Emerging markets have seen a sharp rally over the past few months but it may now peter out, says Prashant Periwal, Director of Altima Partners LLP.He talks to CNBC-TV18’s Udayan Mukherjee on how to risks that markets face and whether earnings have turned the corner in India.Whether the emerging market rally can continueWe have had commodity prices running higher, oil going up by about USD 20, we're at USD 50 now. China unleashing yet another large stimulus to put some sort of a floor on the economy and then you've had massive rallies on the back of that in all the emerging markets. So, from here on do I expect oil to go up by another USD 20 from here? No. Can China continue its credit binge? Probably but it’s not good and that leads you to believe that, the rally has been very sharp, but then probably here's a time we take some sort of a breather and consolidate here.Risks to global marketsMacro events are what they are whether it's Fed rake hike or Brexit etc. But on the other hand, we could have issues emerging out of China. You know, starting from there from currency to overall economy and then on the top of it valuations. So, a combination of all these 3 factors could be a bit of bigger problem. But then of course the valuations are not supportive and that’s like for the market overall. Not to say that bottom-up opportunities do not exist, they do but one has to be selective.Fourth quarter earnings in IndiaOn one hand, if we strip out banks within India, I mean earnings have surpassed expectations but then not to say that we have turned a corner here. With respect to banks I think the challenges could be -- you know, we can always say the worst is over but do we really know that? You could have said worst is over was 2 years ago for some of these banks but it keeps coming.Below is the transcript of Prashant Periwal's interview with CNBC-TV18's Udayan Mukherjee.Q: We have had a great rally since the end of February. At this point given where prices have reached are you still feeling optimistic or do you think it is time to take little bit of froth off the table?A: What led us to this position from February, we had commodity prices rallying higher, oil going up about USD 20 per barrel, we are at USD 50 per barrel now. China unleashing another large stimulus to put some sort of a floor on the economy and then you had massive rallies on the back of that in all the emerging markets. So, from hereon do I expect oil to go up another USD 20 from here? No. Can China continue its credit binge? Probably but it is not good.So, that leaves you to believe that the rally has been very sharp, probably here is the time we take some bit of breather, consolidate here.Q: What is the biggest risk you see going into this summer, is it the fact that valuations have expanded quite considerably given that earnings are still not very strong or do you see events posing a risk like Brexit or the US raising rates, something coming from those fronts? A: It is always a mix of lot of things. Macro events are what they are, whether it is the Fed rate hike or Brexit etc. However I think on the other hand we could have issues emerging out of China starting from their currency to overall economy etc. On the top of it valuations. A combination of all these three factors could be a bit of a bigger problem. Of course valuations are not supportive but that is for the market overall, not to say that bottom-up opportunities do not exist, they do. However one has to be selective.Q: How do you characterise this rally, you explained the reasons behind it but would you say in the overall context of where the market is a powerful relief rally or a rally or do you think as some people are characterising it as a start of something more meaningful like a sustainable uptrend for many months or quarters?A: It is difficult to predict like what happens in next 2 or 3 months but overall we are supportive of emerging markets in general. We have gone up a bit too fast. If you talk about India we have had strong numbers for Q4 FY16. In one quarter data points were very supportive, but everything seems to be taking a breather as of now. We need to see whether the earnings growth pans out and that is going to help us answer whether it is going to be sustainable rally here or we will go back into the shell again.Q: What is your gut feeling, do you think this is the quarter where earnings have turned a corner or you need to see more evidence to conclude?A: We definitely need to see more evidence. On one hand if we strip out banks, within India, earnings have surpassed expectations but then not to say that we have turned the corner here. With respect to banks what the challenges could be, we can always say the worst is over but do we really know that? You could have said worst is over two years ago but some of these banks it just keeps coming. So, for sustainable sort of a revert from here we need to see more evidence in my view.Q: You do have positions in banks in the Indian market, how do you position yourself in that sector given that public sector banks reporting mess after mess but their valuations technically look appealing. On the private sector front you have numbers which are better but in many cases valuations are very lofty, what is the middle line there?A: In public sector banks one is reported price to book and one is adjusted book value. If I was to adjust for the NPLs which are not provided for, some banks are basically zero equity. So, what is the book value there and what is the price to book there? It is sort of infinite.However with respect to private sector banks, you have to pay for quality in this market. All you need is a bank where you can see a sustainable book value accretion. So, you want to be sort of positioning yourself into retail oriented banks. Though it may sound very boring, why buy banks at 3-4 times price to book but if that is the bank that is offering you a sustainable growth the answer is why not?If you look at last 5 years point to point, 10 years point to point and we can compare the returns that the so called expensive banks have given and the answer would be clear I guess.Q: It’s interesting you said that because you are technically a hedge fund and people who stick to these retail banks which as you said boring, they are more like a long term fund who churned their portfolio once in 5-10 years. One would expect that someone like you would be taking a little bit more risk and trying to buy the private bank which is being beaten and bashed a lot, because it’s got a corporate exposure, but you don’t think like that you think that risk is not worth taking?
A: If one is playing a revival then it’s better to play via a private relatively better managed bank, no doubt about it, but we don’t see like if you are a hedge fund manager you should not be one thing versus the other. In hedge fund stakes are higher, so you more skin in the game so you wanted to be know even more sure about what you are doing. We tend to hold stocks for a longer period and we are happy to sit and wait for the value to crystallise. At the end of the day book value of a bank would be growing call it like 18 or 20 percent, so far you are assure of that 18-20 percent, who wants to leave that, nobody I guess so do we.
Q: What about housing finance, that’s an area where you have an interest in. Is that a long term sustainable story in your eyes?
A: Yes, it has done well over the last 3-4 years. Again all those investors who wanted to take position in financials, but were concerned about these mounting non-performing loans (NPLs) quarter after quarter. Housing finance was a good sort of area, I think again valuations are bit toppish there as well, but then are we sort of comfortable with the business model, are we sort of comfortable with the dynamics of how is things in India, I think we are to some extent real estate prices could be a bit of a challenge, but as you understand these banks are not lending very high loan to value. So overall risk is managed and therefore are these stocks going to give me my 16 or 20 percent compounded book value growth if yes, then we would like to stick.
Q: You were saying that your India exposure is one of the largest in the emerging market (EM) that you operate in the basket. How do you justify that to your investors where you see those powerful rallies playing out in Brazil and Russia because the way commodities moved in a short span of time? Do you get questions saying why we are in such defensive market like India where we are not participating in this big 70-80 percent kind of EM rallies?
A: Look 80 percent EM rally is coming after a similar declines, you term it as a defensive EM market, you are still better off point to point. The issue with some of these commodity exporting EM markets Brazil, Russia or South Africa etc., rallies are powerful in short, but then you need to have that sort of a conviction that look if iron ore has gone up 70-80 percent from the lows it will stay around here or it will go up even higher. We are taking a view internally that we are very comfortable playing this China capex theme and therefore all the capex commodities call it iron ore or cooper etc., we would not be very comfortable taking a positive view on these commodities and therefore by definition we would have to rule out certain sectors, stocks, markets.
On the other hand, we view oil as an operating expenditure (opex) commodity and it is interesting statistic that is probably one of the large commodity where China does not consume more than its fair share of global GDP contribution, so it is not like a very skewed sort of a demand profile for this commodity. We view it as opex commodity, so we are happy to take a sort of more constructive view on oil compare to the rest of the commodities. We would not sort of chase the share rallies in some of these markets as you just mentioned.
Q: But you thing oil has bottomed out?
A: It is difficult, but one can sort of make a case that unlike a iron ore mine or a cooper mine where you have set up a mine and it is going to produce for 20-30 years till the time the reserve last. Oil is a different sort of commodity where in an oilfield you set up oilfield, you start producing but then you reach a peak production in 4 or 5 years and then naturally you start declining production from that particular field by say 3-5 percent every year, so how do you replace that production is you have to drill more wells and would you be drilling more wells when oil is USD 30 the answer is no. So a time will come when all the wells that are producing today would have peaked out and would have started to decline, unless we start drilling more. So that makes you think that there is probably a bit more of a fundamental angle, there are many other aspect to it in the short run what would OPEC do and not do etc. But if I was take a more fundamental view than that’s how I would look at it.Q: You said that you are not a big buyer of this China capex recovery theme, you think the market is overestimating it because you look at the rallies in some of the steel companies etc, they seem to be building in a lot of optimism 6 months out even.A: We are definitely not getting excited or tempted to play these rallies. If you don't believe into it we would not do it even if stock prices are going up like 30-50 percent for some of the steel names.Q: Why do you believe that this story is over hyped? Do you think another shock is coming from China sooner or later?A: Yes we think so. There are plenty of statistics around it. If you look at this whole China growth model so far, their debt to GDP has gone up like 100 percentage points in the last 7-8 years. It is at 260 percent of GDP the so called total social financing. However there are people in the market, economist, more learned people who say it does not have all of the debt, so it could be a higher number. Even if you assume it is 260 percent, it is a rising 300 percent of GDP in 4 or 5 years time. So, directionally it is heading in the wrong way. Now when would that large shock come in, it is not one particular date but we would see readjustments happening every six months or so. Eventually it is very difficult to make money on a sustainable basis if you are backing these names.Q: You are underweight China in your overall Asia book?A: In our overall Asia book we are underweight China but since we are talking China there is one sort of say capex led China or old China but then there is a new China which is consumer oriented China and consumption in China has been lagging. It is an over invested economy. So, there is a tailwind for consumption and there is a case to be made for consumer stocks in China. These consumer stocks could be consumer discretionary sort of names. As income level rises people would travel. There is a investment case to be made for healthcare in China. So, all those sort of names are still interesting. They are expensive but then you have to be sure what you are getting into. There are opportunities I would say.There is another large opportunity in China which is like natural gas consumption. It is a relatively cleaner fuel than coal etc. Prices are down if you compare coal to natural gas. On a calorific value basis after accounting for all the efficiencies that you can get in a gas plant, gas is not too far away from coal and it is a scalable sort of a model. So, gas utilities could be interesting names there. It fits into the pollution control theme and you don't want to be burning too much coal. It is a nascent sort of business which can grow rapidly.Q: Are you buying the capex recovery theme in India because this quarter a couple of the results have raised hopes that may be private capex is recovering, is it too soon to say that?A: Yes probably it is too soon to say that. Another way to look at it is if you look at the banking credit to industrial consumers in India, that is flat year on year. If you look at banking credit to small and medium enterprises it is down in absolute terms. Yes I agree we have seen orders coming in but then you can't execute orders without borrowing from banks. So, some more evidence is probably needed for you to buy into this capex recovery theme.Q: So, industrials is not an area you are terribly bullish on in India?A: No but then there are industrial names which are very bottom-up and niche industrial names is something that we are happy to look at. That is because operating leverage can play out significantly. These are some of the companies where they have setup capacities, they are sort of number one or number two player in what they are doing globally, that is the reason to be bullish about some of these names. If the utilisation levels are 50-60 percent as of today, you have massive headroom for operating leverage to play out. So, we would be happy looking at those names. Q: What is your avoid list in India on any count whether it because the sector is not growing or valuations are ridiculous or managements are not clean. What is that subset of stocks where you don’t want to go down that path at all?A: As I was telling you like we own very little number of stocks in our India book and our global portfolio so by definition we have sort of avoid a lot of names, but it is difficult to say which sector I don’t want to leave whether that sector is bad or good.Q: Like you said commodities is something that you are not terribly keen?A: Commodity is something on a global basis we are not very keen on commodities, so that goes again for India as well.Q: What is your best vehicle to play the consumption theme in India is it through FMCG style companies or through other areas like autos or paints and those kinds of areas?A: Well, paints is a good sort of example where the pricing power is still in the hands, it is not really like everyone can jump into, entry barriers are sort of high for a large paint company – that is a good example, I think companies are well managed, valuations are what they are, but then at least you can justify some companies on a discounted cash flow basis. Let’s rule out next 1, 2 or 3 years, but then if I really looked at it on a long term basis, has it really gone berserk in terms of valuations, so the answer is probably no, paints is a better way I guess. In autos there are one or two names we are sort of interested in auto names in India, but these are more of a global plays than pure domestic plays.Fast-moving consumer goods (FMCG) again on a selective basis, this is one sector where probably I would be happy to look at some sort of a special situation and not really looking as we were discussing about banks like buy just the best quality, but in this case you can look for some special situation case as well.Q: You are a hedge fund you pick stocks, but you sometimes also hedged your positions by taking counter position on the index, so do you think most EM markets bottomed out in the month of February or late January with that big fall after which the rally has happened or would it surprise you if those levels were revisited in the course of the next 6-9 months?A: No, that will not surprise me. It’s again the levels that we saw in February or March and again similar sort of fall we have had in August last year, these are all macro events and the stock prices of a good or bad company all of them fall. A good company has not done anything bad for its stock price to go down 20 percent, that’s my opportunity there but then would I be surprised the answer is no, because then the shocks will probably come from our neighbours.Q: Do you think those risks still remain, they have not gone away.A: No. They still remain, what has really changed in China is credit was a problem. If credit was a problem in February, it is a bigger problem today. You have done more credit. There was stimulus led sort of recoveries or rallies as I call it – you are just growing the problem bigger.Currency is another issue that we didn’t speak about. China’s currency policy has been sort of a bit bizarre and we don’t really understand it well, but there is a time when they found to follow a peg, there is a time when they say we want to be market driven and then they reversed the decision very quickly and now that the latest one is that we want to follow a basket of 13 currencies and Euro, GBP and Yen etc., are a big part of it and we know that there are barring one central bank everyone wants to loosen with time, so if someone is not really very bullish say Euro or Yen or GBP then RMB would sell off as well. If RMB sells off then it is very difficult for any other EM markets to bug the trend sustainably you have to follow. Someone just to answer it can a shock come probably yes.
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