Rs 3 lakh-crore fund manager bullish on auto, discretionary names, says defence, PSUs pricey

Mahesh Patil, chief investment officer, Aditya Birla Sun Life Mutual Fund.

IT companies may be facing downgrades due to weak earnings and global spending slowdown but Mahesh Patil, chief investment officer, Aditya Birla Sun Life Mutual Fund, is not too worried.  These companies are generating good cash flows and will show good growth over the next three to four years, Patil tells Moneycontrol in an interview.

Patil, who oversees more than Rs 3 lakh crore of assets, says that investors should not expect any big rally in the short term as the market will show a "reasonable growth" in line with the GDP growth from here. Edited excerpts of the interview:

Where are markets headed now? 

In the last couple of weeks, inflation is kind of coming down and plus we've seen the response from the Fed. The market is expecting that rates have peaked out, which was not the case earlier and you will see rate cuts starting somewhere at the end of next calendar year.

The US 10-year bond has also come off around 50 basis points from around 5 percent to 4.5 percent. That's why the selling pressure from Foreign Institutional Investors (FIIs) has eased up a bit. On the liquidity side, domestic flows continue to remain very strong and robust. Domestic flows have not been impacted at all, despite the concerns about interest rates and global concerns. So, on the liquidity side, the near-term pressure eases off.

On the fundamental side, the quarterly numbers have been fairly okay. There have been some disappointments in a few sectors like the IT sector and consumer discretionary. But by and large, the earnings numbers for this fiscal year haven't changed much and remain intact. For FY25, Nifty earnings growth should be in line with nominal GDP growth of around 12-13 percent.

Markets have consolidated now and earnings are growing steadily. So the valuations are reasonable, it is not in a frothy zone. From here, markets should continue to move up steadily, though we should not expect any big short-term rally as geopolitical and global risks still persist.

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What global risks? 

In the US, rates have moved up, which could lead to some kind of impact as the cost of funds for a lot of corporates has gone up. We will slowly see the impact as we are not expecting a big rate cut soon. Also, the global economy is starting to slow down. We can get a better picture of how it impacts us by the early quarter of next calendar year.

What will be the impact of the RBI's move to increase the risk weight on consumer loans on banks and NBFCs? 

The Reserve Bank’s idea is to really slow down the unprecedented high growth in retail lending and unsecured retail lending. If risk weightages go up on unsecured loans, it will impact the capital adequacy requirement of banks. So banks, which are less liquid, well capitalised should not really panic much because they have room to grow but banks, where the capital adequacy ratio is on the border, will have to calibrate their growth down a bit or raise capital for that growth.

But the NBFCs are at more risk because they cater to consumer loans.  For NBFCs, the cost of funding will go up and impact their margins. So, there will be a moderation of credit growth on the retail side and to some extent impact bank margins.

Is this a short-term slowdown? 

Not necessarily shorter term. Capital access to some of the tier 2 and 3 NBFCs could be worrisome. These players could face challenges as they’re dependent on banks for credit growth. The issue will persist over the medium term.

Was the RBI move expected? 

The RBI had indicated that retail lending is growing much faster and has shown some concern about small-ticket credit where non-performing assets have increased. We had an idea that it’s going to happen, just didn’t think that it would happen so soon.

Earnings growth has been weak for IT and there are concerns about the sector. What’s the potential there?

We are neutral or slightly underweight on IT. We were underweight on IT because of global concerns but now most of the negatives and concerns are getting priced. This year growth will slow down because discretionary spends are cut.

The IT sector over the next three-four years will continue to see reasonably good growth as overall digital spends will continue to grow.

There could be a short-term slowdown because companies aren't sure how the economy will be, especially in the US and Europe. Almost 40 percent of the journey for IT companies is completed, 60 percent is still to be done which can happen over the next three-four years.

So, growth rates will be improving in six to nine months down the line. From here on, we won't be too negative on the IT sector plus these companies are generating good cash flows, there’s good dividend buybacks.

AI might be a concern, as some companies towards the lower end, might get impacted. But otherwise, spends on technology presumably will continue to move up.

Your view on FMCG and consumer stocks? There has been a slowdown in rural and there are a lot of new entrants. 

In the consumer sector, the rural has been weak. Money will flow down into the rural economy since this is an election year and there could be some government spending. Money could flow into the hands of the bottom of the pyramid and that could improve the volumes going ahead.

There is also some competition in the B2C spaces, especially in personal care. These players are, taking some market share because they’re able to reach the consumer directly because of their online presence but it is a stable sector to invest in given the current uncertainty. The outlook is relatively better with reasonable growth, not very high growth that we've seen in the past.

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But aren’t consumer stocks expensive?  

Staples are relatively expensive. Despite the slowdown, the market is paying a premium for safety and stability. Valuations across the consumer sector are not cheap, they’re on the higher side. The market is expecting a recovery, so we are just ‘buying growth’ in the consumer sector.

Small caps and midcaps have become expensive, is the rally sustainable? 

These stocks have run up due to the great outperformance in the past. The money flows here have been disproportionate compared with what we have seen in the past and there is a limited appetite to absorb this (additional money flow in the smallcap segment). At this point, the risk-reward in smallcaps and midcaps looks limited. In largecaps, the risk-reward looks slightly better.

When markets correct, the vulnerability in the midcaps and smallcaps could be larger because if the money has moved in, it can move out also. Plus there are liquidity challenges. So we are not structurally negative on midcaps and smallcaps but in the near-term one needs to be more cautious and need to reallocate their portfolio.

Do you prefer largecaps over small and midcaps? 

The risk-reward looks better in the large caps space, yes.

What would be the next leg for growth in automobiles? 

Premiumisation. People now want a lot of premium features like sunroof, and alloy wheels. All these premium features are driving the value per car, which is driving the topline growth for the auto sector.  That’s why we are seeing premium cars, and margins for the auto sector have gone up.

The auto sector was pretty bad for the last four years because prices went up due to environmental norms like Euro VI standards. That's why the market had to adjust. EVs can be an opportunity and threat also, because it is a new space and a lot of companies are entering it.

Exports in auto-ancillary space will be the story going forward. A lot of companies are struggling in Europe because costs have gone up, they aren’t making money, and hence closing down. That’s where Indian companies have the opportunity to take market share. So, the auto-ancillary export story also continues to kind of build up steadily.

The EV space has a lot of optimism but the demand is low. Do you think an overdependence on planning for EV growth can impact the segment? 

You're right. The FAME subsidy was curtailed and now the EV costs have gone up. So, the overall transition to EVs has slowed down a bit. The transition will also be difficult because we have to yet build infrastructure.

Migration to EVs will take its own time, but the roadmap is very clear. Companies will have to move into EVs. As scale and size come in, costs will also tend to come down and the sector will become more competitive. However, the disruption because of EVs, which the market was fearing, is not likely to happen immediately and companies have time to adapt. But companies will have to transition. While their earnings might currently look good, these (that are slow and don’t transition) companies will get de-rated.

The future is very clear as the government also wants to tie into clean energy. So, if a company doesn’t have a play on the EV side, there will be a risk to terminal value, and we would not want to look at it.

Which are the sectors you are positive about and the ones you are not? 

We are currently positive on the domestic sector like autos and domestic discretionary. Even though growth has been weak, it is a more structural story over the next decade. And as per capita income goes up, discretionary spends will also move up.

We are positive on manufacturing. As the government is trying to focus on indigenous manufacturing, then PLI schemes and China plus one is playing out. Private capex will pick up slowly because the conditions are ripe for that. Real estate is seeing a strong demand after a long downturn.

Commercial or residential real estate? 

Residential mainly. In the residential sector, the demand in micro-markets is looking good.  We also like pharma, though it has not done well last year. Healthcare, hospital, diagnostic services is again a sector where the penetration will increase and we can see steady growth. Some consolidation from the unorganized player also will benefit the organised players in pharma.

We are also positive on telecom. The telecom story now will be more about de-leveraging. Investments on 5G and spectrum are behind, so we will see a healthy cash flow generation and de-leveraging of debt. We will be underweight on metals, oil and gas, and consumer staples.

Any recent additions to your portfolio? 

IT and auto, we have made some additions. Specialty chemicals have gone through some pain because of a lot of inventory. So destocking will be happening. Chemicals is now bottoming out, so we have cut our exposure on the chemicals side. However, the pain in the chemicals sector will persist for another quarter.

What is your view on defence and railway stocks, considering the run-up? 

A lot of stocks have become popular because there is a strong narrative, we have seen them run up quite a bit. So we are slightly underweight on that. The structural story might still be good, but valuations don't really fit our kind of framework. Plus we stay away from that because there is a lot of exuberance. So we'll wait for the right entry point. It’s not really the time to enter defence, railway, and PSU stocks.

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