Sharp mkt correction unlikely; upbeat on pharma, IT: IIFL

One of main reason for outperformance in the Indian market could be that funds seem to be chasing stocks where underlying earnings momentum is strong, underlying earnings visibility is high and they are taking a bit  of valuation risk, says H Nemkumar, Head of institutional equity at IIFL.

"In general the mood on the buy side is that better to take valuation risk rather than take a cyclical or an earnings risk. That is the reason why probably markets have done well," he says in an interview to CNBC-TV18. Also read: Economy will pick up by year-end, says Rajan Moreover, the turnaround in market sentiment was because the fear that there could be liquidity withdrawal on back of benign global liquidity seems to have subsided. This and various other factors resulted in markets seeing a sharp pullback. Nemkumar believes the best performing stocks are from tech and pharma sector because these are the sectors where earnings momentum is reasonably strong and earnings upgrades too have taken place. If there is worry on liquidity front that it may again start to dry up then one could see volatility in sectors like banks and some of the other quality cyclicals which FIIs own. I don’t think that we are in for a very sharp correction in the markets, he adds. "We are in a territory at this point in time where I would say till January-February it still look okay." Below is the verbatim transcript of his interview on CNBC-TV18 Q: What have you made of this complete turnaround in market sentiment – from 5100 to 6100 plus has been a very swift thousand point move on the Nifty- do you think it is supported by fundamentals? A: We have to make a distinction between the macro and the micro here. At the macro level all of us know that foreign liquidity plays a very big role on market movements in the short-term. In fact, through 2012 and 2013 up until May 22, India got close to USD 40 billion of inflows even when the newsflow turned decisively bad, and the macro fundamentals had turned weaker. Through this phase one would have noticed that earnings were being downgraded, gross domestic product (GDP) growth estimates were being downgraded. Although interest rates did come down during this period but there was a lot of unease with the way macro variables were behaving; in particular we saw a sharp deterioration in current account. If one would have noticed that there were concentrated flows during January 2012 again post September 2012 and throughout 2013, also after December 2012 when Fed announced doubling the amount of quantitative easing (QE). The bottom-line is that the global liquidity situation continued to remain benign and there was a worry that there could be a liquidity withdrawal so based on which there was that fear lead to sell-off and once that fear started to subside because of a variety of factors there has been a very sharp pull back as well. However, I would also like to highlight the fact that if one looks at the stocks that have done well -  while Nifty has done well, the top seven best performing stocks are from tech and pharma. The weightage of the top two stocks today is the same as the bottom 25 stocks. These are sectors where the earnings momentum is reasonably strong, earnings upgrades have started to happen. Most software companies their FY16 estimates a year ago are now FY15 estimates so the micro seems to be slightly different from the macro. Even as the global liquidity is benign funds are chasing stocks where the underlying earnings momentum is strong, underlying earnings visibility is high. In the process one is taking a bit of a valuation risk but I think in general the mood on the buy side is that better to take valuation risk rather than take a cyclical or an earnings risk. That is the reason why probably markets have done well. Q: What is your sense of how things move forward from here? Do you think because of a market which is intrinsically running on global liquidity perceptions not quite supported by fundamentals barring a few sectors, are there still risk that you could get these sharp gyrations going forward as well if global liquidity perceptions were to change again? A: I think there is no denying the fact that foreign liquidity either perceptions of its abundance or lack thereof, can have a big impact on the short-term movement of markets. That is true of all emerging markets and India is a high beta market on global liquidity. Having said that if you look at the ownership pattern of foreign institutional investors (FII) today, 60 percent of total FII ownership is in 20 stocks. If one looks at the top 50 stocks, there is only one PSU bank, State Bank of India (SBI) at number 26. So, clearly what FIIs have done in positioning of their portfolio is that they have moved into sectors and stocks where they have de-risk themselves significantly if something were to go wrong on the global liquidity side, something were to go wrong, on the domestic macro front something were to go wrong, on the election side. Therefore, if a worry creeps in that liquidity may again start to dry up then one could see volatility in sectors like banks and some of the other quality cyclicals which FIIs do own but overall I don’t think that we are in for a very sharp correction in the market. Q: Right now the liquidity signals are blowing strong, people are feeling very optimistic about the near-term but do you think there is a day of reckoning which is coming, which has been just postponed and once we have this rally which we are going through right now there could still be some very difficult times as we enter into 2014? A: While a few things are turning for the better for India, current account is most certainly improving, the rural economy is in reasonably good shape but there are some severe challenges and most of which is well documented. But inflationary pressures are unrelenting and interest rate cycle is not going to be benign in the short-term. If for any reason, India does not get a good government and if the medium term growth outlook for India changes, two things can happen. One, it could have repercussions on asset quality of banks and that is a very large sector, very widely owned sector amongst FIIs. Second, if that gets challenged most foreign investors whom I meet always tell me, ‘We can live with one year’s growth not coming through.’ But if their view about medium-term growth outlook for India changes for the worse then I think there is a risk that we may fall into a negative feedback loop and that can be pretty dangerous for markets. So, at this point in time it is very hard to say what will happen because on one hand there are lots of low hanging fruits. Just to give one data point - if one looks at investments, total investments that are being executed at this point in time are almost about 80 percent of GDP which is 2 times the number that we had in the last downturn and almost 50 percent of the projects are in two sectors which is essentially power and transport. Transport also includes roads, airports, railways etc. The reality is that for a lot of these projects execution has slowed down. Execution can very quickly pick up if sentiments changes for the better and if we are able to find some solutions for some of the problems that these sectors are facing. For that one needs political will and I am not so sure whether that would happen within the next 5-6 months or so. Once the new government is in place, if that confidence comes back then some of the sectors which have lagged can very quickly join in into the rally. For the other sectors, anyways the earnings momentum at this point in time is strong. Meanwhile, if for some reason the medium-term growth outlook for India is challenged then obviously a lot more selling can happen in banks and in fast moving consumer goods (FMCG) names. Probably there will be small islands where investors would still be okay to park themselves like IT and pharma but that will be a small portion of the market. We are in a territory at this point in time where I would say till January-February it still look okay. By then we will be too close to elections- depending upon opinion polls at that point in time. There is a possibility that there could be a pre-election rally. If the markets start pricing in that a better government, a more pro-growth government will be in place. Eventually, much will depend upon the election outcome because some of the cyclicals if they have to join into the rally then they have to probably need better policy support for that to happen. _PAGEBREAK_  Q: Do you think the markets are also eying the state elections quite closely and if they find that the Bharatiya Janata Party (BJP) or the National Democratic Alliance (NDA’s) is doing well in the state elections could they start to price that in into a possible election verdict in 2014? The market seems to be keen on a BJP led government for next year which would be a new government, a different government and with expectations of probably re-stoking the investment cycle at that point. Could the pricing in happen if the state election results give some hint in that direction? A: Yesterday, our research guys had put out a note highlighting the three myths that are going around. Ond one of the myths is that the state election outcome could be an indicator of what could happen in future. But we just step back into history and see and in 2003 BJP won three out of four states and Congress won the 2004 elections. The same thing happened in 2008 and 2009. In 2008, BJP won two out of four states and Congress did not do so well, but Congress did exceptionally well in 2009 election. Therefore to draw any conclusions from the outcome of state elections to my mind can be foolhardy but you never know. There are a lot of participants in the market, so people start drawing all kind of analogies and it could potentially have a positive rub-off impact, but I am not so sure whether you can draw any firm conclusions. I would probably look at the alignments in a few states like Tamil Nadu, Andhra Pradesh and Orissa. Also the opinion poll outcomes maybe in February to get a better sense of what could potentially happen in the May 2014 elections. Therefore, I am not so sure whether it would be right to draw any conclusions based on the outcome of the December elections, but sometimes markets can be irrational and can start making conclusions of sort. However, I would be wary of it. Q: The bigger question for a lot of domestic participants is - when does the markets start broadening out? It is already fine to have a few IT, pharma, FMCG names leading the index higher but a very large part of the broader markets still remains at a fraction of the all-time highs. When is the earliest you see the broadening out of the market which touches more sectors and stocks? A: Hypothetically if a pro-growth government is likely to come in then maybe you could see a sharp rally prior to May itself in some of these sectors. A more sustained rally is possible only after the election outcome. One should not forget the fact that balance sheets of a lot of these companies is in bad shape. If you are just playing the operating leverage then it is fine, but there is a huge financial leverage as well. Companies would need to repair their balance sheets. The markets will have to give an opportunity for companies to raise equity capital, raise a risk capital and for that prices have to move much higher from where it is today. Once the financial deleveraging cycle kicks in that is when a better visibility will emerge on sustained recovery in the capex cycle. Today a large number of participants who actually drove the investment cycle post-2006-2007 are companies that are in bad shape financially. Therefore I would say that much will depend upon the election outcome and eventually that will happen. I would also like to say that if you look at the history of cycles you can never say what will trigger a recovery in a cycle. The fact that investment cycle started to slowdown towards the end of 2010. We have had almost three years of continued slowdown in investments and maybe it lasts for another one-one and half years. Depending upon which government comes to power you could think of two scenarios. One, as a bull case scenario where a favourable government comes in and the sentiment changes and a recovery happens in investment cycle much earlier than 2015. It probably starts sometimes in the middle of next year itself. Two, if that does not happen I would say that by 2015 or so the recovery has to happen. You cannot have investment cycle on such a bad wicket for a prolonged period in time, at some point in time it will catch up. So, when you look at portfolios, part of the portfolio, you have to think about what is the time risk that you are taking vis-à-vis what is the risk on capital that you are taking and partly, you have to start investing in some of these sectors where at this point in time focus on operating leverage and not on financial leverage. Eventually, if the outcome of the elections is also good then probably you can revisit some of the more riskier stories. Q: What would be a good approach for an investor now? Would you say with confidence that we are close to turn in the cycle and this is a good time for investors to get in or we are not quite there yet. We are just being lulled into that feeling by a good phase of benign global liquidity? A: As I said before, a recovery in cycle can never be forecasted and when times are bad it is never easy to say that a recovery will happen. I remember that in 2002 and early part of 2003, we had put out a report based on one of the theories put out by University of Glasgow professor - it was a study of business cycles and when we were looking at improvement in capital and labour productivity at that point in time, across spectrum of companies that was happening but earnings recovery was not underway. Then what happened was that, there was a time risk. It took almost two years for the recovery to set in but when the recovery finally came, the stock prices moved up many times over. The real issue is that it is very hard to say when a recovery will happen and that is why one has to manage the risk well by not buying into companies which have very high financial leverage. But when one looks at companies with very high operating leverage; good quality companies but in a bad cycle then what happens, my advice would be put some part of your portfolio into some of these names, don’t look at the day to day price of these stocks and allow the cycle to play out. One is taking time risk but one is taking less of a price risk because a lot of these stocks are probably down 60-70-80 percent from their all time highs, so earnings are depressed, valuations are depressed and therefore in some part of the portfolio one needs to take some bit of risk there by owning some of these names. However, to use this as a full blown strategy and go overweight on these names, probably I would rather give up the initial 30-40-50 percent because when a recovery happens the stocks multiple several times over. The stocks move up by 3-4 times then there is equity, then the financial leverage comes down, balance sheet looks better, the stocks re-rates further, revenues pick up, earnings before interest, taxes, depreciation, and amortization. (EBITDA) margins pick up and all that kind of stuff will happen. For that visibility is still not there. My advice would be take a part of your portfolio, put it into some of the high quality cyclicals and one is taking more of a time risk and less of a price risk and stay put rather than because one will give the full rewards only over time not by looking at the stock price on a day to day basis.