Earnings will be better in Q3 due to base effect of demonetisation, says UTI MF's Vetri Subramaniam

“The base effect will certainly look much better and when you look through the earnings we see a wide divergence between the numbers and when we break down the aggregate numbers we see strong growth in some sectors which essentially belong to commodities space,” said Vetri.

Also read: Too much pessimism over IT; pharma still not cheap: UTI MF’s Subramaniam

Sectors which are underpinning strong earnings growth include oil & gas, metals, and refining. Whereas, a lot of the traditional domestic areas which held up earnings growth in the past are experiencing stress on profitability.

Commenting on the troubled companies, Vetri said investors should stay away from companies which are referred to the NCLT. “These stocks are not on our list because we don’t know what form and fashion they will exit the NCLT process and equity holders will have to take a significant haircut,” he said.

Below is the verbatim transcript of the interview.

Anuj: How do you see this new Samvat? Last Samvat was good one for investors, do you see this Samvat as good as last one?

A: That is sort of hard to define. I don’t think the market really cares about Samvat’s in that sense, so, eventually I think market will do what they need to do and they don’t really care about things like New Years and quarters. So I am sure that is really the best lens through which I would look at what the market is likely to do.

I think the market has done pretty well in India this year, but the truth is that it has been a pretty strong year for markets across the world. When I look at equity markets around the world, they have all done pretty well and that is really the backdrop in which we need to look at the performance of our market. As somebody pointed out, in fact India is somewhere more in the middle of the pack relative to global and emerging markets over the last six months. So we have done well but nothing as spectacular.

I think specifically as far as India is concerned, the two things to look at this point of time is that what sort of a recovery do we get clearly out of what has been a weak spot for economic data, and b) at which point of time do we actually start to see the earnings trend start to move higher because we need that to support this move in stock prices.

Latha: What is your sense about the earnings season so far?

A: It is still early days, but I think not a very definitive trend in terms of numbers coming in pretty much in-line with expectations. I think the ask rate will get slightly easier in the next quarter, which is the October to December quarter, because that was a very difficult quarter last year because that was the demonetisation quarter. So the base effect certainly will look much better.

I think when you look through the earnings, what we are seeing is, there is still a very wide sort of divergence between the numbers. When you break down the aggregate numbers, what you see is, that while there is strong growth in some parts of the market that is largely coming from the global commodities space, be it metals, be it oil and gas, refining, these are the areas which are actually underpinning strong earnings growth for the market whereas a lot of the traditional domestic areas which otherwise have been the sort of area that held up earnings growth, I would say right through 2014-2015 when global commodities were not doing very well, it is that same domestic area which is actually now seeing significant stress on profitability including in financials where the pain that the corporate facing banks are experiencing is offsetting the strong growth that the retail oriented banks are experiencing.

Latha: As a fund manager would you be even looking at all these troubled National Company Law Tribunal (NCLT) companies? We have seen such huge gains in Bhushan Steel and even Uttam Galva Steel, GVK Power & Infrastructure. Are you getting a sense that that is getting resolved and therefore some of these are worth the risk?

A: Without getting into individuals names no; I think at this point of time it is too premature to be taking a call on any of these NCLT companies that have been referred to the NCLT. We do not know to what extent debt will have to be written down, we also do not know to what extent equity shareholders may have to get diluted or written down.

The NCLT stocks not on our list of companies. We eventually do not know what form and fashion they will exit the NCLT process and whether equity holders as well will have to take a significant haircut. So it's not something we are looking at.

Anuj: You have seen many market cycles. Where do you stand on telecom right now? There is a huge gain that we have seen in Bharti Airtel year-to-date and it has come out of multiyear sort of bear market. How would you approach this sector? I know you won't be talking stocks but the big telecom stocks, how would you approach them?

A: The key call to take in the telecom sector is whether now we have reached a point where with all the sort of weak players being taken out, the industry is likely to consolidate with maybe just three at best four strong players left in the market and three of them are going to be very dominant and to that extent telecom has been a space where over the last few years we have seen significant deflation in pricing year-on-year. So if we can even arrest that trend of deflation and start to stabilise the average revenue per user (ARPU) numbers then fortunes might gradually start to improve for the telecom sector. That said; remember that they are still operating significantly below, what I would define as being a healthy level of return on capital employed. So even if we were to turn incrementally positive on the fact that a consolidated industry might see more pricing power. There is still a very big ask left in terms of them being able to raise their return on capital to a level where it start to make economic sense but certainly incrementally one has to look at developments there most positively as they are coming out certainly in favour of the industry players because of consolidation.

Surabhi: Coming back to the point of stress, obviously Axis Bank was the bad googly this time around, in Q2 so far. Which are the banks that you are comfortable holding? Which are the banks that you will strictly avoid?

A: I cannot talk specific banks there but broadly speaking our comfort level is with those banks where there is a strong liability profile and therefore they are able to compete effectively and if they have got a strong retail franchise on the lending side and high quality book on the corporate side then credit cost is not much of a challenge for them. They are able to absorb the current level of credit cost comfortably. So you have to be selective over there. It is the banks which have a very large corporate focus and particularly historical project lending focus, so the banks that grew their project lending book very aggressively somewhere early GFC all the way up to 2012-2013, these are the banks who are currently experiencing a large amount of stress because that build-up of their project finance book during four-five year period is now coming back to haunt them. Having said that even within that space we do sense that we are somewhere closer to the peak of credit cost recognition in their profit and loss account, so we are watching that space to see if any of these names start to get comfortable; some of the numbers do come out and scare you and shock you but there is likelihood of an opportunity emerging even in some of the corporate focused banks presuming that they have enough capital adequacy at this point of time to ride through the rough weather that they are currently experiencing.

Latha: We have been waiting for earnings growth and people derisively point out that every year for the last four years the second half will bring us earnings growth and they don't, but should one really be so despondent? After all there are a lot of good things in terms of direct benefit transfer (DBT), goods and services tax (GST), the monetary policy committee, the definite lid over inflation, the definite lid over crude prices so to speak. So do you think that there is no room for despondency and that it is only a matter of time before earnings will kick in?

A: The way I look at this is that we have got good strong macroeconomic platform, certainly one of the strongest sort of platforms that we have seen in my history of tracking the economy and the market and certainly this is a platform from which we can accelerate in terms of much higher growth rate for the economy which should eventually convert into higher earnings growth rate as well but that hasn't happened for the last two-three years. There have been pockets of higher earnings growth but aggregate market earnings growth has still been soft. It is very hard to say exactly when these will turnaround. The only point that I would make here is that we have all the ingredients required to spark earnings turnaround but we do not have the ability to put our finger on it and say whether it will happen next quarter or two or three quarters down the road. I think the necessary conditions that we need to see for that kind of a broad based earnings recovery, at some level would also require the other two cylinders of the economy which are currently not firing, which is investments and exports, will also have to come to the forefront if we really want to see a big pickup in earnings growth for the economy.

Anuj: In that case a larger question. For the overall market health, so far liquidity has trumped valuation and we have seen domestic liquidity, almost a bit of a tsunami in domestic liquidity but this new investment that we have seen over the last one year hasn't seen even a 10 percent correction. In the last bull market we had a lot of corrections, 10-20-30 percent corrections. Do you think if we have a global correction and if India also falls inline, in that case we could be vulnerable especially money which has come off late over the last one year or do you think this money is here to stay?

A: Liquidity always plays a role in rising stock prices. It is only a question of who is providing the liquidity. We were having this conversation five years ago and we have been talking about foreigners pumping in money five or six years ago and today we are talking about locals pumping in money. So somebody always provides the extra doses of liquidity rushing into buy stocks at some point of time. So it doesn't matter who it is.

The bigger question you ask is in terms of corrections. It is largely true that markets around the world including India have not displayed the kind of historical volatility that one associated in the past. In my own career, going back to early or mid-90s, 10-20 percent corrections were de rigueur every 12 months; there was hardly any 12 month period in which we didn't see the market slide 15-20 percent. To be fair in the last two years we have seen one cut of about 20-24 percent going back to February '16 when the market dropped about 20-25 percent but since then there hasn't been anything of that sort. I certainly hope that to the extent investors are coming in through the systematic investment plan (SIP) route, to the extent that they have been allocating money to asset allocation products and balance funds. It does reflect their ability to think longer term and also think tactically in terms of which kind of fund strategies might be better place to ride volatility but it is a very key think for all of us in the industry to educate investors that volatility levels right now are quite low and by historical standards, if anything, we should expect that at some point of time there will be a spike in volatility and stock prices take setbacks for various reasons. We will never know what those reasons are completely before hand but in a market which is traded up in terms of valuations quite significantly, I would certainly worry that at some point there would be a setback and there would be a spike up in volatility and I hope investors have been prepared for that and certainly all of us have done a lot of talking to investors to educate them on this point.

Surabhi: Since we are on the subject of liquidity, I wanted to run this past you, the new Sebi circular that came, talking about the classification and categorisation of mutual funds and how every fund house can have only one scheme per category, an estimate that I got said that out of the 858, 860 odd open ended funds, there might be a lot of mergers of schemes and that number might come down to 500. I don't know if you agree with that view or not, but if that were to happen, can that impact flows in the interim at all as this consolidation happens?

A: I think it is still sort of early to comment on that. If you are familiar with the circular, each fund house has to now sit down, evaluate all its strategies, take it our trustees, and then get the trustee approval for the rejig of whatever schemes as may be required based on the circular and then take it to Sebi. I think certainly there will be some reduction in the number of schemes, there will have to be some mergers, but it is still early days and I cannot speak for the other fund houses. However, I think every fund house will find that it will have few mergers that will have to be done and few sort of rejig of strategies to make sure that we fit it in with the existing mandates.

So there are some challenges but I don't think anything which is inordinate. I think the new part of the circular is the fact that effectively we have defined largecap, midcap, and smallcap companies. There were different definitions of these which were being used in the industry earlier and the only challenging part of this is that at some level it could be argued that 150 companies being defined as midcap is sort of restrictive in an economy like India where we would expect a large number of companies to come for listings over the next few years. If you restrict it in terms of number of companies, then in a way will price discovery happen in an efficient fashion for a lot of mid-sized companies which might choose to come to the market over the next few years is something that I think we should all think about.

Latha: You tweeted about 'The Most Important Thing', Howard Marks's book. I have never seen such generous praise -- what a powerhouse of a book, please read it and then read it again and again - that is what you had written. Give us one big idea that this book has that makes you recommend it so strongly.

A: I think the one thing that sticks with me mostly deeply and I wish I had read it 20 years ago, unfortunately it was not written 20 years ago, and I may not have appreciated it 20 years ago, but I think the point that he makes that eventually everything in life is cyclical, everything     in the markets is cyclical, I think that to my mind is something that we need to keep in mind because too often I see people jump on everything and call it the new normal and they presume that things will be stable.

If anything, the understanding that you should take away from 'The Most Important Thing' is that a lot of things in the markets are cyclical and the cycles will happen. You never know beforehand what will cause those cycles to happen, but you can prepare for it. I think that my mind was the most significant take away from the book.