DAILY VOICE: Unmesh Kulkarni of Julius Baer India highlight 3 critical factors for stock selection

While some part of the earnings growth may be on a low base (due to the pandemic), there is also a structural and broad-based recovery taking place on the back of improving demand, pick up in realization for commodities and energy, a pickup in manufacturing and the investment cycle (benefiting cyclicals) along with robust rural consumption.

Given the pace of the market rally and the heightened expectations of investors, one should certainly be cautious and exercise prudence in the near term.

Markets can be vulnerable to a correction anytime, on account of several risks building up – a) China policy uncertainty affecting sentiment for emerging markets, b) possibility of COVID 3rd wave in India, c) recent geo-political developments (Afghanistan) and d) the likelihood of the US Fed tapering in the coming months.

However, despite these headwinds, the economic and earnings recovery story remains intact and should act as strong support to the Indian equity markets.

Besides, given the positive recent investing experience and the lack of any alternate attractive asset class, equities could continue to keep investors interested.

Any meaningful correction (say, 10% or so) in Indian equities should be bought into, from a medium-to-long-term growth perspective.

Q) What is your investment mantra before picking stocks for investment?

Unmesh Kulkarni: While identifying structural equity investment opportunities, we believe a few parameters are of paramount importance (a) a position of leadership and/or competitive advantage in the segment that the company operates in (b) quality of the management, growth, and earnings and (c) relative attractiveness in terms of valuation.

While the first two parameters are structural in nature, the valuation metric is more dynamic and requires patience and perseverance.

Besides, in portfolio construction, thematic opportunities often present themselves depending on where you are in the market cycle.

For instance, for this year, we had identified and successfully participated in a few key themes – earnings momentum, rotation trade (value/cyclical making a comeback), out-performance by mid/small caps and the revival of the CAPEX cycle.

Our near-term positioning is for mean-reversion (large caps and defensives), given the sharp broad-based rally that has already occurred across the market.

Q) US Fed minutes caused a knee-jerk reaction on D-Street in the week gone by. The world has got used to easy money now. How will it impact equity markets across the globe including India?

Unmesh Kulkarni: The spurt in CPI inflation in the US has prompted the US Fed policymakers to review their policy outlook. While the Fed has opined that the current spike in inflation is transitory, it has provided some guidance on rate hikes, and the consensus seems to be indicating the first hike to take place in 2023.

Fed officials have also initiated the taper talk a little while back, which is making the markets wonder about its timing and pace.

Broadly speaking, the Fed seems to be preparing the markets for the eventual tapering and withdrawal of liquidity, while also suggesting that the process would be gradual.

The larger concern for the Fed, however, is the Delta variant and its rapid spread in the United States as well as elsewhere in the world, and its potential impact in terms of slowing down the pace of the economic recovery.

A more concrete announcement of tapering is likely at the September Federal Open Market Committee (FOMC) meeting. While there may be some market reaction around the announcement (before/after), it is likely to be muted, as expectations are already building along those lines.

Indian equity markets will naturally take some cues from the US Fed talk and the accompanying global market reaction.

However, apart from the noise around tapering, the key factors for Indian equity markets would be the evolving Covid scenario (3rd wave or not), global flows as well as the earnings story, which looks pretty much intact.

India could also emerge as a possible beneficiary of some re-allocation on account of the recent uncertainty around Chinese markets.

Q) The recent price action suggests that smart money has started moving from small & midcaps towards largecaps? What are your views?

Unmesh Kulkarni: Midcaps and Small caps have significantly out-performed Large Caps in this calendar year so far. The Nifty Midcap and Small Cap indices have posted stellar performance, rallying 31% and 40% respectively YTD CY21, and 149% and 195% respectively from March 2020 lows (as on 25 August).

The current phase of the economic recovery and earnings expansion augurs well for mid/small caps, and we continue to be constructive on this space.

However, given their sharp out-performance in a short period, there is a case for mean-reversion in the near-term.

Large caps could start seeing renewed interest from investors, while there is also a possibility of profit-taking in mid/small caps, especially if the markets were to correct from the current levels.

From an overall equity allocation perspective, it makes prudent sense for investors to allocate incremental monies to large caps at the current juncture.

Q) Warren Buffett will celebrate his 91st birthday on August 30. This legendary investor has been an inspiration for most value investors. Has he also inspired you in one way or the other and is value investing losing sheen in a high beta market?

Unmesh Kulkarni: The iconic guru of global value investing, Warren Buffet, has inspired several fund managers around the world over the last few decades.

While not many money managers follow the value investing style in their portfolio construction, there are certain aspects of Warren Buffet’s stock-picking philosophy that would benefit most investment managers, irrespective of their investment style – e.g., identify companies that exhibit solid fundamentals, strong earnings power and the potential for continued growth.

While there are definite merits of value investing, there are some practical challenges as well. One needs to have a sufficiently long horizon to experience the full potential of value investments (investors need to be patient), whereas growth companies tend to deliver more consistent performance.

Besides, in a fast-changing macroeconomic as well as the business environment, especially in the 21st century where technology has changed the way businesses operate as well as their scope and reach, the definition of “value” itself becomes a bit blurred, as quite often the identification of a value company is driven by market cycle rather than economic cycle.

Generally speaking, among value companies, cyclicals typically tend to out-perform in the initial period of economic expansion, as we recently experienced in the global markets and are currently experiencing in the Indian markets too.

India, being among the emerging markets, is typically looked at by global investors as a “growth” market, and the flows from foreign investors generally follow accordingly.

Q) So where are the money-making opportunities in this market?

Unmesh Kulkarni: After a strong FY21, earnings for FY22 have begun on a healthy note. Management commentaries across the board suggest an improved demand environment post June’21, led by the easing of restrictions and a pickup in vaccinations.

We expect earnings momentum to accelerate in FY22, as the pace of vaccinations picks up and the economy opens up further. Banking/Financial Services and commodities are expected to drive FY22E earnings.

While so far in the year we were looking more favorably at mid/small caps as well as a rotation trade from defensives to cyclicals, given the sharp market run up, we expect to find near-term opportunities in large caps and some defensives (healthcare, consumption) as these play catch-up with the rest of the market.

1) Banking/Financials also would be a preferred segment, as its performance has been modest so far and the outlook should improve with the economic recovery and earnings momentum continuing into the next financial year.

2) Autos can also emerge as a contra play, considering its recent underperformance, as we may potentially see a good volume uptick with normalisation of activities, favorable progress of monsoon, and as we head into the festive season.

3) Also, Industrials/Infra can be an interesting space to look at, with an expected revival of the capex cycle (especially from the private sector), aided by benign interest rates, improving utilization levels, improving export opportunities and Government measures such as PLI. Pick-up in order flows will lead to increased investor interest in this space.

Q) Given the fact that we are trading in unchartered territory – should investors consider rebalancing their portfolio? What is the ideal portfolio allocation at this point?

Unmesh Kulkarni: As far as investors’ “strategic” asset allocation is concerned, it should stay largely intact through market cycles, as it is long-term oriented and based more on the risk profile of the investor rather than the state of the equity markets at any point of time.

However, most investors also tend to have a “tactical” overlay in their equity allocation, and typically, in bullish markets such as the current one, most investors would have gone tactically overweight on equities.

Given the sharp rebound as well as outperformance by equities, it would be prudent for investors to reduce their tactical overweight on equities and realign their portfolios to their strategic allocation.

This would serve the purpose of preserving some of the excess return made over the last year as well as aligning the portfolio as per the risk appetite of the investor.

The challenge, however, that investors will face at the current juncture is that fixed income returns are very low and hence a dis-incentive to move away from equities; however that is a compromise one has to make in the near-term if one wishes to safeguard the portfolio against potential market uncertainties.

Within equities, one can look at rebalancing the portfolio a bit in the near-term in favour of large caps and defensives, and also by possibly introducing some hedge in the portfolio through hybrid strategies.

Q) If we look at the sectors which gained as Sensex moved from 50,000 to 56000 in August – Metals rose 73%, Smallcap was up 40%, Utilities and Power were up 27-37%. Which sectors will lead the next leg of the rally? Do you see some profit-taking in some of these sectors?

Unmesh Kulkarni: The markets have been a bit polarized of late, with a few sectors such as IT, Metals, Cement and Chemicals seeing elevated levels of market participation.

On the other hand, a few sectors such as Financials, Auto, Healthcare, Consumption and the PSU pack, which have been facing some near-term challenges, are seeing complete apathy from investors, and in fact witnessing a gradual drift/correction.

We think there is a case for sector rotation to play out, which may invite some profit booking in the sectors that have been big outperformers recently. On the other hand, we may see interest coming back in Financials and certain defensives (healthcare, consumption).

Q) Auto was down over 3% as Sensex rose from 50,000 to 56,000. Do you think there is potential in Auto space in the near future as EV space hots up?

Unmesh Kulkarni: The Auto sector has clearly been a big underperformer recently, having been impacted by the disruptions from the second wave of Covid-19, shortage of raw materials (semiconductors) and the increasing input cost pressures, which started hurting the margins as the companies are reluctant to pass on the entire increase in input costs in the currently fragile demand environment.

However, we believe Autos can be a good contra play at this juncture, considering that the valuations have started turning attractive and as we expect overall volumes to pick up over the next few months.

Regarding the transition to EVs, we believe it can happen faster in Scooters and the LCV space. We may not see a very rapid transition in the passenger vehicle (PV) space due to challenges on the charging-infrastructure front and the currently prohibitive cost of the vehicles.

Hence, we could see a much slower transitioning and a critical mass being created only after a few years. Besides, the hybrid vehicles could probably see more traction in the near term rather than the Battery EV (BEV).

However, EVs are definitely the way forward and accordingly, almost all the companies are gearing up to have a presence/offering in this space.

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