Current valuations 10-25% above 15 year average but they are justifiable: Prashant Jain of 3P

There are clear signs of a consumption slowdown. Consumption driven by leverage often outpaces income growth, leading to reduced demand when growth normalises. This is the current scenario. The central bank has taken steps to moderate retail loan growth, particularly for unsecured loans, to encourage more sustainable consumption levels. On the exports front, the global economic slowdown, compounded by China’s surplus production capacity, makes it difficult for India to increase its manufactured exports. However, services exports are thriving, supported by India’s competitive edge. While these factors may temper growth in some areas, we remain optimistic about India’s broader economic potential.

Where do you see the most significant stress in consumption patterns?

We don't have extensive data, but we observe a shift in consumption patterns, which is adding to the slowdown in more traditional categories.

You recently discussed valuations, stating that they are about 15-25 percent higher than historical averages. Could you explain this perspective?

Current valuations are around 15-25 percent above the 10-15 year average, reflecting India's promising growth potential and a reduced cost of capital. The cost of capital in India has fallen as the yield gap between US and Indian rates has narrowed from 4-6 percent to about 3.8 percent, with low forward dollar premia. Additionally, domestic equities have experienced reduced volatility due to steady domestic flows, which supports the higher multiples. Although estimating an exact fair multiple is challenging, the current 20-25 percent premium over historical averages seems justified. India’s premium over other EMs (emerging markets) aligns with this shift, so current valuations are explainable and not a cause for concern. A DCF (discounted cash flow) analysis on similar economies suggests India may be about 10 percent overvalued, indicating minimal room for further multiple expansion, with earnings growth expected at about 11-12 percent CAGR (compound annual growth rate).

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Could you elaborate on the long-term return trajectory you envision for large-cap indices like the Sensex?

We anticipate that large-cap indices such as the Sensex should compound at around 12 percent annually. Expecting higher returns than this may not be realistic, given the current valuation environment. However, we remain cautious regarding small- and mid-cap stocks due to their hard-to-justify valuations. We see no data supporting higher growth rates in aggregate for small- or mid-caps, as many companies in these segments lack the strength of their large-cap peers.

Do you believe small- and mid-cap growth rates could justify their current valuations?

No, we don't. In fact, we have yet to see data suggesting that small- and mid-cap stocks deliver higher growth rates overall. Many companies in these categories tend to be weaker compared to their larger counterparts within the same sectors.

Given the headwinds in consumption and exports, where do you see the market over a one-to-three-year period?

Forecasting short-term equity movements is challenging, but I believe the Nifty's downside appears limited. Historically, Nifty returns have aligned closely with economic growth rates, and certain Nifty components, like banks, are reasonably valued and have even underperformed. Valuations have adjusted to reflect the current growth outlook, suggesting limited downside risk and potential for positive returns in the longer term.

What triggers might signal a reversal in this outlook?

Valuations and stock supply would be key indicators. Notably, the Nifty has seen minimal dilution in sectors like banking, software, consumer goods, pharmaceuticals and large autos, unlike some other sectors. This, combined with persistent mutual fund inflows, suggests Nifty valuations could align with broader indices. Even recent record outflows, partly due to funds moving to China, had a limited impact on the Nifty, underscoring its underlying resilience.

In your newsletter, you mentioned that in this market environment, it's essential to focus on defensive strategies, akin to scoring singles and doubles in cricket. Could you give us a framework for this approach?

To reduce portfolio risk, we focus on high-quality, sustainable businesses and avoid those with weak fundamentals or temporary growth. Valuations are critical—overpaying can lead to significant penalties if growth slows, as we’re seeing in consumer companies where even slight underperformance in growth is heavily penalised. It’s essential to manage risk, focus on quality and set realistic return expectations. This isn’t a market to pursue aggressive returns.

You own stocks in a diverse range of companies like Zomato, Ixigo, Mahindra Holidays. What's the theme here, especially considering the consumption slowdown?

Consumption patterns are shifting, with consumers prioritising convenience and services over traditional spending. Categories like air travel, rail travel services and food delivery are growing as consumers allocate more spending to these new areas. This shift explains why the portfolio includes emerging categories, while traditional consumption segments may be slowing.

In this theme (of convenience), if we take individual companies like Zomato, it was looking like a bargain a year ago but how do you justify the valuations it is trading at now?

Let’s not discuss individual companies. But I would agree with you that even these businesses are not cheap at all, particularly in these market conditions.

What’s your thesis on consumer discretionary, especially given the sector’s slowdown? Are there any specific trends or picks defying this trend?

Consumer discretionary as a whole is not slowing, though certain segments, like four-wheeler sales, are under pressure. Other areas, such as air travel and food delivery, continue to perform well, reflecting shifting consumer priorities. Consumers today are spending more on experiences and electronics, with limited budgets, and reduced net financial savings are also impacting spending patterns. Rapid growth in consumption-related loans has supported this shift, though repaying these loans will eventually constrain growth in traditional categories.

You’ve been bullish on financials, especially private banks. How do you look at concerns about leverage-driven consumption and slowing growth?

We favour large banks because their growth rates and valuations are now aligned with current economic growth rates. The dependency of large banks on unsecured personal loans is relatively low; they lend across diverse categories. Their superior customer profile also minimises risk from slippages in unsecured loans compared to smaller banks, NBFCs (non-banking financial companies) or MFIs (microfinance institutions). Additionally, large banks’ valuations are close to 10-15 year averages, unlike other sectors, where valuations are at a premium. This balance of strong fundamentals and reasonable valuations makes financials an attractive choice.

And what about pharma, where you have increased exposure even though their earnings multiple does not fit into your investing framework?

Pharma is a high-quality sector with significant competitive strength both domestically and internationally. The sector includes businesses that demonstrate attractive ROCE (return on capital employed), reasonable entry barriers and strong management with good scale. Valuations are also reasonable given the broader market context. Additionally, the pharma sector tends to follow a bottom-up approach in investment decisions due to each company’s unique growth prospects and business mix, making it less dependent on macro trends than sectors like banks or IT.

You also have quite an eclectic bunch in autos, you have passenger cars, you have two-wheelers, you have quite a range of stocks. What is your call there from Mahindra and Mahindra to Eicher Motors?

In autos, valuation dispersion across categories is low, supporting a diversified investment strategy. You pursue concentration in your portfolio when you find great value in some pockets because then it makes sense to put a lot of money in those few pockets… But in this market (across sectors including autos), the dispersion in valuation is low, so it is better to run a diversified portfolio. The valuations are converging and the growth prospects are similar, then why take additional risk of putting a lot of money behind a single idea?

Did you invest in the Hyundai IPO?

We thought it was very expensive.

Do you invest in IPOs? What are your thoughts?

The IPO market has seen a significant increase in supply. Promoter stakes are reducing, not from selling but through dilution. For the first time in the history of Indian capital markets, MNCs (multinational corporations) have sold down stakes in listed companies over the last one year. This trend has gone even one step further with the Indian arms of these MNCs listing in India because valuations in India are much higher than what these parents trade at outside. Hyundai was the first such case and we would expect a lot more companies to go public. The supply of stock in India is increasing rapidly. Some cash-rich companies are also raising capital to take advantage of attractive valuations. This rapid supply increase may lead to moderated returns and valuations over time, similar to historical patterns seen in 1992, 1999 and 2007.

We remain keen on investing in IPOs, as the goal is always to find sustainable businesses at reasonable valuations. While we do not follow a short-term strategy to sell on listing, we look for long-term value in IPO investments without distraction from our overall low-churn investment approach.

What do you see as the biggest risk for this year?

The primary risks this year include geopolitical uncertainties and US 10-year yields. So far, oil prices have remained stable despite ongoing wars, minimising the impact on India as long as conflicts do not escalate. The US yield curve, however, is a concern: while the short end may decrease, long-term yields are likely to remain high due to increasing borrowing and persistent deficits. If US 10-year yields reach 4.5-5 percent, it could affect global capital markets. However, India may be resilient due to a lower current account deficit, strong local flows and reduced dependency on FII (foreign institutional investor) inflows.

Do you see any risk to local liquidity at all? It seems like this is the new normal that every time the market sells off 5-7 percent and you stop because there is so much buying that comes with every dip. Is there anything at all that could change or reverse this trend?

This surge in local market liquidity appears to be structural, stemming from decades of financial education and investment in public awareness by funds, regulators, media and banks. Domestic flows are likely to continue as long-term investments. If three-year returns drop significantly, domestic flows might slow, but currently, the trend remains robust. A potential moderation in IPO pricing could further benefit the market by sustaining interest without speculative spikes.

How would you explain or describe last year, and what do you expect for the coming year?

Expectations are high, with a new wave of investors, many of whom have not experienced a down market cycle. This could lead to disappointment, especially in high-risk areas like F&O (futures and options) or speculative investments in popular narratives. Long-term potential remains promising, but it’s critical for investors to be realistic about returns and mindful of risks, focusing on the quality and valuation of what they own. Markets may favour those who approach investments with discipline and long-term thinking, rather than chasing narratives or inflated prices.

I also noticed that you have also exited a lot of stocks in this space that you had—defence, some of the power stocks, the power NBFCs, etc. So you made quite a timely exit, I guess, in all of these.

Our investments are based on two simple promises, buy good quality businesses and don't overpay. So I think when good businesses are available cheap, you buy them, and when they get overvalued, you reduce exposure. That is a sensible way to do well in these markets.

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