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Last Updated : Jun 11, 2016 03:25 PM IST | Source: CNBC-TV18

We like India but it's at a 50% premium to EMs: Investec

The Indian market is a "good place to be" but valuations are at a 50 percent premium besides the economy facing some problems with policy execution and some sectors facing deep stress, says Archie Hart of Investec.

The Indian market is a "good place to be" but valuations are at a 50 percent premium besides the economy facing some problems with policy execution and some sectors facing deep stress, says Archie Hart of Investec.

In an interview with CNBC-TV18's Udayan Mukherjee, Hart also talked about the impending British referendum and said if exit camp wins, it's going to cause an instant reaction in the market followed by weeks of negotiations and handwringing.

Below is the verbatim transcript of Archie Hart's interview with Udayan Mukherjee on CNBC-TV18.

Q: What do you make of the Brexit situation and how much of a problem do you think it could be for emerging markets like India?

A: It is going to be a very close vote. It is going to be a knife’s edge either way. What will happen is that there will be an instant reaction by the markets, but actually, there will then be a very longer period of negotiation, if we were to leave. So, I think after that kneejerk response, things will settle down quite quickly to a perhaps prolonged period of uncertainty. So, it is going to be very interesting 2-3 weeks in the UK.

Q: What is the market pricing in according to you right now?

A: The market is probably a little bit on the complacent side in that it expects no change. So, if we see a vote to remain, the markets will probably not do too much. If we see a vote to leave, there could be more of a break in the markets potentially.

Q: What do you see as a bigger trigger this summer? Is it what the US Fed eventually does, given the data it has on hand or do you think it is something coming out from Britain?

A: Brexit really is very important if you are Britain over the year. I am not sure of the effects globally are going to be huge. I think the real thing will be the Fed and actually probably the things that we cannot forecast, the unknown unknowns that come from that field. And one of the more obvious places there might be say, China where clearly policy is evolving and that could be very influential on markets over time.

Q: What kind of positioning do you see from most of your large investors? Are they relaxed about emerging markets now after the pull back that we have seen since February or are they still uncertain?

A: Markets have been very bad for an emerging markets investor for several years. So the asset class has underperformed developed market equities now for several years. So, investors in emerging market funds generally are feeling very beaten up and although you have had that 20 percent rally from the very bottom, it only gets you back to where you would have been a year ago. So, actually a lot of investors are making that decision between is that rally a beginning of something better or is this just a bit of noise in markets which will remain under pressure.

And really that is the interesting thing about our world, is that is it at a turning point or not. We can certainly signs of positive change in many respects. So, the Modi government in India, Jokowi in Indonesia, recently, a new government in Brazil. Companies are beginning to react to the new environments. So, Brazilian banks have laid off 10 percent of the staff. They are becoming more efficient. Korean banks becoming branches. Miners and oil companies are again cutting costs, generating more cash flow. But on a more wider basis, the trouble with our asset classes is that it is very cheap. Sort of a significant discount to its history, significant discount to the developed world, but companies are still under very significant pressure. And that makes it difficult to make a compellingly positive story at this point.

Q: You can say with some confidence that earnings are beginning to bottom out in the emerging market universe in many countries or it is too early to say that?

A: Unfortunately, it is too early to say but a bit of a turning point, the information is always unclear, we always have questions, etc. So, what we are seeing is signs of a response by electorates, by politicians, by banks, by companies, by just the people of emerging markets. But it is too early to say whether that is going to feed into a positive earnings trend or not. I would say that I would be cautiously optimistic, but the word cautious is not as important as the word optimistic almost.

Q: Do you think things which are particular emerging markets will drive this trend, or do you think it will still be a global top down kind of a trend which will partly be determined by what the Fed does, what happens to the dollar, which will determine the outcome on emerging market equities finally?

A: The big defining issue of our age is the centrality of central bankers to our world at this point. So, we saw in 2008, the central bankers step in and rescue the world from complete collapse. So, we saw that huge liquidity injection, quantitative easing, all those ways of keeping interest rates very low, liquidity very high. Problem is eight years further on, we have reached that level of diminishing returns and the markets are saying if after eight years, you are continuing this policy of liquidity support for the markets, that something is badly wrong if we still need this eight years into recovery.

The central bankers appear to believe that what they need to do is more. If we do more, this will solve the problem. So for example, they made it from zero interest rates, to negative interest rates, the markets are not convinced. So, really our world is going to be determined by the actions of those central bankers for better or for worse at this point. And that is quite a profound concern for many people who work in the markets because we have had too much of a good thing, but weaning ourselves off that liquidity is going to be a very difficult transition point for the markets.

Q: Let me ask you about this whole Brexit thing, how much of a risk to global risk trade does it present in your eye?

A: It is a very good question, it’s obviously huge topic of debate in the UK. It’s going to be very close vote. It is going to be knife-edge either way. What will happen is there will be an instant reaction by the markets, but there will then be a very long period of negotiation between the European Union (EU) and Britain if we were to leave. After that kneejerk response, things will settle down quite quickly to perhaps quite prolonged period of uncertainty, but it is going to be a very interesting 2-3 weeks in the UK at least.

Q: What is the market pricing in according to you right now?

A: The market is probably a little bit on the complacent side in that it expects no change. So, if we see a vote to remain, the markets will probably not do too much. If we see a vote to leave, there could be more of a break in the markets potentially.

Q: What do you see as a bigger trigger this summer? Is it what the US Fed eventually does, given the data it has on hand or do you think it is something coming out from Britain?

A: Brexit really is very important if you are Britain over the year. I am not sure the affects globally are going to be huge. I think the real thing will be the Fed and actually probably the things that we cannot forecast, the unknown unknowns that come from the left field and one of the more obvious places there might be say, China where clearly policy is evolving and that could be very influential on markets over time.

Q: What kind of positioning do you see from most of your large investors? Are they relaxed about emerging markets (EM) now after the pullback that we have seen since February or are they still uncertain?

A: Markets have been very bad for an EM investor for several years. So the asset class has underperformed developed market (DM) equities now for several years. So, investors in EM funds generally are feeling very beaten up and although you have had that 20 percent rally from the very bottom, it only gets you back to where you would have been a year ago. So, actually a lot of investors are making that decision between is that rally the beginning of something better or is this just a bit of noise in markets which will remain under pressure.

I think really that is the interesting thing about our world is that, is it at a turning point or not. We can certainly see signs of positive change in many respects, so the Modi government in India, Jokowi in Indonesia recently, a new government in Brazil. Companies are beginning to react to the new environments, so Brazilian banks have laid off 10 percent of the staff. They are becoming more efficient. Korean banks becoming branches. Miners and oil companies are again cutting costs, generating more cash flow. But on a more wider basis the trouble with our asset classes is that it is very cheap. Sort of a significant discount to its history, significant discount to the developed world, but companies are still under very significant pressure. That makes it difficult to make a sort of compellingly positive story at this point.

Q: You can say with some confidence that earnings are beginning to bottom out in the EM market universe in many countries or it is too early to say that?

A: Unfortunately, it is too early to say but a bit of a turning point, the information is always unclear, we always have questions, etc. So, what we are seeing is signs of a response by electorates, by politicians, by banks, by companies, by just the people of EM. But it is too early to say whether that is going to feed into a positive earnings trend or not. I would say that I would be cautiously optimistic, but the word cautious is as important as the word optimistic almost.

Q: Do you think things which are particular EM will drive this trend, or do you think it will still be a global top down kind of a trend which will partly be determined by what the Fed does, what happens to the dollar, which will determine the outcome on EM equities finally?

A: The big defining issue of our age is the centrality of central bankers to our world at this point. So, what we saw in 2008 the central bankers step in and rescue the world from complete collapse. We saw that huge liquidity injection, quantitative easing, all those ways of keeping interest rates very low, liquidity very high. Problem is eight years further on, we have reached that level of diminishing returns and the markets are saying if after eight years, you are continuing this policy of liquidity support for the markets, than something is badly wrong if we still need these eight years into recovery.

The central bankers appear to believe that what they need to do is more. If we do more, this will solve the problem. So for example, they made it from zero interest rates, to negative interest rates, the markets are not convinced. So, really our world is going to be determined by the actions of those central bankers for better or for worse at this point. That is quite a profound concern for many people who work in the markets because we have had too much of a good thing and we need to move, but that weaning ourselves off that liquidity is going to be a very difficult transition point for the markets.

Q: Do you think central bankers will be able to do it convincingly because it seem like the US was about to get out of the exit door but every piece of data which comes out which is negative makes them pause. Do you think it will be a very prolonged kind an exaction plan from that kind of a liquidity injection?

A: It would seem that the Fed particularly is going to be very cautious in how to exit the current liquidity stimulus but I would say that they have started whereas if you look at the European and the Japanese, they are still working out whether there is a plan B and what plan B might be. I think at least the fed has decided that they need to normalise rates over a considerable period of time.

Q: How easy or difficult is it now for an emerging market fund manager to go out and say this is the place to be after eight or ten years of fairly pedestrian kind of performance for the asset class in general?

A: As an emerging market investor the interesting thing is there is an US investment consultant which ranks asset classes on an annual basis and it looks like emerging market equities, developed market equities, largecaps, smallcaps, commodities, property, high yield bonds, sovereign bonds etc. They have done this over 20 year period; 15 of those 20 years emerging markets have either been the very best or the very worst place to be. So it has been very highly cyclical asset class over a time. In the late \\'90s we had the Asian financial crisis, the Russian default, it was not a place to be then in the early 2000 it was a great place to be and in the last few years it has been a very bad to be.

However, what I would say is that we can see response to the things that have happened in the politics, in the economies, in the policies, in the companies, so I would say at some point there will be a turnaround. Is it this year or next year or a year after is a question but I do think that in a cyclical world at some point there will be a recovery, difficult to say what the timing of that will be

Q: Where does India fit into your emerging market picture? Are you underweight, overweight relative to some of the other peer markets?

A: We are relatively too slightly underweight at this point and many investors have much higher weightings in India than we have. Now we are bottom-up stock pickers, so our attitude to India - it is going to reflect particularly on a negative view on India; we actually quite like India but we have sort of probably three broad reservations out of stock market. The first is that we like government policy. We are concerned about execution and implementation, so we would like to see goods and services tax (GST) but that is obviously difficult to execute; political reasons, there are many stalled projects which remain stilled, there are lot of issues, public sector banks particularly that need to be resolved. Second, there are some parts of the Indian equity market that we struggle with, for instance the consumer companies, we think great companies continue to grow but valuation we think is very full at this point in time. The resourced companies look very challenged and we find the uninteresting equally the public sector banks, we think are uninvestable until we find a resolution to that issues and the third point is that we like the Indian market and about 50 percent valuation premium to emerging markets generally, so good place to be but that is reflected in valuation and hence we are less excited and the right price we think will be a great place to be but we cannot we cannot quite far near.

Q: So you steered away from these expensive consumer names completely in India?

A: Not completely but we find them challenging. I think basically you have to believe in a changing world that these companies are going to grow for a very long period of time and consistently maintain profitability for a very long period of time to justify the valuation and we are not sure that our crystal ball is going to forecast that far out. So in other words we think that risk of buying at the valuations are quite high even though some may argue the opposite.

Q: What about pharmaceuticals that’s another space where people had such apprehensions, but in the last six months we have seen a dramatic correction in Indian pharmaceutical names. I did see a couple of names in your India portfolio there from pharmaceuticals. What do you think about that space?

A: That is a sector historically we have liked. That is one of the areas where India excels. You have one of the best generic pharmaceutical sector in the world and world beating companies and we had significant holdings overtime and made very good money on them. We are slightly more cautious in the short term and the reason for that is the market is changing and what I mean by that is that we have more competitors. There is much more pricing pressure. Companies are having to move much faster to stay ahead of the game. For instance, generic pharmaceutical pricing is falling high single digits in the US now.

Whilst the market is still growing for generics, the price erosion is reducing growth, so we are looking at more tough environment for the average Indian pharmaceutical company and to be fair they were saying that we need to move into biologics, more difficult to manufacture areas, more niche areas – they are right, but the success of individual will depend on individual management strategies. The glory days of 20-30 percent annual growth are perhaps over. Is just a more difficult place to be than it was.

Q: You spoke about public sector banks, but even private sector banks have got hurt over the last year because of these asset quality issues. Do you have significant holdings there or are you wary of that entire space in general?

A: In general, we are wary of that space and this is an EM market sort of issue generally is that very high quality growth companies attract very high multiple. People like the security, they like the visibility of the growth and that’s largely private sector banks in India. Those companies which are seen as very risky and very challenged - public sector banks are very cheap. As an investor you have this problem where you have companies you like to own, do you think that they are pretty fully or fairly valued companies which you really don’t like, but actually looking incredibly cheap and that’s India you have the private sector banks are relatively expensive, the public sector banks are potentially quite cheap, although there is lot of moving parts to that analysis. At this point financial as a sector where we haven’t got much exposure in India.

Q: What you do with commodities because that such a big call that you have to take in EM universe. Of course, you can take country calls like Brazil, Russia and they have rebounded more than India, but even in India you have a lot of resource companies which are going pretty cheap. As an investor, as a portfolio manager how do you time commodities into your investible universe?

A: I think interesting about commodities at the moment was – it used to be one overarching thing, so what you had was the very strong growth in China drove the whole commodity complex upwards. You had this very strong rally for several years in commodities. When you had the slowdown in growth in China and also you had supply catching up with demands, so we had overcapacities. We have the great commodity correction.

Now what we are seeing is much more diversion differentiate for example the oil prices are up 80 percent from the bottom, the iron ore prices are up 30 percent from the bottom, but aluminium and copper prices are up less than 10 percent from the bottom quite a lot of divergence – going forward what we are going to see is going to be very commodity specific. So for example iron ore there is a lot of supply, a lot of low cost producers, China is closing steel capacity – that looks like a difficult place to be. Zinc is quite the opposite. Zinc if anything mines will shut; supply may contract that maybe a mineral where the prices hold up relatively better. It is becoming very specific by commodity and very specific by company. The companies with the best mines, with the lowest costs, with the best cash flows will do much better than those companies with lower quality mines, higher costs, which still have a problem with cash flows – going to very case by case I think going forward.

Q: What are you big bets in India? Are they relatively defensive sectors like information technology or have you gone down the risk ladder there?

A: One of the interesting thing about information technology was it was very defensive for many years because these companies are in euro and US dollars and have rupee cost. However, at the time of weak India, their rupee costs are falling and they are benefiting from European and US revenues. What is happening at present is that is beginning to change a little, so they are finding revenues harder to earn, they are finding harder to give guidance and to grow the companies and there is a change in the information technology environment; it used to be, we give you 1,000 people and the purchase is saying why don\\'t you automate that and maybe we will need 900 people. If you automate it and provide 900 people of 1,000 people, what happens to that 10 percent revenue that lost? So there is structural change where some automation coming in and that is beginning to moderate the revenues.

India, we think there are some interesting places and we do have one or two Indian IT names, we have some auto names where auto demand has been restrained for some time and we see demand coming back there and you need to have some good auto manufacturers. We have one or two cheaper consumer goods manufacturers where we like the growth and we can find values. So it is much diversified portfolio in India which probably doesn\\'t look too much like the market and we are quite happy with that at this point.

Q: Do things like what is happening with the Japanese yen over the last few months and what it could mean for currency devaluation in China and do these appear as major risk to the emerging markets spectrum to you?

A: What is happening to the yen is around that central bank, we spoke about at the beginning which is the central bank moved to negative interest rate policy, the market said as a banking system how do you make money, how do you add capital when you have negative interest rates. So we think about negative interest rate, if I charge you for putting your deposit in my bank, you might think about taking your deposit out which would potentially destabilise the bank then in that environment if you are going to make a lot of new loans so there are a lot of secondary effects from negative interest rates which are potentially quite frightening and I am not sure that this has been thought through so that yen weakness is somewhere around the market becoming quite uncomfortable with policy and more broadly central bankers would force for good in defending the world against catastrophe in 2008. There are rumours now of instability although they may not see themselves that way. So it is critical for markets going forward that they extricate themselves from being central to the argument and go back to where they were which was in general relative to the peripheral to the economic argument rather than being central.

Q: We have had 5-6 ordinary years in EM market. Do you think we still remain in that regime of a difficult overall market - not saying bear market, bull market, but a difficult market or do you think we are beginning to come out of that kind of a phase?

A: I believe there is evidence that where we are going to see a turnaround. We can see the changes in governments, the changes in economic policies, the changes in what corporate managements are doing – that’s a good indicator of what better times ahead. The thrill with that is you are finding is various headwinds, so that’s actually tough to do and the timing is somehow quite difficult to predict as well. I would say the one risk facing all of us is simply China.

And I think China is a very untransparent thing of great importance to the world to give you an idea how important China is. China produces 24 million cars roughly this year, the US only produce 12 million and in many, many industries now China is the biggest single driver and China is going to go through this difficult transition from a way investment led economy whether they have been driving growth for heavy investment and rising debt to another way, where their growth will not need quite so much debt going forward, but clearly that transition is difficult to do and I think one of the great challenges of China and for the world will be to watch how China makes that transition.

We would say that there are indications they understand the issue is, so they are now cutting capacity over their steel industry, their packaging industry, their coal industry. They are cleaning up debt at the local government, so there are things that they are doing, but they need to do a whole lot more – to really sort of alleviate those risks. I think China is centre for us not just for Asia or EM markets, but globally for all of us. It is difficult to quantify because it is such an opaque place. It is very difficult to understand what the seven guys around the table talk about every day.

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First Published on Jun 10, 2016 09:40 am
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