Daily Voice | PMS Head of LIC sees investment opportunities in mid and small caps

The financial market veteran manages assets worth approximately Rs 1,700 crore. Here are the edited excerpts of his interview with Moneycontrol:

Q1. What is driving the market currently and where is it now headed? Do you believe the Nifty will clock a new lifetime high before 2022 ends?

India’s outperformance will continue and we reiterate our belief that the current leg of the upmove will be catalysed by ebbing of rates and the dollar surge that triggers Emerging Market (EM) carry trades into the year end. India being the second largest component of the EM index now will clearly be a beneficiary of such a revival of animal spirits.

Domestically, India was firing on all cylinders throughout 2022 with strong macro and micro, in stark contrast to the rest of the world. This is coupled with the midcycle spoils of rising tax collection, rising credit growth and improving capacity utilisation (a classic midcycle play that is already played out in the west). On the corporate side, a classic midcycle play is visible in the corporate profitability metrics of banking, cyclicals and consumption. These sectors continue to do the major heavy lifting for Earnings Per Share (EPS) growth as they take the baton from early cycle commodity plays and global latecycle exposed Information Technology (IT).

Globally, right from the start of 2022, financial and physical assets have seen a tumultuous ride as the multi-decadal-high inflation level caught monetary policy napping. But in the last month (October has ended 6 of 17 bear markets since World War II), as the peak inflation narrative started to visibly fructify in commodity prices, the narrative ebbed and calmness started getting restored. US inflation data triggered a sharp bid on rates and the dollar. Treasury yields and the dollar saw their largest daily fall since 2009 after the soft CPI. These were the key global headwinds that prevented the global market from stabilising and India heading into a higher orbit.

Also Read | Daily Voice | Not increasing positions in IT as headwinds in US, Europe fairly strong, says this investment professional

Q2. Considering the Nifty is already at 18,000 and taking into account the current valuation the index is trading at, do you believe now is the time to invest in equity? Do valuations look reasonable or attractive? If not, has the risk premium for equities increased?

Price and Earnings are the bedrock for valuation. If you look at Price and Earnings separately both are suggesting a different picture. However, if you look at absolute price action, India looks expensive, whereas, on most popular metrics of Price to Earnings (PE), India is still not expensive. On October 19, 2021, when the Nifty conquered 18,600, the trailing PE was around 28 times and 1 Year Forward PE was 25 times. Currently these numbers stand at around 19.7 times and 21.4 times, which is very close to longterm averages, and clearly suggests that the earnings side has the entire heavy lifting as rates have moved higher, leaving no scope for multiple expansion.

Q3. What is your reading of the Q2 FY23 earnings season so far?

The S&P witnessed a reasonable enough earnings season. Contrary to pre-season fears of this earnings season prompting a lower reset for expectations, the tone and substance of management guidance has been good enough.

At home as well, with more than half of the NSE 500 companies already reporting their numbers, there is an 8-9 percent dip in earnings for the first time in many quarters. Besides, the second-order impacts of financial and operating leverage is yet to play out in the full force that is likely to keep the earnings trajectory resilient.

Index heavyweight sector BFSI is leading with strong growth in Net Interest Margins (NIMs) while the Automobile and Consumption space has witnessed strong volume growth. Early cycle plays like metal and globally exposed sectors like technology saw an earnings dip.

Q4. Which sectors are you confident about and which ones are a big no at this point in time, and why?

Rising tax collections, rising credit growth, improving capacity utilisation and multiyear high are classic signs of a standard midcycle play. However, our midcycle is clashing with the western world's latecycle play as most large economies, led by the UK and Europe, are dealing with risks of a recession. The portfolio implications from this are one should look at the domestic story and not globally exposed Technology (impending recession fears) and metal sector (usually an earlycycle play).

We continue to remain upbeat on midcycle plays like banking, cyclicals (excluding metals), auto and consumption. And top tier IT firms could also be added to the portfolio.

As visible in strong Net Interest Margins (NIMs) in Q2 FY22, along with asset quality issues having ebbed, the sector has been seeing credit growth resurging over the last five years. With credit growth picking up to 18 percent and loan growth to be around 13/14 percent in FY23/FY24, the major banking universe may deliver growth in profit after tax.

Auto and Consumer discretionary, which typically does well in a mid cycle, especially with India’s per capita income rising beyond $2,000,  is in the reckoning as well. While the Auto sector is likely to see margin improvement of around 300bps coupled with strong volume growth, on the consumer discretionary side, companies are expected to take price cuts to pass on the benefits of lower input costs to end consumers and thereby boost volumes in the second half of FY23.

Also Read | Daily Voice | Despite recent run-up, this investment strategist sees PSU bank valuations reasonable

Q5. If we look at the past 3 months and 1 year, your LIC MF – Value Equity + fund has outperformed the benchmark. What has led to this outperformance?

For our portfolio, we first analyse with a macro lens to zoom in on sectors, take an under/overweight stance on a sector, and then opt for bottom-up stock selection, which may generate returns. This approach aided the outperformance.

We went underweight on  IT and Metals at the start of 2022, as the macro signals were clearly suggesting that inflation is not transient and the monetary response would be growth restrictive.

Q6. Looking at your portfolio, your top 5 holdings are mostly blue-chip and out of those 2 are banks. Are you bullish on the financial services and IT sectors and why?

This portfolio is benchmarked to the Sensex 30 and hence the stocks are bluechips but it has a strong tilt towards the domestic cyclical story. Banking, even though it touched new highs on November 11, continues to remain at the top of our pecking order in the largecap space going into CY23. As of October end, valuationwise, the sector was trading at the 10-year average. Also, price performancewise banking has still not fared the way key sectors like IT and Auto have registered 2-2.5 times gain from Covid lows.

Large Cap IT is one space that one may have in the portfolio. While we believe that margin contraction may be in the rearview mirror, a likely recession in the  UK and Europe and its business impact on revenue growth is still not fully priced in. However frontline IT has seen sharp price destruction and is being bought in a staggered manner.

Q7. Smallcap stocks form a relatively small part of your portfolio. Why is that so? Is it that the current market valuation gives you confidence to invest only in largecaps and selective midcaps?

Value Equity + PMS aims to capture the underlying economic and corporate buoyancy. The economic activity is constructive and that is good news for stocks in the broader market. However, the cardinal investing checkpoints of FCF generation, visibility of earnings and growth and zero corporate governance issues are sacrosanct.

We have increased our allocation to the mid and smallcap space and currently over 40 percent of our portfolio weight comes from these two segments.

In the midcap space, we see many opportunities, especially chemical, agro, and pharmaceutical companies — which have very strong long earnings growth visibility — under our China+1, Make in India theme. In the smallcap space, there are goodquality names in the logistics, infrastructure and financial space that have earnings growth visibility, falling under our PLI and Inward-looking story.