Samvat 2072 uninspiring; bet on mid,smallcaps: First Global

With distress around the globe continuing, Samvat 2072 hardly looks inspiring, says Shankar Sharma of First Global. Speaking to CNBC-TV18, Sharma said India's journey from previous Samvat to this Samvat has not been glorious, despite high hopes. Analysing the disappointment, Sharma said it was injudicious to assume India will stand out post 2014 victory of the BJP when global economy was precariously perched. It was a very simplified analysis in total disregard of the fragile economic story worldwide, Sharma explained. Although Sharma acknowledges stability in India's macro situation, he questions its strength in driving corporate earnings going forward. Instead, he says the improved macros will aid smallcaps. Large corpoartes cannot revive significantly under the current growth scenario. Largecaps will need real GDP growth to propel them, he said while ruling out the possibility of 17-20 percent earnings growth in FY17.In the next 24 months, the middle and smallcaps will continue to remain a fertile ground for stock pickers, he said. Sharma gives example of infrastructure sector, arguably the worst performer, where smaller companies have seen phenomenal growth but the likes of Larsen and Toubro had to struggle. Similarly the larger pharma companies keep facing FDA hurdles from time to time, but smaller and midcap pharma companies have seen stellar growth. Trust the fund managers, they are the ones who know what to do, Sharma advised. Below is the transcript of Shankar Sharma’s interview with Latha Venkatesh and Sonia Shenoy on CNBC-TV18. Latha: The Nifty has not given us too much by way of gains. From last Samvat to this Samvat, barely 1 percent negative. How would the year ahead be, Samvat 2072 for the Nifty itself? A: First things first. My view, last year was, if you look at election as being the big factor of 2014, my view was nowhere close to the consensus view that things are going to change dramatically for the better if a certain party is voted to power. And I found the whole mass hysteria around the election results or even leading up to the election results to be extremely under analysed and very over simplified. And it has nothing to do with the person in question, it is simply to do with the fact that in a very complicated and troubled global situation, to expect 1 person to have a secret that none of us who are engaged actively and watching macro and micro, that none of us have any real clarity on how things will develop globally, to expect that one person who knows exactly what is to be, he has the keys to the kingdom, I found that to be a very childish perspective. And I am sorry to say, but every fund manager that you can get or name or every self set analyst you can care to name just forgot that we are getting paid to critically analyse management views, whether it is the management of a company or the management of a country. We just assumed that he knows something that we do not and guys let us just go with that; I mean that is a very puerile way of looking at analyses. So, I never belonged to that camp and I still do not belong to that camp. I am not a cult worshipper of anything, not even God. Sonia: I take you point about over simplification of the political narrative, but tell us how does the year ahead look to you? A: My view is that as far as our macros are concerned, they look okay. As far as the micro is concerned, which is the corporate numbers because ultimately, we need to see corporate numbers rather than just look at gross domestic product (GDP) numbers and we all know how the GDP numbers have been sort of given a colour which none of us can actually buy or digest. So, let us forget about that make believe number and let us come down to hard numbers and the hard numbers are corporate numbers and you know exactly where they are and we all kind of agree on one thing that definitely for the next quarter or two, there does not appear to be any significant revival of corporate numbers. On the other hand, we have still a very troubled situation on the global economy which there is no wishing it away. We have a very troubled situation on emerging markets in particular because of the strength of the US dollar, there are weakening currencies across the board in the emerging market space. There are big redemptions being faced by funds that do only pure emerging market investing. We cannot wish those very significant market related factors away so, in light of that, my view is that the year ahead for largecaps does not seem at all inspiring. And this has been my view for the last 12 months as well that largecaps, I do not see big economic tailwind, because largecaps require big economic tailwinds to deliver numbers – Larsen and Toubro, Hindustan Unilever – they will need a big revival of real GDP growth rather than just make-believe GDP growth. But that is not the same thing for small companies and smaller companies can derive growth out of very micro factors like the particular state doing well or two states doing well, etc. So, I have been focused more on the macro, on the smallcaps space and if you look at the performance of smallcaps versus largecaps, it is a huge divergence that you will see in the last 12 months. I see that divergence continuing, in fact, probably widening in the coming 12 months as well. Latha: Let me just take you up on the economy, or the lack of economic tailwinds, falling interest rates, low commodity prices, non-performing assets (NPA) more or less getting recognised, power distribution company reforms, will all this together not bring growth? A: On the macro, I do not think there is anything to disagree, I think things are looking okay. But whether that translates into growth big enough to drive corporate earnings up. It is not that we do not have growth, it is not that we are not going to see growth, but the base of that growth is still tepid relative to what we require to show big numbers increase in corporate earnings. That is the central point. It is not binary that we do not have growth or we have growth. It is simply that the growth that we have and that growth that at least I see going forward is not adequate to move the needle for a Larsen and Toubro or move the needle for Hindustan Unilever. But can it move needles for smaller companies? For sure. So, that is the point. I do not think we should take an extreme perspective in this. We have growth but not enough growth required to sustain companies with market caps of Rs 50,000-2,00,000 crore. Sonia: For the last three years, we are starting with a 15 percent earnings forecast at the start of the year and then we are ending in low single digits or even in middle single digits. Will FY17 earnings growth be the same or do you expect it to rebound to high teens? A: I think you said it. You said that it starts out with high teens kind of number and by the time it actually translates into reality, we are down into the middle 5-7 percent. To talk about FY17 in my view, with still two full quarters left to go in this year, that is a little premature. But looking at the way things are, I do not see numbers being 18-20 percent kind of earnings growth in FY17 either. I would be very surprised if that were to happen. Latha: I agree it is premature. Let me steer from the micro to the macro yet again. In the next 12-24 months, what would be your best sectors or stocks if you will talk? A: I do not look 24 months out. The world is too fast moving for me to make such long predictions. I do believe that mid and smallcaps are still on a dare and I think if one has the option of not looking at largecaps, one would like to exercise that option. I do not see anything exciting out there. The other thing I also see and that I quite significant is that because of the huge flow of capital into smaller companies in the unlisted space which is the venture capital (VC) or the private equity (PE) money is coming into smaller companies. I see big disruptions happening in larger companies’ business models and I do not think larger companies are equipped intellectually or from a purely organisational perspective to rework their business models that rapidly. I know of several companies largish companies who are grappling with that problem because to run something which is small today but which can potentially become big tomorrow, you need to have very fire in the belly youngsters out there doing it for you. But they do not want to work for a large company. They do not want to have a five percent stock option, they want to be owners, they want to run the businesses on their own, they want to own 50 percent or 40 percent of the companies. So, large companies will have problems in reworking the business models and you can see that across the world and not just in India. In India, in any case, large companies are very old business houses who are quite sclerotic in their perspectives. I see that as the other big issue coming up. I mean, if you take banks for instance, the whole disruption that is going to happen in the banking space few years down the road, thanks to Reserve Bank of India’s (RBI) opening of taps on various micro banking kind of business. Those things can have quite severe knock-off effects on the larger banks. I am just giving one example. Latha: Actually I agree with you on that and I had written a piece myself on how a large part, definitely midcap public sector undertaking (PSU) banks and probably old private sector banks can get wiped out by the payment banks, but are you telling me that the payment bank challenges can be even severe on the large private sector banks? A: If you think about it, a payment bank in my view is a perfect banking institution. I have a basic problem with banking as an industry and this I have had intellectually for many years. It does not mean that we have not like banks as investments, but if you take a larger perspective, the banks basically leverage up their net worth 10 times, 15 times and then they use that leveraged money to go and make loans. All you need is a bad economic cycle in which you will lose 5-8 percent of your capital and basically, that is all the capital you have in terms of what is the net worth. So, you are going to wipe out your net worth every 4-6 years. And we have seen that happen many times. You will look at even non-banking financial institutions (NBFC) in India, some of them are running non-performing loans (NPL) of 7-8 percent which means, basically, you have no capital. You are really a zombie institution. Payment banks take away that big problem in banking as far as my thinking goes which is that they are not required to make loans. It is not their business, so they are only required to give it in risk free instruments from the RBI. So, that part being done, it becomes a purely liability generating machine and the people who have gotten the licences in my view, further people will get those licences, are people who can make very micro liability collection centres, be it a mobile company or be it an e-governance company where you can have a single person sitting in the village collecting deposits. That none of your large banks are capable of running branches. I mean if you think about it, State Bank of India (SBI), the largest branch network, at about 15,000 branches which is nothing for a country this size. But, the reason why they have only 15,000 is that they cannot make branches viable beyond that number. In fact, in my view, even 15,000 would be having large parts of loss making branches within them. So, I see that the small deposit, small-ticket deposit business being completely taken away from payment banks. I am not saying this is going to happen tomorrow, but look at a five year perspective, that your incremental deposit growth has to come from the under-banked areas of the economy or the unbanked areas. Those, the large banks have no cost structures which allows them to do that. Sonia: You said the midcaps are a fertile ground for stock picking, so let me ask you flat out. Can you give us some stocks or even some sectors that can make the viewers or investors money in the next one year? A: Sectors, I think, are safer in any case. And remember, for the average viewer of your channel, it is a very hard thing to go and pick a winning smallcap or a winning midcap because we being full-time into it, we have so many hits and misses in that because it is promoter quality, business models, accounting, sanctity, number of things go into it. It is beyond the reach of any small investor to be able to do that level of work. But that said, if you look at even infrastructure, which we know has been a very troubled sector, but within that if you look at some of the smaller infrastructure companies, there are many, like Ahluwalia Contracts or J Kumar, etc. they have done phenomenally well. I mean Larsen and Toubro has done nothing, but the smaller ones have been multi-baggers because as I said previously that there is some growth in the economy, but not enough growth for Larsen and Toubro’s order book to change markedly. But for a small company, a Rs 1,000 crore turnover, he can get a Rs 1,000 crore order book, he is looking at a 100 percent growth year-on-year (Y-o-Y). So, that is the differentiation I am making. Same industry, the large company does not have enough growth, but smaller ones do have adequate growth. So, I am just giving you one example where I see infrastructure being a good sector to get into provided you have done your analyses right. But the smallcap infra looks quite interesting. Latha: Clearly, a stock picker’s market, but drug companies, they were the classic defensives until recent weeks when the spate of US Food and Drug Administration (FDA) warnings brought a cloud over these companies. Do you look at drug companies – midcap, largecap, smallcap? Would they be still relative outperformers? A: I think you can. I think against smallcap pharmaceuticals, some of the names of smaller midcap pharmaceuticals have done quite remarkably well. So, again, maybe the larger ones are also in terms of size of a size and scale that is going to be hard to keep replicating big numbers Y-o-Y. But again, in the small and midcap pharmaceutical space, there have been incredible number of winners. On the larger ones, the FDA problems have kept popping up from time to time for several years, nothing new. I think the better ones find a way to deal with it, find a way to streamline their processes and the FDA does not want to shut down our pharmaceutical companies, I mean it did not even shut down Ranbaxy for God’s sakes which was an absolute scam which we all know. They did not even shut Ranbaxy down, so I doubt if Dr Reddy will be faced with a life-and-death situation. They will deal with it, it is a good company. Sonia: Since you are bearish on growth, will technology be the safe harbour at least in the near-term? A: IT, I do not think it takes a genius to figure out only one thing which is the rupee’s direction. That I think we can all agree. But, that said, again, IT I like, within the context of a very troubled situation, but remember, that is a business that is ripe for again being sort of disrupted. So, you can never tell that Amazon can become a huge IT company and it already is a reasonably sized IT companies through the Amazon Web Services. So, who is to say they cannot take away businesses from our IT giants who are in some senses very old economy, new economy companies. So, cloud can completely disrupt business models of our Indian companies. So, while right now looking good, longer-term, there might be some question marks out there as well. Latha: From your conversation should I take it that you are telling our viewers leave it to the fund manager, is that your main advice? A: 100 percent. I think there are very smart fund managers in India, have a lot of respect for them and there are very good smallcap, midcap funds out there. I think pick a good basket of them and then relax, because if you try to do it on your own, do it at home, I think it ends up in disaster. Sonia: That is important advice and 9,100 on the Nifty, is it the high, will it be taken out in the next 12 months? A: Sobering thought here is the dollar index has still not taken out the 2007 end highs. That is really a very worrisome thing. We can keep talking about the Nifty and nominal rupee terms, but the reality is that the big money obviously comes from overseas and if you go back, we are still lower than where we were in 2007 end which was the peak of the bull market. Since then we have been basically in a large trading range, if you will, and which is also an important thing to keep in mind that not just India, if you look at emerging markets as a whole, if you look at the exchange-traded funds (ETF) as being a representative of the entire basket, that ETF, the most liquid ETF for emerging markets called EEM, is at USD 33-34 approximately which is where it was in 2006. 10 years hence, zero returns. If you take a look at the US market itself, the Standard and Poor (S&P) was about 1,500-1,600 in 1999. It is barely at 1,900 or so now. So, 16 years on, all you have got is, if you look at the compounded annual growth rate (CAGR), it is probably like a 2 percent CAGR over 16 years despite zero interest rates. Japan, long-term bear market. Europe, obviously nowhere close to the highs of 2007. So, all we have seen in the last several years is a giant trading range and if we have been lucky, we have got the bottoms and sold at the top, but they have not been secular bull markets at all, not in India, not in emerging markets, not in the US, not in Japan, not in Europe. That is a sobering thought. So, within that context, remember, that is happening because largecaps are not going anywhere, nowhere in the world. But smallcaps in the US or India or in Japan, they have been on a tier. So, I am saying it is a larger global phenomenon on smallcaps and that is because smaller ones are having models which are disrupting the larger ones.