In an interview to CNBC-TV18's Udayan Mukherjee, Krishna Kumar Investment Director at Eastspring Investments shared his view on Indian economy and the road ahead for equity markets.
Below is the transcript of the interview.
Q: After such a strong start to the year, almost everybody is watching earnings very carefully now. The earnings season has just started. Do you think we will get glimpses of the turnaround that we have all been looking for for the last couple of years in this earnings season?
A: Yes, we are coming at the back of a demonetisation quarter which was the third quarter of December, 2016. So, there is a base effect which will show quarter-on-quarter, a sharp improvement. I am not sure how sharp is sharp, but reality is that there will be a marginal improvement. Is that decisive enough to conclude that the entire economy is turning around and we are back on the growth path. I will hesitate to say that it is possibly not.
We are going to see some recovery. There are improvements in the margins. Quarter-on-quarter, we will look better, but the consensus numbers are likely to be missed.
Q: Is that a worry because this hope trade we have played for the last couple of years, people keep saying this is the year of the turnaround and then in the middle of the year, the hope fizzles out. Are you more confident that in the next 3-4 quarters, we will see a decisive turnaround or are the metrics that you monitor not giving you that conviction quite yet?
A: There are a number of things that we are watching. One, obviously is the way the gross domestic product (GDP) is trending. Second is the overall matrices that add up to become the GDP which is maybe cement, maybe power, maybe multiple other factors which are pointing towards the GDP number.
All-in-all, in summary, it looks like it is going to be a recovery, but it is a very gradual recovery. It is not a sharp rebound. How much do we rebound, it is a question that we will have to wait and watch. But the important element to the story is that there is an improvement on the margin and the improvements are gradual, we would like it to be much quicker because these are known facts. These have been lingering issues for a very long time.
Having said that, you must realise that the market expectation of a sharp rebound and a quick recovery is obviously going to be belied. The important point here is that the numbers have not been reset for FY18 and the multiples obviously telling you that there is a sharp recovery coming through in 2018.
In FY18, there are a couple of episodes/changes that would happen and that can be a bit of a botheration would be goods and services tax (GST) obviously. And we just hope that GST does not kind of make things look very difficult for the economy to recover. Overall, I feel that the path of recovery is going to be very gradual and there are a lot of housekeeping initiatives that need to be completed before we get back on the growth path.
Q: But how much of it is already in the price? If you look at how much valuations have expanded since the start of the year, do you think the market has already taken a march on or a leap towards pricing in a fair degree of recovery already? I am not talking just about the index, but a whole host of universe of midcap stocks where valuations seem to have expanded significantly pricing in not a gradual, but a fairly speedy recovery.
A: Absolutely, I completely agree with you. The midcap space is in a bubble zone and people are buying as if things are going out of fashion and it looks like almost worrying to an extent. The largecaps have remained more moderate, more sober, more tempered, but the fact is the midcap space is also a function of liquidity and function of hope and optimism that the midcap have got higher beta to play out and they are running way ahead of expectations.
On the largecaps side, it is more sober because people are earnings are more predictable, earnings are more visible, but I am not sure whether the midcap recovery can happen without a largecap recovery, it is more a function of economy recovering. I am a bit worried about the way price-earnings ratio (P/E) multiples have expanded and the market is pricing in a very sharp recovery, if not in 2018, at least in 2019. But I just hope that things are not as bad or maybe they just recover as we progress, but I remain very concerned that the midcap valuations are completely out of range.
Q: If there is to be disappointment, because global markets have all done very well, where do you see that disappointment coming in from? Do you think it will be something which is not very predictable like the geopolitical news which is coming over the last few days, which is not great and has the market a bit on edge, or do you think a disappointment is likely to be more linked to earnings or macro data which is more fundamental to the market?
A: It could be anything which could be as flimsy as earnings miss because the earnings miss is basically something that people are not factoring in. if there could be earnings miss, there could be a sharp correction. If there could be a rise in rates in the developed markets which is already obvious now will also result in a fair bit of correction. Reasons will follow, but the fact is that the yield gap which we saw, which is basically the real rates which have been playing out have clearly played out.
And I am also mindful of the fact that the central bank has guided very clearly that the easing cycle is complete and they will not want, they are more hawkish than they were before. They have reached the neutral rate and from here, possibly I do not see too much downside. So the rate cycle is clearly done and next step to think about is how solid is the recovery in terms of domestic consumption. If that falters, we might see that there could be sharp disappointment.
Q: How do you see monetary policy domestically and its impact on equities this year?
A: Rates are wherever they are. I do not see rate environment being volatile but they will be more benign and so downside is if there is a rate spike, what happens. That is the key thing to look out for and you will at some stage see that the real rates actually moderate which would mean that either inflation rises or India will have to take that corrective measure between the gap between the developed market and emerging market real rates.
Q: One of the key macro metrics which everybody seems quite worried about is the very tepid credit growth that we are seeing in the system month after month, yet it is not showing up in the reported numbers of at least the top corporate banks or the retail facing corporate banks. Do you see sluggishness getting into the banking system because that will be a blow which will be difficult for the market to digest?
A: Yes, there are several questions there. The first bid is on credit growth. The credit growth will remain tepid. There is a step change happening in the banking system and the change is basically that wholesale banking system is obviously moving away. It has got disintermediated by the corporate bonds and the corporate bonds are clearly now more active which is through the sovereign funds or the insurance money that is available. So, that is clearly taking over. So, we will possibly see a more sluggish credit environment that we have.
The second bid is to notice that the wholesale banks are basically now moving away as the cost of lending to these projects/corporates or the spreads and margins of lending to these corporates is clearly thinning down. So, the wholesale banks have moved away from corporate lending or project lending towards more small and medium enterprises (SME) and retail.
So the fact that to sustain their margins at current levels, they will need to move away from the corporate lending where the margins and spreads are thinner. So, effectively, I think that if they continue to be in the same space of wholesale lending, there will be a sharp decline in net interest margins (NIM) which is a reason to think and worry about.
The other bit is moving to retail and SME space which is reasonably a turf where you have seen the non-banking finance companies (NBFC) and the small private retail banks running very hard and they are incumbents in that space. If you want to go to that space, you will see more competition creeping in because the wholesale banks will go into that space and push the margins down because there will be more competition which will creep in there.
Effectively, the third bit is obviously technology and the delivery system which we see the new banks coming up with. They are far more quicker, far more rapid, they obviously work with lower cost and hence, the spreads will come under pressure. The whole banking system I suspect, in India, is going through this phase of change. And that will result and we need to think about lower spreads and lower NIMs going forward.
There is a potential. The other question which you spoke about is the lower credit growth. A fair bit is getting replaced by the domestic flows into insurance and mutual funds. So, you should not think about credit growth as 3-5 percent which is only the banking system. You should think about credit growth which includes the money which is being lent in the corporate bond side which is the non-convertible debenture (NCD) market which has become very active. That is a function we need to put together and say that the overall credit growth is about 9-10 percent.
So if the non-banking system is going to take over the wholesale lending and other pieces there is a very serious risk of NIMs settling much lower.
Q: How do you play this space then, as an investor? Which part of it do you position yourself in given the kind of fairly significant changes you are pointing towards?
A: It is a fair bit of challenge. We are very valuation driven people. The private sector expensive banks are obviously out of the purview. What we think about is the banks which are less vulnerable, which have a reasonably broad based book and are much cheaper in valuation where there is a fair bit of concern in terms of high non-performing loan (NPL) accretion, belief that they will not be nimble enough to move their banking system to adapt to the changes that are happening. So, we have a sprinkle of private sector banks which are much cheaper compared to the peers and also a few public sector undertakings which are larger and hence, we create a basket.
We are also in the NBFC space which basically, some of them have got bruised in the last few quarters and we thought that there was an opportunity to buy into them and we have a basket of both private, public and NBFCs. We were reasonably brave to have bought some of the names that people were extremely concerned about when the system actually went through a reset, we bought names which were at about 0.6-0.7 book, but reasonably sustainable return on equities (ROE) of close to around 17-18 percent.
Q: The other space which would challenging you as an investor now is IT and Infosys numbers would not have made it easier for you. I know you own some of these larger IT companies in your portfolio. How do you see the road forward? Should you just keep holding them hoping for a turn or do you think they are probably going to be fairly low growth companies for a significant length of time?
A: That space has been quite a worrying space for a variety of reasons. First is obviously the changes which are happening in the world. The huge disruption in terms of technology evolution which is happening now and there is a fair bit of artificial intelligence (AI) robotics which is changing the overall landscape.
The second bit which is changing is the evolution to cloud and increasingly the adoption of cloud which is happening. So, these are changes which are going to be very scary as far as our Indian IT space is concerned. Are they going into ex-growth, I think not yet. They are not yet ex-growth, they are not yet to be written off. They are capable of adapting, they will go and acquire some businesses, they will manage change and it is going to be a bit of a challenge and the way we have interacted with these large IT companies, they are mindful, they are not blind to these changes.
The fact that these changes are happening, because they are very cash rich, some of it they will return, some of it they will use to acquire, they will continue to generate cash. If you have about close to 30-40 percent of your total market cap in cash, you will happily play them along and their ability to generate cash is also going to be a floor where they will distribute back. So, there are multiple things. First is the business challenge, second is the evolution and third is the ability to keep generating cash and returning.
But having said that, it worries that these stocks are trading at about 15-16 which is one standard deviation cheaper than what they have been historically, it is obviously value. At some stage, you must believe that these people have done whatever they have done to get a USD 10 billion mark and they will evolve and it is not a hope trade, it is not a faith trade. It is kind of a trade where we believe that this process of transformation in the world which is happening now, the Indian companies will not get left out.
What is not working for them are two things or three things. First is obviously the currency is not working for them. Second is the protectionism which is pretty global. And the third is their inability to automate their system or abuse the work automate in their system which is making them look a little archaic. So, they have to work around these three situations to kind of come out of the hole.
Q: I want to ask you about telecom because I wanted your thoughts on whether, as an investor, you have included some of these names because I am sure, they would have been out of favour for the last many years. But after the recent changes, not just the entrant of a new aggressive player, but also the consolidation which is going on, are you taking a relook at the sector or do you still remain quite sombre about its prospects?
A: That is one space that really worries me. There is really a big change happening in the overall market. The total revenue base is approximately around Rs 2,00,000 crore and that is what the sector does today. Close to around 90 percent is voice and 10 percent is data. Here comes a challenger who says that voice is free and I will charge you only for data and let us grow from here and let us grow data harder and harder and he is going to make that step change or he is going to be the biggest disrupter of the entire sector.
All these telecom companies have paid their arm and leg to get or acquire spectrum and they have incurred cost and they have done whatever they have. Once the voice becomes free, increasingly, this Rs 2,00,000 crore which you will see shrinking rapidly as voice becomes free and the classy example that somebody told me was he was on a Rs 2,599 plan with Vodafone and in six months' time, Vodafone is offering the same service at Rs 699. It must be across all operators. It is not just picking on Vodafone.
But the fact is that if the loss of revenue in terms of voice is going to cause this industry to shrink rapidly before data catches up, the disruption is going to be for much longer and balance sheets will possibly get seriously destroyed as we emerge out of this with more sanity and more sensible players in terms of finances. So, I am actually very concerned about telecom as a space and more concerned about the collateral damage that will happen.
The collateral damage is the ecosystem that the telecom sector works on. The ecosystem that supports the telecom sector because if there is a revenue shrink and an earnings before interest, taxes, depreciation and amortisation (EBITDA) loss, I mean there is going to be a reduction is EBITDA margins, I am not sure whether they are going to go out and spend as much money as they have in the past. And also, the small and medium enterprises that are being associated with them, they will see a sharp change in the way they work. So I really worry as to how much uglier it gets before it gets better.
Q: Let me ask you about a more generic question because I met a lot of your peers who are emerging market investors off-late and some of them said maybe we are at the start of a four-year emerging market cycle again because it went out of fashion. For four years, we had a real difficult time convincing investors globally to invest in emerging markets as an asset class. But maybe, what we have started to see this year is again a new cycle in emerging markets. People are sceptical right now, they may be in denial, but this is how a cycle typically starts. Are you convinced because you have been investing in these markets for many years now that we have embarked on a new earnings and a stock market cycle in emerging markets?
A: There are a couple of markets that got completely left out in the last couple of years. The classic one is Philippines, Indonesia and Taiwan. They got completely left out of the rally and they were all trading ex-growth and Philippines obviously suffered because of valuations and change in government. But reasons follow.
I think the way I am looking at is there are pockets of Asia which are actually very cheap. There are pockets in Asia where people are paying enormous price for growth. There are pockets in emerging markets which actually for us, includes Latin America, the eastern block in Europe and multiple other markets where there are a lot of things which are very cheap. So, when these markets start to rally, you will call it emerging market rally, but it does not mean that people are paying high price for growth will actually kind of benefit out of it when they do not see growth.
I will not be surprised because the emerging markets are obviously quite cheap. The emerging markets are very politically vulnerable, the emerging markets are capable of growth, but in a softer interest rate environment, it really helps them to grow faster which I do not think is the case.
The other bit is in terms of political stability. Emerging markets are seeing more politically stable countries which could also drive. So, there are multiple factors which will drive, but the other bit is I think the money flow has to be to more thematic/sustainable 5-6 years of earnings growth which could be in emerging markets and pockets of emerging market are obviously very cheap.
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