The underperformance of the Indian equity market is not sudden, the problems started way back in 2016, when the commodity cycle bottomed out is the word coming in from market veteran Shankar Sharma, Co-Founder and Chief Global Strategist, First Global.
According to him, neither the Indian equity market nor global market are in a bear market because there is no bubble or irrational valuations visible in any of the global markets.
So, if there is no bear market in emerging markets, in developed markets then why would India stand out, he added.
The Nifty and Sensex will underperform, while the smallcaps will outperform global markets, said Sharma.
According to him, the Indian micros remain strong but the macros are a big concern. The Indian macros are most worrisome amongst BRICS because of oil, he said in an interview to CNBC-TV18.
The same oil dividend, which earlier gave us a lot of pleasure will give us pain when it reverses and it has reversed, said Sharma.
He also does not think that the long-term capital gain tax (LTCG) introduced in the Budget 2018 is solely responsible the underperformance of Indian equity market, although it did contribute.
If India wanted to mirror the global trend of moving into riskier capital since it is still under owned in terms of household income wealth in equities then that move should have been intensified and LTCG could have been imposed 10-12 years, said Shankar, adding by that time 30-40 percent of savings could have been equity markets. It was just like giving an incentive to an industry, especially a nascent industry.
The under performance is mainly because of oil, which is likely to move 20-30 percent from current levels, said Sharma.
Below is the verbatim transcript of the interview.
Anuj: It has been a rough year for the market, if you look at the MSCI Asia Ex-Japan, from the highs it is down quite a bit. However, what is interesting is that we have underperformed quite a bit. What do you think is going wrong with the Indian market in 2018?
A: It has nothing to do with 2018. The problem started in sort of -- I would say the seeds the problem were sown in the early part of 2016 which is when the commodity cycle bottomed out. I have been publicly bullish on oil and other metals, generally the commodity complex since February-March of 2016 and that is where problems for India started. Of course a lot of problem built up over time, they happened on stealth, but really India got the dividend of a sharp fall in oil for two or two and a half years preceding that and that dividend slowly started to get eroded from the lows of oil at USD 27-30.
So, the underperformance you are seeing now was actually building up. It is not like sudden and I was of the view that the same oil dividend which gave us a lot of pleasure, will give us a lot of pain when it reverses and it has reversed. Incrementally I think India is the most if you talk let us say just broad macro, Indian micro is still very good which I will come to later, but Indian macro amongst emerging markets or let us say the BRIC pack, appears to be the most worrisome largely because of oil because our macros turned for the better only because of oil because structurally India was still the same.
There was nothing really structurally that changed much, but just that oil came down so inflation came down, rates came down, household savings started to get channeled in the stock markets, equity became more attractive versus fixed income, etc. we all know that story. That story to some extent has been dented because of the rise in oil, the rise in bond yields, rise in inflation, and imposition of capital gains tax. So, the point you are making was in the building and it has been only accentuated by the recent moves in the Budget. However, it is not something that is surprising, at least not to me.
Anuj: How much of a factor has the long terms capital gains (LTCG) tax been? We have seen a lot of aggressive selling by FIIs but that was the case all through last year as well and the Indian market was still going up. So a lot of people are asking that has that imposition of LTCG changed sentiment a bit, is that largely responsible for the underperformance of Indian market for the last two or three months?
A: No I do not think it is solely responsible for the underperformance. I think it has contributed, but I would not say that that is a large part of the problem. It is a smallish part of the problem. My view on LTCG has been very simple that yes there was a case to impose a tax on equity gains, question was when. India is still – you do not have to view it as a revenue generation measure, you have to view it that you need people to move away from gold and real estate and even fixed income into a riskier asset class such as equities which is the way the world has, let us say the developed markets have moved, where people do not own real estate much, they do not hold much fixed income or gold, and it is largely household wealth is concentrated in equity markets.
So if we want to mirror that global trend of moving into riskier capital, then you have to incentivise that move. So the exemption of LTCG was an incentive for people to move away from fixed income and other unorganised forms of saving into an organised form of saving which would fuel growth, companies can raise money, etc. You cannot look at it just as a revenue generation exercise. India is still under-owned in terms of household wealth in equities. So yes there was a case, question was when, my view was maybe 10 years later when maybe 30-40 percent of savings are in equity markets. Globally developed countries are like 50-80 percent; we do not have to wait that long, but when you are – wherever we are right now, you have to give incentive.
It is like giving incentive to an industry, you had to give incentive to backward area sort of industries, you have to give incentives to pharmaceutical, you had to give incentive to telecom, you had to give incentives to software, view it as an incentive being given and to a very nascent industry which is equity investing. I just view it from that lens and from that lens there was no justification to do it now. However, there was justification to do it at some point in the future, but that is a long way down the road.
So, yes, it has affected sentiment, but I do not think the underperformance is because of that. I think the underperformance is because of the fact that I think two major factors and I think the overarching one is oil. My view on oil is very bullish, it has been very bullish for the last year and a half, so, I do not want to sound alarmist from an Indian perspective, but I would not be surprised if oil goes up another 20-40 percent from here over the course of the next month or year. That will be problematic for India and that is one of the reasons why the market is behaving the way it is. So the market is reading the tea leaves that the macro for India over the next 12 months will be let us say more worrisome than the macros are for Brazil, Russia, or China.
Brazil and Russia are obviously big beneficiaries of the up move in commodities, so they have done phenomenally well in terms of stock prices. Brazil in the last couple of years in dollar terms has almost I think doubled, I think maybe 80 percent up. Russia is doing very well. India that way has been a little tepid performer if you look at the Nifty. Over the last four years I think it is about 12-12.5 percent return which is not worth writing home about in context of an overall global equity bull market. It is only the smallcap which have gone up 45 percent compounded in the last four years which changed the picture for Indian equity returns completely. Otherwise just looking at Nifty, it is nothing worth writing home about, the last three or four years.
Sonia: Coming back to the market, give and take everything, it is not even a 10 percent correction from the top. What is your view for the rest of the year, do you think that this is still a correction in an on-going bull market, or have we started to see the beginning of a bear phase in Indian equities?
A: No I do not think there is any bear market in Indian equities, nor is there a bear market in global equities. We kind of forget that market do not have to just keep going up perennially or even 4-8 months we will have sharp cut backs and then it is just one of those things. There is nowhere in the market globally, in markets globally that I see a bubble or I see irrational valuations; S&P is like 15-17 times earnings forward. Bear markets do not start when you are looking at those kinds of valuation.
So if there is no bear market in emerging market, there is no bear market in the developed markets, why should India stand out. In my view the Nifty and the Sensex will underperform global markets. The smallcap will vastly outperform the global markets. So there are two different markets in India and just looking at equity returns in the last four years, it is very apparent, 12 percent versus 45 percent compounded, that kind of return divergence has never happened in the history of India. I have been publically very bullish for the last four years on smallcaps and that has been the reason that I have been worried about the macro but not worried about the micro.
So India will not have a bear market, there is no bear market globally, there is no bear market in India. India might lag on a largecap basis relative to emerging or relative to sort of developed markets, but there is no bear market.
Sonia: I also wanted your view on politics because it is the biggest talking point now. Is the Modi government losing a bit of its magic? We are seeing major farmer agitations now and this was the government’s key agenda, right, solving the agrarian crisis. Do you think 2019 elections are going to be much different from what we saw in 2014 or is it too premature to view that?
A: My view is that the magic etc. to be used for politics is misplaced. I do not believe that politicians can create magic. When people have such huge expectations which are irrational, disappointment is inevitable and I have said this at the beginning of the election cycle in 2014 that you are betting -- it’s just a way out bet which can only end in disappointment. So whatever you are saying right now, I am not surprised at that. It is just like a management coming out and you believe blindly in that without analysis. So you will have some degree of disappointment. Even though they have tried well, they have done whatever they were supposed to do to some extent, you will still come away saying you could have been better.
So I do not pay much attention to all these sentiments around politics of India, for that matter rest of the world, but yes 2019 will be interesting. Obviously the kind of numbers you saw in 2014, it was like absolute dream run for the ruling coalition. It does appear that it may not be that smooth and that will play on the market and that we know, I mean from a limited lens of stock market, one can assume that 2019 maybe a little bit more problematic than 2014 was.
So yes, that is one of the other factor that will build up as a concern on our stock market as the year progresses. The other thing of course is we don’t even know whether it is 2019 or even 2018 as the buzz that we hear is it could probably happen this year itself. So those things are fairly near term. A year is not that long a time or even six months is not that long a time. So the market is kind of a little worried about that aspect as well.
Anuj: You have been on record saying Indian smallcaps is the best asset class in the world. Right now there is no danger to that thesis because we have seen a sharper midcap and smallcap correction and the fear is that it may impact equity inflows especially from the mutual funds and from domestic households?
A: I have spent the last month or so speaking to various companies that we are interested in, we have interest in almost across the board. FY19 numbers look absolutely in the bag for practically all of them where you are looking at earnings growth of 30 percent, 50 percent and even 150 percent and that makes the valuations not very demanding.
My learning in market is only this that when you have market corrections like the kind that we have seen and I have lived through in my 25-30 years, god knows 200 of such things, when a move like this happens, you would just need to go back again to fundamentals, remove technical for a minute, come back to fundamentals, stock prices are down 30 percent or 40 percent or 35 percent, if balance sheets are in good shape and if the earnings number are still intact, then they represent no-brainer buying opportunity – that has been my central learning and that is a very simplified learning but it has really worked over the years. All the companies that I have spoken to, stock prices are down 30 percent, numbers look intact and balance sheets are in good shape. I think it is a no-brainer to go out and buy those companies without any doubt at all.
I am sure my universe is not as large as many peoples’ universe. I am sure the same story is there in dozens of smallcap companies where they are all doing very well, they are unaffected by the worsening macros of India and that is one of the reason why I have liked smallcaps apart from their micros that the macros do not affect the smallcaps; interest rate rise, inflation rise, they will affect the big ones, the big players like Larsen or the banks etc. but a small company doing some small business in small part of India, they are unaffected by all this. My view is this correction for the companies that have the earnings growth intact, it is a no-brainer opportunity by way of buying.
Anuj: Some of the PSU banks have also become midcap and smallcap. How do you approach them? Do you just write them off saying I am not looking at them or is there an opportunity in this whole mess?
A: There could be but I am not a big fan of banking or businesses which require giving credit to people and then you go chasing after them to get your money returned to you. I think there are easier ways to make money in life than to do this; NBFC or banking etc. There are a few exceptions here and there like IndusInd Bank or HDFC Bank which we have liked but broadly as a category my view is that there are -- I buy peace of mind apart from buying equity and there are easier ways to make money.
So PSU banks are problematic and we all know that. However, the real problem in my view is happening post the Nirav Modi scam that there is and I have spoken to bankers and spoken to companies, it is a weird situation wherein we do not have credit growth, companies on the one hand are scared to expand, banks on the other hand are scared to lend and this whole turning the screws on every loan above Rs 50 crore to be scrutinised by some investigative agency etc. I mean government might have some logic for doing that but my view is only that that the behaviour of bankers will turn contrary to what you really want to do which is that you have to encourage some degree of risk taking to rekindle the animal spirits in India because the animal spirits have gone dormant for last several years. If you want to rekindle them, you have to inject a bit of risk. I am not saying blind risk or unbridled risk, but without risk there cannot be any capex.
Which promoter, I am a businessmen, I invest in companies, I run companies, I can tell you there is risk in every single move I do and there are moves that I look back upon and say why on earth did you do that. That is not because I am scamster or I am corrupt, it could be simple business decisions gone wrong. When you create a fear of psychosis, you will cut back on lending and that is precisely the wrong medicine for this patient.
The other problem of course as I have just recently learned is that it is not only a company - you are a good company but if your bank is in trouble, that is under the PCA - the prompt corrective action, then you will not get credit because your banker is in a problem even though you are in the pink of health. Imagine that a company has now got to do a credit check on the bank and the bank has to do a credit check on the company. I mean this situation is completely absurd. If you were to tell this to somebody in US, they would say are you guys serious. I mean it is just a bizarre situation.
I think we just need to step back, take a deep breath and say look problems happen in finance, problems happen in banking, in Barings Nick Leeson lost billion dollars, sub-prime scam happened, nobody broke this system, nobody created a fear psychosis, and business went on. We need to really back off a little bit here and allow business to function. I know companies who are saying that for the big road projects financing is not going to come forward incrementally at least not for a while. I mean imagine you want an aggressive road program and banks are scared to lend to roads, is that a situation you really want out of this? I think we need to lighten up a bit here. We need to accept that scams will happen in banking. They have happened across ages in the world and it will happen in India too. But let us not throw the baby out with the bath water.
Sonia: A lot of stocks have corrected 30 percent, a lot of good quality balance sheets, cases in point names from the auto space, cases in point domestic stories etc. Where do you hunt for value now?
A: I think the metals pack, steel looks terrific. I have been bullish on all steel companies for last year and a half along with my bullishness on commodities. They have corrected now because of market and because of the tariff, etc. being imposed by the US. But I don't think that really matters. I think they will go back, steel prices will be firm across the world and Indian companies will benefit. So that looks good.
Construction companies look good. I have not liked this sector for a long time, at least in 2004 to 2007 bull market towards the end I thought it was completely irrational in terms of bidding, too much competition, 30 players for a single road project. Now it is a little bit of pricing sanity, number of players are shrunk. I like the road sector, the government's program on roads is reasonably aggressive at least on paper.
Even if part of it materialises, you are looking at very solid order books for these companies. Quality of tenders has improved in infrastructure overall. So, overall that space looks good. There are good players in that. Large players like Larsen will do very well apart from a smaller ones in the overall roads and infrastructure sector. So, overall the space looks, the construction space, infrastructure space, road space broadly I like that, I like metals and interesting those are the two sectors I did not like in the previous bull market. So you have to remain flexible.
Anuj: One call which worked out for you beautifully, I remember when I did that Unplugged show with you, you said that Indian IT will go through some serious problems and we did see a big derating of Indian IT for two years. However, has something changed over the last six months? Are you noticing some change or is this just a case of market moving to - the valuation gap being just too high and the market correcting that?
A: The business model hasn't changed and I don't think the business model is really being reshaped that fast. In Infosys's case there was a chance because of Vishal Sikka being there at least - let us put it this way at least he had the right words of all these machine learning and artificial intelligence and all these things which itself has some value in today's world. If you mention that you get some value from investors.
I think Indian IT needs to remake its self. Over the last few months some sanity in terms of stock price, little bit of performance has come in, but I think it is too early to say whether it is back into a bull market mode. I would really reserve my comments on that. I haven't thought it through completely whether it has been remade enough for it to deserve a big bull market. I do not have a clear view on that.
Anuj: With proper disclosure, any say two or three stocks that Shankar Sharma is betting on, for this year, 2018 or for three or four years?
A: I have told you smallcaps, I have told you roads, I think that is enough hint. There are not that many players in the roads space, in smallcaps and with reasonable sort of balance sheet. On the smallcaps side, some of it is known, some of it is unknown, but I can tell you that that space is still buzzing. I still have great number of opportunities staring me. You are really spoilt for choice there.
I just think this correction presents a great opportunity. If you are a small investor, don't buy the stocks, you can buy good smallcap funds, they are plenty of them out there. If you are a professional investor, I think you should welcome an opportunity like this.
Sonia: A month back you had tweeted that this is not a repeat of 2008, this is just a correction and an overbought market. Despite all that has happened over the last one month -- the scams, the frauds, you still stick to that view?
A: 100 percent, without any doubt. I will go out to the extent of saying that you are going to see a huge bull market in emerging markets. It is just the beginning of a resurgence of a bull market. If you go back in time, EMs have been actually trailing the global markets from let us say 2010 onwards. I think that trend is reversing. I think that is because of the commodity bull market and the weakness in the dollar. These two factors will drive emerging markets significantly higher.
One more thing, if you look at the dollar index of emerging markets (EM), it is still I think 10-15 percent away from 2007 highs. So, we have not even taken out the highs in dollar terms of emerging markets what we saw in 2007. In my mind, a bull market starts when you have cleared out long term highs which happened 5-10 years back and then a new bull market is born. So, still not even a bull market in EMs, the bull market will start when they clear out 2007 highs in dollar terms. So, I think there is a big journey ahead in terms of bull market in EMs without any doubt.