Sell FMCG, buy steel; see next upmove in cyclicals: Mowat

Investors would be better off booking profits in shares of fast moving consumer goods companies, and deploying that money in banks, select steel and automobile shares, feels Adrian Mowat of JP Morgan, who also wore the hat of a guest editor on CNBC-TV18 today.

He is betting that the next big move will in cyclical stocks, and is bullish on stocks like JSW Steel and Tata Steel. Mowat’s team has downgraded its rating on China, and is recommending clients to invest in India instead. Indian shares could consolidate after the recent run up, feels Mowat, but does not see uncertainty over the outcome of the general elections as a big dampener. Investors will buy shares irrespective of whichever party comes to power. He also thinks global factors will decide the trend more than domestic politics. US economy is still to show signs of recovery, but that should not be of much concern to Indian investors, says Mowat. According to him, the Indian economy is more co-related to the European economy, which is showing some nascent signs of recovery. And while he is bullish on cyclical stocks, Mowat does not think it is time to bet on capital goods companies yet. Capital goods companies have been among the beneficiaries of a weak rupee, as costlier imports reduce competition from foreign equipment makers. However, those gains are largely negated by weak domestic order flows, as second quarter numbers of Larsen & Toubro showed. Also read: Fed maintains strong stimulus as US growth stumbles Below is the verbatim transcript of his interview on CNBC-TV18 Q: Its good times for our market, historic highs! A: Indeed it is. I hope I am not going to be interviewed on the day that marks the end of the rally. Q: Do you suspect that it is looking toppish? A: I am constructive on emerging market equities including India. However, India has had a decent run so a period of consolidation seems to be reasonable. We still have plenty of challenges whether it’s signaling the end of quantitative easing (QE), some of the macro economic data coming out of the United States is somewhat less constructive. Q: You saw the Federal Open Market Committee (FOMC) statement yesterday, some people are splitting hair that there is less of reference to the financial tightness which was a phrase used in September statement. Would you say the Fed is sounding less dovish? Where are you placing tapering? A: We are placing tapering in the second quarter of next year. I think there is a preoccupation with tapering. What tapering is - is signaling the end of quantitative easing. I do not care whether the Fed goes from buying 85 billion to 84.9999; its the same thing as going from 85 billion to zero, it signals the end of quantitative easing The problem that central banks have today is they came out with great idea which was forward guidance, which is fun if you are going to keep interest rates low forever but whenever you hint that you are going to end quantitative easing the market tightens for you, which is what we experienced back in May. So, let’s do what the Fed says they are going to do, which is look at the data. The data of the United States in terms of durable goods and Purchasing Managers’ Index (PMI) have been poor and so the chances of tapering in near-term look low. What happened in Capitol Hill was we kicked the can in January, so we could easily have the tea party holding the country to ransom again and the first quarter data turns out to be poor. But then if we do get a resolution on the budget, the debt ceiling, we could have pent-up demand in the second quarter, the data gets better and Fed looks at the data and perhaps that is when you get tapering and you signal the end of quantitative easing or the start of the end of quantitative easing. Q: At this point in time what does an Indian market investor do? This market has rallied about 16 percent from August lows but domestic retail participants are completely out – do you see that side of the market return anytime soon? A: While looking at the show this morning, someone was being quoted as saying that bulls are in full control of the market, but I disagree. I think the bears are on the back foot. I have been seeing a lot of clients in the last couple of days and generally people are saying market shouldn’t be going up, the market is not looking very good but one must remember that markets move because the perception is different from what is actually delivered. The results so far haven’t been as bad as people thought they were going to be - it is that type of things. It is that is why markets go up The other thing to bear in mind is your stock market is not your economy - A lot of Indian equity earnings come from abroad. We have a large section of this market, which are staples. Parts of this stock market that are sensitive to the economy like the infrastructure stocks, their equity value is very low. There was some statistics showing what has been driving this market back up to its high, some of the big banks are down quite a lot from where they were at the previous high. So it is very important to understand what is driving the market and don’t try and relate that directly to the economy. Q: If this market is sustainable, if this rally is sustainable as we have called it, what could be the next leaders that will drive this market higher? A: We have advised clients to move into the banks, into some of the steel names and also names in auto sector - perhaps those more exposed to the rural consumer. I think staples are underweight; they are particularly overvalued because so far this year we had poor economy, so people go into staples. We had a lot of merger and acquisition (M&A) activity globally in staples which has driven valuations up. So you come out of staples, you come out of exporters and you are into near cyclical like the financials and then deeper cyclicals. We do think it is going to be more of a cyclical move but part of that cyclical move is not demand in India, its export demand. _PAGEBREAK_ Q: A moneycontrol SMS question to you - Is the India rally being driven only by FII inflows? A: I think there is a preoccupation here by flows. Investors manage money – they decide to buy an asset because they believe it has got better fundamentals than are currently discounted in the price. What happened globally in emerging markets is they have under performed by 40 percent developed markets since late 2010. Expectations in emerging markets (EMs) in general have gone from euphoric in 2010 to extremely pessimistic. What investors are saying globally, in most EMs, not just India is the price of equities is low versus what they think the long-term cash flow that is available Q: You distinguished between financial markets and the economy and said that you wouldn’t still bet that the economy has turned – would you say the economy is still to see depths or would you say worst is over for the economy? A: I think we are scrapping along the bottom hoping for a slightly better 2014 Q: Clearly, the current account deficit will at least be narrower. A: Yes, so the current account deficit is narrower and if that is being solved by import substitution which has to be explored a bit further then that will be good for domestic demand. Obviously, if the current account just comes down because there is collapse in demand for imports that is less good but the current account is better, foreign exchange reserves are rising and the market has a fair amount of confidence in the policy that is being promoted by the RBI. Q: What is your stance on the Indian market? You have been overweight on emerging markets for a while. Have you changed your stance on India between August and now? Most of the people on the street have got it wrong but you have still been overweight? A: We are not overweight Indian, we are neutral within an emerging market context but we have changed the sectors we own. So, it is that rotation from exporter defensive sectors into the near cyclicals like the banks, the more cyclical sectors like metals and mining, autos. That is the change that has gone on. The change has gone on as we have had a stabilisation in the rupee, the rally in the rupee - people were extrapolating that the rupee was going to continue to fall, we are going to get terrible credit crunch and that is not the way it has panned out. So, it is about playing these expectations. Q: Relatively what do you do now because when we talk to a lot of experts, we get a sense that people prefer to put money into markets like China vis-à-vis India because of the improvement that we have seen there? A: We have recently downgraded China, so we are underweight China at the moment. We prefer India over China. China the preferred sectors like internet, staples - remember China had its cyclical high already in the Q3, they have got very expensive and I do not want to rotate into cyclicals. Whereas what we have in India, we have very weak economic conditions at the moment - we have got banks announcing big increases in non-performing loan, we have got a lot of write-offs going on in companies, so there is kitchen sinking and that is interesting. That sets your lows and you get better data going forward. Q: A kind of a correction started yesterday in the US markets after the FOMC. Do you think this continues for a bit because we have had a fairly good rally in developed market equities and in emerging market equities. You think now there could be an extended pause? A: I am not sure if it will be an extended pause but we have had a very good move in global equities. The US result season is running above expectation but typically towards the end of the result season, you get more misses than beats; the good news always seems to come out first. So, there is a seasonal nature to this and the data in terms of macro economic data like durable goods, PMIs has been less than the market was expecting. Q: What does an Indian investor do, for what it is worth although valuation wise we are much cheaper? This is a revisit of the new high 6,300 on the Nifty and 21,000 on the Sensex. Do people go in and buy at this juncture or do you think that they should pause? A: My advise is take money out of the staples, the very expensive growth stocks and rotate into near cyclicals etc. So, there are plenty of things to do with your portfolio. However, I would be optimistic about the returns for Indian equities over the next 12 months. I think the bulk of the returns will happen this quarter and the next quarter and that tends to happen seasonally. If tapering is an issue for the second quarter then maybe market is going to have more trouble in the middle of the year but that also tends to be the way the calendar works for equity markets. Q: Most of the cyclical haven’t yet announced numbers and we haven’t got numbers from Tata Steel etc - Why are you so bullish on cyclical. Is it because there is an import substitution story there or is it that you are seeing beginnings of growth in India? A: What we are seeing is the beginning of growth globally. It is not a big number - 2 percent growth but that compares to 1 percent last year. Europe is growing; it wasn’t growing at the beginning of last year. Our economies are more correlated to Europe than they are to United States so that is good for exports. We have got this rather nice condition where US data disappointing, which means that tapering is further out and the European data is good which is good for exports and let us not ignore the fact that Japan which still is the third largest economy is also producing good data. Q: If we talk more about one particular space metals, if you look at the stocks – if you have bought Tata Steel or Jindal Steel and Power (JSPL) five years back when Sensex was at high in 2008 then you would have been a big loser today because all those stocks are down 60-70 percent. Do you think you should buy it now? A: Yes, I do and this is where the economy has had a real influence on the stock market – it is in this section and so there is lot of value there. Also remember, whatever you get with that particular stock, you get a large exposure to Europe, and the fact that Europe is now expanding reduces the risk in owning that stock. Q: So it would largely be export story that would make you pick cyclical, not because you see some capex cycle here? A: It would but I also think we should look as we go into next year; although there is some ambiguity about whether this was a good or a bad monsoon, did the rains not arrive at wrong time for the harvest or at the wrong time for harvest perhaps but as you run into an election year, rural income will get the boost and that is where the bulk of the electorate are. So, I think the pessimism around the two wheeler sector, the auto sector is probably overdone, and maybe those are of interest as well. Q: Between these two triggers for the next six months, one is the global market movement and second is our elections, which one do you think will have a bigger impact. If there is a new government that comes in, Narendra Modi led Bharatiya Janata Party (BJP) government then all this taper talk will be out of the window and we might hit 6,800-7,000 on the Nifty? A: I think that global factors are very  important. We invest in India despite the government, not because of the government, and most international investors are not particularly interested in Indian politics because there is very little evidence that there has been a lot of policy coming out of the Lok Sabha that has had real impact on this economy. Companies here are like US companies - they ride their business with the assumption that economy is not going to be very good that they are not going to get help from the policymakers and that is why people buy Indian companies. If I ask clients internationally about the election in May, first of all it’s a long way off and second, their expectation if (this would be a very weak consensus) is that the statistics suggests that the Congress is likely to form another weak coalition. When I am talking to clients here, particularly in Mumbai, I find they have a much greater fixation on the BJP and there is a disproportionate number of Gujarati males in the equity business in Mumbai and maybe that is why it is. However, it is a very different picture than I get from talking to international clients. _PAGEBREAK_ Q: If you can flesh out the theme of import substitution and cyclical a little more, which kind of stocks do you like, Tata Steel, Hindalco or do you like even import substitution companies in the capital goods space? A: I do not think capital goods is the right place to look in terms of import substitution. The capital goods stocks are suffering from the ambiguities when it comes to coal pricing. There are number of power plants that are ready to start but haven’t started yet. So, it is much more a policy story for capital goods. I also think we got to be little bit nervous about the whole electricity generating space. Solar power has now moved to greater equivalent pricing, certainly in Japan and it looks like it is doing in China as well. So you could start to see quite major role out of solar power and so the need to have these large gensets or the amount of demand for them could be revised. Q: I was referring to the constant complaint of BHEL or even for that matter Larsen and Toubro (L&T) that they get Chinese competition and now of course that will become difficult because of the cost of the dollar. You do not think there is any advantage in that space? A: There has been move in them, they are more competitive but at the same time China’s spend on infrastructure needs to slowdown, So its huge capital equipment companies will be looking for more export orders. Q: What about the metals. Is there any favourite in that space? A: We have alluded to liking something like Tata Steel where we are seeing import substitution. Q: I wanted to talk about one sector that has been anchoring this market for so long, the IT space. Despite sky high valuations, the argument in the market is that managements across companies are now turning positive even the laggards like Infosys and Wipro are indicating that the deal pipeline is going up. Do you think that despite sky high valuation you should accumulate any of these stocks or would you move this sector to the backburner? A: For now , I have got less emphasis on it because there is more upside in the banks, the steel companies, the auto companies but they are still good stocks and I do not think the valuations are sky high. They are about at mid to high teens valuations on forward earnings. That is not a particularly high level of value for these stocks. They may have had higher growth rates in the past when they were smaller but now they are very large entities with great balance sheets, they have proved themselves through difficult times; they are beneficiaries of the weaker the rupee. I still think they are fundamentally very attractive. Global clients continue to like these stocks. Q: Tata Consultancy Services (TCS) is one fellow with 22-23 times valuations, you like him? A: They have delivered better than the rest of the market and they definitely have been rerated but if you look at the valuation of HCL Technologies, it is about 15 times looking into 2015. Q: What about fast moving consumer goods (FMCG), there they have been some chinks that have opened up. This whole rural story is expected to play out in the second half but the management themselves have been so cautious about competition? A: Staples are sell, avoid and its just valuation. It is valuations because people were pushed into staples as the economic data disappointed and then you had a huge amount of M&A activity in the staples placed globally including India. Q: You were speaking about banks and the tougher part of the financial are the public sector banks. Would you buy any of them? A: The discount is now large enough that you should consider some of the public sector undertaking (PSU) banks and the story so far seems to be that credit cost have risen but maybe not as much as people feared. One area we need to explore little bit more is idea of restructured loans and the restructured loan numbers have been going up a lot. Q: What about the broader markets although the Nifty and the Sensex maybe at historic high, the midcap index is 40 percent away from its peak.. A: I think it’s a great opportunity. Q: Would you increase your exposure in the midcap space and where would that be? A: Absolutely. We would be looking to find the companies with particular characteristics rather than a sector. It is the companies that have grown their cash flow through this difficult environment and because they are midcaps people have missed them or they have sold them because of liquidity risk. Talking to clients there is a lot of interest in doing some work in the midcap space. Q: I would assume that you still like the private banks a lot; you still want to buy them even at these valuations? A: The largest private bank ICICI Bank highlighting down 25 percent from where it was the last time when the Sensex was here, so yes. Q: And you were impressed by their numbers? A: The numbers were not as bad as people feared. _PAGEBREAK_ Q: A lot of the public sector banks which are saddled with much more of restructured assets than private banks like Axis Bank do tell us the same number, around 25 percent; some of them even come with a lower number probably 20 even 14. Is that the way you value public sector banks, just take off 25 percent from restructured then is the book attractive? A: I think people are suspicious that the number might be larger. We see this in other countries where extend and pretend - you restructure the loan, you capitalise the interest and you pretend it’s a good loan. So the lack of transparency around this is a cause of anxiety for investors. Q: To draw historical parallel which is never the same - the last time around between 1997 and 2003 we had a lot of restructured assets. One entire set performed brilliantly after restructuring and that was steel. Almost all of them gave us multibaggers after the restructuring and the banks took a hit at that time but some of those which were restructured ten times over like Enron never came back to the table and continued to remain laggard but that was much less than the total amount of assets that were restructured? A: True but the benefit we had from 2003 to 2007 was the Chinese government took fixed capital formation from 35 percent of gross domestic product (GDP) to 47 percent of GDP. We had a bull market in commodities, steel etc. So, there was a big cyclical help for that sector. Guest Editor’s Q: Do you think anti incumbency is a particular urban issue or do you see it with the role of voters as well? Rajdeep Sardesai (Editor-In-Chief, CNN IBN): We have seen in general elections (Indian election) tend to be an aggregation of state election. So you will have some states where there is strong anti incumbency and Delhi being a good example, you will have other states where perhaps the government is seen to be delivering on basic governance and in those states you will not see the anti incumbency to the same extent. Similarly, there are parts of rural India where we have seen in the past the anti incumbency tends to be magnified more in urban areas than rural India but it is difficult to make any broad generalisation at this stage. The national election tracker that we last did in July suggested that there was a general sense of dissatisfaction - whether that will translate into voter anger. I think the anger is much more at the moment in urban India and the urban-rural divide is not a sharp as it used to be. A lot of urban families have family in rural India, and the media has spread right across the country. So, the urban-rural divide is perhaps not a sharp today as it was 10-20 years ago.