Earnings key, don't see much improvement in Q3: HSBC Global

Below is the verbatim transcript of Tushar Pradhan's interview with Latha Venkatesh and Sonia Shenoy on CNBC-TV18.

Latha: You just heard what the Power Grid management was telling us. What is the sense that you are getting with capital expenditure (Capex) generally? This seems to be the only company which is talking about Capex. Everybody else is talking about emaciated order books. Are you getting a sense that the earnings growth that we have been waiting for is going to get postponed?

A: I think it depends on which kind of term that you are looking for where it will get postponed for. Clearly, the expectation that we had for FY16 is not likely to be fulfilled. So, it is going to be a picture which will emerge only in FY17 in terms of what it is likely to be. One dose of reality I would like to add is that when you talk about Capex. The Capex turning into earnings growth for companies comes with substantial lag. So, you mentioned about the capitalisation rate, so it depends on the capitalisation itself for the company who is doing the Capex.

And even for companies which are providing the equipment for this Capex, for them as well, it comes with a lag in terms of when it will end up in their earnings. So, even if the Capex does start and that is where the debate is that when will it start and even if it does start, the reflection of the same in the earnings is going to be so many quarters later. So, I think the whole picture looks to be that we are all in a wait and watch pose.

Latha: I admit my argument was weakly connected. But, basically, this earnings season as well, we understand two thirds of the companies have lagged earnings estimates. We will probably have more downgrades than upgrades, you think at the end of this season? Will the third quarter at least be different?

A: I cannot see why the third quarter will be any different because the pick-up, as I said, even if it starts in the second quarter, because, what we are seeing in the second quarter is just a little bit of a dip compared to expectations. But if any activity begins in the third quarter as we go into it. Then the reflection is yet to come probably by the fourth quarter of this year and maybe the first quarter next year. So, again, ending December, I still do not see any change from what we have seen in the second quarter so far.

Sonia: We are seeing some amount of momentum flag off or rather lag in the market. The nifty for the last five to six days has been under quite a bit of pressure. What is the sense you are getting about the later half of the year? Do you think we are in for some amount of underperformance compared to our global peers?

A: No, I think in the long run, the markets really are a slave to earnings and we can debate whether an event is going to make the market go up or sustain it or bring it down for the interim. But why the markets have sustained over so long in India have just been the story of very strong earnings momentum which we are not seeing in the past couple of years which is FY15 as well as now going into FY16. We are seeing that kind of momentum really wear off.

So it is giving rise to these conclusions that the markets are expensive, so and so forth. But let me just reiterate that earnings eventually is where the market will sustain its level. So, if the earnings growth is going to come in with a lag, even if it does come with a lag, the markets will sustain simply for the fact that the earnings per share (EPS) numbers will get posted up higher. So, unless we have a real debate whether the earnings are actually going to go up or not – which I do not think the debate is on really – it is just a matter of time.

So, if I take the rest half of this year, and to answer your question what it will look like, in the interim, all the events will drive where the markets will go. Again, the debate about elections, whether that will really be an indicator, whether the reforms will be accelerated or not, whether the US hikes interest rates, whether domestically, interest rates start to come off, there are a whole host of reasons where the market will go in the interim.

So, if I were to predict the market for the next half, I would not.

Latha: You said that the third quarter will not be that earnings generating quarter, will it be fourth? What is your best guess now?

A: I think, again, I would just try to temper my comments to the fact that the economy as a while whole is not really homogenous. You mentioned the kind of Capex the Power Grid was talking about. I would iterate again that if you look at pockets of the economy, you take infrastructure for example, in roads and in some parts of rail as well as ports, I clearly see a lot of Capex coming in. And that is going to feed into some of the earnings that will actually eventually come up in some of the companies which are listed on the exchanges.

So, I think if on an average, on were to take, I would not really be very far away from where the estimates are now coming to. I do not think there will be significant downgrades from here, but the number that we had in the beginning of the financial year, that will be at a substantial discount what will eventually come. I have seen some of the analysts now cover their numbers to a certain extent which are a lot more realistic than what they were maybe in February, this year. But as we go into November and December, the numbers which will come in after the second quarter numbers, the analyst numbers will more or less remain the same by the end of the fourth quarter, I do not think that to be changing too much.

Sonia: I was going through some of the holdings in your funds and one of your top holdings in the HSBC equity fund is Tata Motors. That is actually the biggest Nifty gainer today on the back of a second successive month of good Jaguar Land Rover (JLR) in the US region. Is this stock still giving you high risk reward, or do you think that a lot of the good news is now already into the price?

A: The way we look at stocks, generally is about sustainable profitability versus valuation. So, if you take any parameter you take a return on equity (ROE) for example as a parameter for judging profitability, we have seen Tata Motors be one of the highest generators of ROE for a long time. And if you look at valuations again, if you take a parameter like price to book for example, that also indicates that it is a lot cheaper than most of the other companies in that area. And if you look at the trends, one of the things that come very clearly is that luxury items whether the economy is up, whether it is down, it generally tends to sustain no matter what happens and Tata Motors, now driven largely by JLR sales, that is catching the trend in terms of having a very sustainable future for it as long as the model is demand, as long as the brand is considered to be luxury.

So, this is the trend that we see in this company longer term and of course, there are cyclical events that we need to be ready for. But we still feel pretty comfortable about the luxury space in general. I would not really want to make any comments specifically for Tata Motors, but the point is that our view in about what will sustain profitability is more important for us that what happens to any company at any point of time. So, just to give you a little bit of a long-winded answer to your question, we look at sustainable profitability available at reasonable valuations and that still fits the bill.

Latha: Finally, what is your view on banks? We have seen two rating agencies saying that the worst in terms of asset quality is known and there will not be incremental bad news. Does that make you a buyer there, especially of public sector banks?

A: I will make a distinction between what the asset quality is all about. So, I think we have come a long way from the 1980’s and the 1990’s where the assets were suspect. So, for example, when you were an asset quality problem with banks, the issue was whether you have collateral. And most of the time, it was fraudulent, most of the time, the assets were just not there. But, today, if you look at the known asset problem, you realise that the assets very much are on a ground. They have either an issue of a start-up issue or they have a regulatory issue or they have an arbitration issue. But the asset is there and it can be valued at any point of time for somebody else to buy it at any point of time. So, the banking industry from that point of view, I do not see that much of a risk to it as long as they are able to do some merger and acquisitions (M&A), they are able to do some movement of assets into better hands.

And if you look at the interest globally, there is tremendous interest still in India. And whether it is a listed market or whether it is an FDI, there is enough capital to go around in the world to kind of look at these assets ion a fresh perspective and that is somewhere where I think the banks will find some relief. So, financial is a very large part of the market. We definitely look at it positively.