bottom-up basis. Yes, there are some midcap companies probably quoting at more attractive valuation but we cannot over generalize because we are not comparing apples to apples. We are definitely looking at midcaps but we find opportunities across the spectrum.
Q: What will it take to review retail interest because we have seen such a long many months of continuous redemptions, do you think it will be crossing over into new highs. What will give the local population the confidence that its time to get back to equities again?
A: The big shift into equity has always happens when the equity markets rally and then the greed takes over and that’s how people have got interested in equity markets historically at least the new investors. So we believe that it is going to take a multiple cycles for the investor education to increase meaningfully and investors to act more rationally and intelligently and investing in a market in downturns rather than after the rallies. But for the time being it looks like rally is what is going to attract investors into the market.