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Daily Voice | This equity advisor explains 3 factors for stock picking in high inflation and interest rate regime

Once you invest in fundamentally great companies and follow the two principles of discipline & patience, success is a matter of when & not whether….

July 27, 2022 / 07:39 AM IST

The equity market is in the process of pricing in a host of major challenges like the end of the low-interest-rate era, lack of monetary policy support, sustained geo-political tensions, and soaring global inflation.

But these can't be priced in seamlessly within 3-6 months in a dynamic environment and therefore markets may continue to remain volatile on incremental developments, says Devang Mehta of Centrum Wealth.

Seasoned in the research processes across multiple sectors, valuation methods and behavioural finance, Devang says in an environment of higher inflation and interest rates, it is imperative to have a stock-picking strategy where one buys businesses with huge pricing power and moat.

"Once you invest in fundamentally great companies and follow the two principles of discipline and patience, success is a matter of when and not whether."  The expert with more than two decades of rich experience in investment advisory, equity sales and portfolio management shares his views in an interview with Moneycontrol. Excerpts from the discussion:

Do you still have a cautious view on the equity market, given the current macro environment, including geopolitical tensions, policy tightening by central banks, slowdown in growth in US and Europe?

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The market is in the process of pricing in major changes like end of low-interest-rate regime, hardly any monetary policy support, geopolitical crisis and precedence to inflation targeting rather than growth. All these cannot be adjusted in 3-6 months and, therefore, markets may continue to remain volatile basis incremental developments.

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Rising inflation and hence rising interest rates is a given for some time to come. The only tools so far with the central banks is to squeeze liquidity and raise rates.

However, with a substantial drop in commodity and crude prices, inflation is expected to trend lower in the coming months. Also, supply side bottlenecks seem to have come down materially which will again help. After a long while, we are seeing foreign outflows slowing down this month, in fact there is a minor net inflow. While the indices have fallen by close to double-digits in 2022 itself, at a stock level, the fall has been much higher. You can't time the bottom to perfection and hence slow and gradual buying would be prudent.

Power turned out be the biggest gainer among sectors, reporting 28 percent gains this year. Is it the right time to enter this space?

Power as a sector has never created consistent wealth for investors. Yes, off late as a bucket of value which also offer low beta & decent dividend yields, it has been a beneficiary of sector rotation while the high value or high PE (price-to-earnings) stocks readjust in this fall.

Rather than buying into this space, we prefer some anciliary proxy plays as well as select capital goods companies, which have seen robust orders & performance traction. In times, when capex is about to come to the fore, even corporate capex oriented banks will benefit and valuations here are still extremely reasonable.

Several experts feel the Fed will not let the economy go into recession. What is your projection for the US economy - recession or slowdown?

All the hard work done from the start of Covid times and the earlier stimuli would tend to sink into the oblivion, if US gets into recession. All efforts to prevent it from getting into a recessionary trajectory will be made. But yes, slowdown is desirable and inevitable as inflation print of 9.1 percent is substantially high above the tolerance zone. The higher-than-expected US inflation means the Fed will continue its aggressive tightening in the near-term with another hike in July. Unprecedented times call for unprecedented measures. Hence a rate hike of 75 to 100 bps is on the cards.

Also readFed meeting: 75 bps rate hike a certainty but 100 bps can't be ruled out

But the long-term bond yields in the US indicate a possible rate cut by March 2023. In brief, this 9.1 percent inflation print is likely to be the peak inflation.

Also markets were relatively calm looking at the 9.1 percent inflation print & have also started to factor in a large hike. Ideally, in the prevailing sentiment, it should have fallen, seems markets have had enough of inflation and interest rate rhetoric.

Do you think the IT stocks have seen enough correction and now it is time to buy the space? The IT index is the biggest loser in this year, down 24 percent.

At the expense of being repetitive, let me say that, Indian IT more often than not derives its trend from the Mother Index Nasdaq, which has gone through a severe bout of correction. Add to this the PE multiple contraction due to issues like attrition, margin miss and order pipeline led to this sort of valuation correction.

To add to the woes, in India, IT has been one of the most overowned sectors and a traditional favourite of foreign investors, hence when the outflows were huge, the correction was enormous.

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While IT earnings will get impacted by slower growth in developed markets, they will have the cushion of lower rupee that benefits them. More important than earnings this season was the management commentary which was optimistic. Given the credibility and the business model of most of top IT companies and few mid - caps, post this correction, the valuations and price points have only got attractive, it is definitely time to look into select companies.

The rupee fell below 80 against the dollar in July. Do you think the currency has already seen enough depreciation and what could be supporting factors?

The Indian rupee has fallen to fresh lows and breached the 80 mark, amid a global risk-off sentiment and investors fleeing emerging markets assets. Unprecedented selling of Indian equities by FIIs for almost 10 months now has also added to the rupee falling against the dollar. Widening trade deficit primarily due to surge in crude oil prices has also resulted in the rupee depreciating against the US dollar.

Also readIMF cuts India's FY23 growth forecast by 80 bps to 7.4%

However, if you look at rupee in a global spectrum compared to other currencies this calendar year, we are relatively holding up much better than even developed market currencies like Euro, Pound, Yen, thanks to RBI's proactive measures. Also, foreign direct Investment has been on a steady growth path along with exports which has also seen traction. The strong forex reserves, which are now depleting to support the rupee, has been put to good use during such times of crises.

What should be the proper stock selection criteria (including ratios) if one is new to the equity portfolio building?

In an environment of higher inflation and interest rates, it is imperative to have a stock picking strategy where one buys businesses with huge pricing power and moat.

Three important factors to look at picking businesses should be whether the size of the opportunity of that industry is growing, whether the company has dominant market share & does the stock provide one, a necessary margin of safety. Try to be in companies which are ideally debt free, companies with high return ratios, impeccable management quality and reasonable valuations. Very little diversification exposes one to huge risks & over diversification without conviction will lead to sub optimal returns.

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A check on the last 3 years, 5 years and 10 years history of growth in revenues, EBITDA (earnings before interest, tax, depreciation and amortisation) and profits along with market cap expansion will help to understand the volatility of earnings, if any, and also the cyclicality of business.

It is also important to look at the next two three years of earnings & growth visibility for the businesses in the portfolio. A regular review of the constituents of portfolio from a professional advisor will help in maintaining good financial health and hygiene.

Once you invest in fundamentally great companies and follow the two principles of discipline & patience, success is a matter of when & not whether….

Disclaimer: The views and investment tips expressed by investment experts on Moneycontrol.com are their own and not those of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.
Sunil Shankar Matkar
first published: Jul 27, 2022 07:39 am
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