Equity and long bond markets are currently trading at par around 15 times earnings, says Ridham Desai Head of India Equity Research & India Equity Strategist at Morgan Stanley. "If one were bullish on bonds and bearish on equities now is the time to make the swtich," he says in an interview to CNBC-TV18.
Indian stock and long bond markets are currently trading at similar yields -- around 15 times price-to-earnings for stocks, translating into 6 percent earnings yield, which is roughly the same yield on the 10-year, says Ridham Desai Head of India Equity Research & India Equity Strategist at Morgan Stanley.
In an interview with CNBC-TV18, Desai said that given the current state of valuations, if one were bullish on bonds and bearish on equities, "now is the time to make the switch."
Although it is tough to predict the precise impact of demonetisation alone, in combination with other measures like the GST, it will aid in formalising the economy over the next 4-5 years and eventually have a positive fiscal impact, he says.
He feels that while corporate earnings momentum has been set back by couple of quarters due to demonetisation, stock prices have turned more attractive than they were 2 months ago thanks to the 7-8 percent correction seen.
Desai sees a 15 percent upside in the Nifty over one year. However, he cautions this will only happen if India is able to fight the general weak trend in other emerging markets.
He expects an interest rate cut by the Reserve Bank at its monetary policy review today. This will be the second time India will go against the US Federal Reserve, which could raise rates up to 6 times next year. He would watch out for the RBI's monetary policy framework more than rates in today's meet.
Globally, Morgan Stanley is underweight emerging markets (EMs) but has the top weight on India within the EM basket followed by China. Desai says India has moved out of the low-return status and is entering a better return environment.
Among other economies, it is overweight Japan on depreciating yen which would prove good for equities there. It is also overweight Europe but has recently downgraded US to equal-weight.
He believes India’s consumption demand is intact but for a temporary aberration. Similarly, he believes some NBFC stocks can be bought. He is overweight consumer discretionary and neutral on materials and pharmaceutical sectors.
Below is the verbatim transcript of Ridham Desai’s interview to Anuj Singhal, Latha Venkatesh & Sonia Shenoy on CNBC-TV18.
Anuj: I remember the last chat that I was having with you, you identified so many baggers; you said 10 baggers now don’t give you any thrills you are looking at 100 baggers now. Are markets, do you think over next 10 years will still produce 100 baggers?
A: In hindsight you will get a lot, but to tell them in advance is always very hard. So, that is the tough one. Tough one is not about identifying stocks that go up. The tough one is to actually buy them and stay with them because you get tempted to sell out when the stock goes up 20-30-40 percent. It is all return people make and sometimes these stocks go up very quickly in a very short span of time. To just stay there and watch this stock hang around or even correct and not act on it is I think something that either you need tremendous amount of luck or you need just enormous amount of patience’s.
Latha: And confidence that your choice is right?
A: Well, no, actually the opposite, the confidence that you are not right. I mean so the lack of confidence helps because confidence easily mops into over confidence and then you make mistakes. Then you think I will sell this and buy at 20 percent lower and then you somehow miss it. So, I think you have to have bit of uneasiness about what you are doing.
Latha: This demonetisation, are we getting away with minor bruises?
A: I think growth will obviously get impacted. I heard you say that we don’t know exactly what the impact is and that is very honest answer. We don’t know exactly what it is, we can make our guesses. We forecast earnings and gross domestic product (GDP) growth, so we have to model this and come up with some numbers, but it is very hard to tell what the precise impact will be in terms of growth.
What I have tend to focus on is where the share prices are. Share prices are a lot more attractive than they were two months ago. So, stocks are worth buying. The growth impact will pan out in the next couple of quarters and hopefully the worst will be done. So, there will be some growth impact no doubt about it. India is a very cash intensive economy and to replace 220 billion or Rs 14-15 lakh crore of currency notes is not a job that will be done overnight. Specially in a country that is vast, well not only the size but number of people we are talking about.
If you just assume that on average people have a Rs 1,000 in their pockets imagine how much of currency has to circulate before that money reaches them. There was also a tendency in the middle about couple of weeks ago people hoarding Rs 100 notes. Because there was a shortage, so that again kind of exaggerates the impact. That will ebb overtime and hopefully I think the worst will be done by the end of this month.
Latha: How long is the rebound going to take in earnings?
A: Couple of quarters I think. I think the important point is that we actually had momentum in growth. I think this has kind of set it back. So, in fact we were looking at the first quarter in almost six years where earnings revisions may have turned positive. Now that may get deferred by couple of quarters. So, stock prices were already anticipating that and very clearly stock prices realised quickly enough that this is not happening now so we have to now give up the next two quarters of price gain. In fact you are getting share prices maybe 7-8 percent cheaper than what they ought to be.
Anuj: We have all discussed demonetisation but maybe it took lot more screen space than it should have. At the same time we saw a long DM short EM trade play out. I mean India was not alone in this fall, we saw a lot of emerging market (EM) fall. Do you think that trade is overdone for now, do you see reversal of that or do you see more gains for developed markets?
A: Globally, we remain under weight EM. We are overweight Japan and Europe and we have downgraded the US to equal weight. So, our pecking order is Japan, Europe, US and EM. So, EM we are underweight; inside EM our top pick is India. So, we have actually lifted our weight in India couple of weeks ago on the back of the correction that had happened. We have also upgraded China. So, now India and China actually happen to be amongst our most favourite market story.
Anuj: However, they would still be lower than developed markets in the pecking order?
A: Japan, because we are expecting the yen to depreciate a fair bit over the next 12 months taking most of the brunt of the dollar rise and that will be good for Japanese equity. So, that is why we are quite bullish on Japan. We have got fairly big upsides compared to say India or China. However, India is also I think exiting its low return status. For the last two years the market has done nothing. In fact it is down, cumulatively maybe by 5 percent. So, I think we are entering into a better return environment for Indian stocks.
Latha: Is there anything positive in the medium-term because of this clean-up that we have done any fiscal gains?
A: I will come to that little latter but on the positive side of course this is one of the many steps that this government has taken since it has resumed office to clean up the country. So, it has to be seen in that context. I don’t think it should be evaluated in isolation. In isolation I think the impact is less compared to what the consensus think but I think in combination with all the other things that has happened I think this is a fairly potent move in cleaning up the economy, in weeding out corruption, in formalising, if I may use the word the Indian Economy. So, I think over time it will reflect in that sense. When you combine this with the potency of goods and services tax (GST) which I think is actually far more potent than demonetisation and hopefully GST does not get delayed, because the signals right now are, there is the potential delay there.
Then I think we are on our way to formalising the Indian economy over the next four-five years which will basically add to the reported GDP and will lift government tax revenues with positive fiscal impact. However, directly from demonetisation I don’t think there is any fiscal impact. I have heard people to say about big dividend from the RBI, I think currency is a notional liability for the central bank so you cannot actually payout dividends from the reduction in the notional liability, so that is not there.
So, going back to your point on fisc the fiscal gains come out of greater tax compliance. Greater tax compliance which is whether it is the Mauritian tax treaty, whether it is the electronification of the Indian tax system, demonetisation, GST and all these cumulative steps which will formalise the Indian economy, raise tax to GDP ratio rather than the one time check that people have been speculating the RBI will ride I think that probably betrays a lack of understanding of how the RBI’s balance sheet operates.
Sonia: The big theme of 2016 up until demonetisation was the consumption story, the autos, the cement plays etc. The paint companies, post demonetisation everything is in a flux. What do you do now?
A: The stocks are cheaper I buy them. I think India is consumption story is still intact. There is a temporary aberration. In some sectors there is permanent loss of demand which is gone like you are not going to buy the biscuits that you didn’t eat on November 9th or November 10th, but you are certainly going to buy the car that you didn’t buy last month. So, that is just postponement of demand so some of their losses are done and dusted I think the share prices reflect that.
In most parts the share prices are actually lot lower than they were even in financials for that matter and I think there are stocks to be brought. I mean look at non banking finance companies (NBFCs) they were the markets darling in October, now nobody wants to buy them. This is the time to step in and buy because the story remains intact.
Latha: The most important event today is the monetary policy. What are you expecting and what will that do to the markets? Will the market just be unruffled?
A: The monetary policy is another one of those things that were always the most important thing on the day, but people do not remember any monetary policy. You do not remember any. The only one I remember is the one that happened in September, 2013 when the framework changed. So, that is what I would focus on is where the framework is. What the rate cut actually is and we are expecting 25 basis points which is in line with the inflation trend.
So, one of the things out of demonetisation which is a little bit more predictable is that it will be a kind of a dampener on long-term inflation because to the extent the cash to GDP ratio drops, currency to GDP ratio drops, it will remove some of the tailwinds to inflation over medium-term; near-term of course, there will be some damage because there have been price cuts and all that but beyond that. So it warrants slightly lower interest rate over a medium-term. That is not today’s story. Today, we have to keep three things in mind. One is that the Fed is likely hiking in December and this may be one of the many hikes that at least we are expecting. We are expecting six in all. So this is a big change in Fed policy. Last year’s hike was an isolated one. It did not get follow-up. We think this hike will have follow-up.
Latha: Because you think there is going to be inflation next year?
A: Because US employment is full, US inflation expectations are rising and therefore, the Fed has to now move to a late cycle policy otherwise they will run the risk of inflation running ahead of them. So now, if you go back, since India opened up its economy, go back to 1993, very rarely have we acted against the Fed. This is the only occasion, which is they hiked in December and we cut after that. And this will be the second time if we cut today and they hike later that we have actually gone against the Fed policy.
Now keep it in context of India’s macro stability. It is fine to a certain extent because India does have very good macro stability today. The current account deficit is narrower, balance of payments (BOP) is in surplus, we are enjoying a very good time with our macro. Thanks to the cumulative actions of both the government and the RBI. But we have to be careful that we do not go overboard with that because if we get too loose then it may attract attention and then that macro stability may turn on its head. So, maybe a 25 basis point rate cut, but I would be more interested in the discussion on the framework. The framework entails the level of real rates, the outlook for inflation and what we are going to do in response to the potential changes to the Fed policy.
Anuj: You said that three months back everyone wanted to buy NBFCs, now they have corrected so much. Are you buying any of them? I am not of course going to tell you to give us names, but NBFCs is such a wide gamut, what kind of stocks interest you?
A: We had actually cut back on both discretionary consumers as well as financials in our model portfolio in September and we had raised cash because I was not comfortable with market valuations. We have put all that back to work. So, financials and discretionary consumer again become our top sector bets along with technology and we can come back to that in a moment, but these are the only three sectors that merit attention. We are underweight almost everything else, except for healthcare and materials where we are neutral.
On the NBFC space, you want to buy the business models that are diversified, not mono-line. So, the ones that have got a single business, those businesses may have done very well over the past 15-20 years, but now is the moment to be diversified. Keep an eye on valuations; of course, adjusted for earnings growth and return on equity (ROE) potential because not everything trades on the same multiple. On average, the NBFC basket trades at about two times book with about 16-17 percent ROE. So, keep that in mind when you are picking your stocks.
The third thing is the pedigree of management because again, the practices are not uniform across the space. So, there is a lot of variation in practices and some of them who do not have good practices will hurt from demonetisation and the ones with better practices will gain. So, risk management is a very critical input and that is a subjective thing.
Latha: So the best sector will be NBFC?
A: So, in our focused list, we have a couple of NBFCs now. We have added them in the recent fall.
Sonia: You also said technology merits attention. That is interesting because the space is plagued with so many issues – lower client spends, now Trump changing the policies, etc, but good time to buy?
A: The expectations are very low compared to what this sector can deliver, which incidentally is also lower than what they have done in the past. So, no doubt the earnings potential has turned down. The enterprise area is challenging, the new areas are still small for the large IT companies. Some of the midcap and smallcap companies may be okay because for them it is a larger share of their revenues and that is a faster growing thing, but I do not think the environment is as bad as what is in the share prices. The share prices are overdone on the negative side. So, my view is again, it is a valuation oriented view, stocks are cheap and you buy them and then the trigger will come.
I do not think America can throttle immigration to the extent that the market believes because it is good for their economy and if you look at the Trump narrative, it is about bringing America back on its feet, making it great again as he says and one of the inputs to that is access to low cost manpower. So, I think India tech companies will receive better business and now, we are constructive on US capex. There are not many companies in India that benefit from that. There are a few in the auto sector and then the tech companies.
Anuj: So why the same is call not working for pharmaceuticals? I heard you say you are neutral on pharmaceuticals because here again the valuations are lower than the median valuations.
A: We were upgraded. So we were underweight and we have upgraded pharmaceuticals.
Anuj: But you do not think this could be a leg for the market on the upside?
A: I think the valuations have become reasonable, but not cheap enough. So, if there was another down-leg then I would reconsider that position.
Latha: So, what are your positive sectors besides NBFCs, any of the consumption sectors?
A: We are overweight consumer discretionary, we are overweight financials, so private sector financials, NBFCs and we are overweight consumer discretionary, which includes autos, media, retail and the technology sector. Those are the three sectors we are overweight on.
Our sector positions are actually very wide. Before I entered the show, Anuj made a point that this is a stock-picker’s market. I actually think to the contrary. This is a macro market, you make big macro trades, we are going to get a big Nifty run up at some point in time. So, it will be a little different from what we have seen in the last two years which was clearly a very stock-picker’s market.
Anuj: So, are we somewhere near the 2002 kind of phase where after that we saw a big rally?
A: I do not think I can draw comparisons with history. 2003 was different. This is an interesting question you asked, so I will draw some comparisons here. The metric I used to make this judgement is the relative equity to bond multiple. You invert the bond yields, you get the multiple at which bonds are trading. Today they are trading at about 15 times earnings. Equities are also trading at about 15 times earnings. The multiple is at par. Now that has not happened often in India - when equities and bonds trade at the same multiple. In 2003 and 2008, equities traded at a discount to bond multiples. So they were a lot cheaper than today.
But since global financial crisis (GFC) this is the lowest multiple that equity has had versus long bonds. So it is an asset allocation shift. If you were bullish on bonds and bearish on equities, now is the time to make the switch because this multiple -- for equities, I imagine that the multiple in India should be at a premium because equities have cash flows which go beyond 10 years. Mind you, bond cash flows end in 10 years. So, you do not have anything after that but equity cash flows continues. So, I would reckon that equities should trade at a premium and that premium comes back. You get a big equity trade. Timing, I do not know.
Sonia: When you said that the Nifty is going to see a big run up. Do you have any levels in mind? When we celebrate our 18th birthday next year, where do you see the Nifty?
A: A 15 percent upside is possible from here. Again, these absolute numbers have to be taken in the context of what emerging markets (EM) may do because we are not expecting EM to do well. So, India has to fight that trend in EM and the EM trend is looking shaky. So the absolute return has to be seen in that context, in fact I tell everyone that my index targets are to be seen in the following framework. One, the target is in the context of what the overall world does. We cannot operate in isolation. We are the eight largest markets in the world. We cannot do what small and midcap stocks can do, they can go up 30 percent in a flat index environment. We are largecap stock in the global market.
The second is the range which is that these point forecasts are very dangerous to hang on to. Of course, the press loves them because it makes a nice headline – ‘Ridham Desai forecasts 30,000 on the Sensex.’ I go more wrong on my Sensex target than anything else. But there is a range there. The range is where my confidence levels are higher and then the market will operate in that range. The range for 2017 that we have put out for the Sensex is between 24,000 and 39,000. So, if you look at that range, it is a pretty big range, but,there are factors that may take it all the way.
Latha: But the upper part of the range is much higher from where we stand than the lower.
A: Good observation. The skew is to the upside which underlines my bullish tone. You look at the price and make your decision and growth will take care of itself. India is a growing economy; we will get hiccups along the way. This one has created a hiccup, but the bigger story here is that it has created an opportunity to buy stocks.The Great Diwali Discount!
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