Underweight on IT, banks remain near-term worry: Kotak MF

The earnings season has begun on a disappointing note with two big IT companies delivering lower-than-expected numbers, says Harsha Upadhyaya, CIO-Equity, Kotak Mutual Fund. He is underweight on the sector saying it is unlikely to surpass market in terms of  earnings growth and suggests investors to look at financials instead. Although Upadhyaya sees market consolidating at the current level, he pins his hopes on FY17-18, which he says will be better than FY16. Talking about banks, he says despite macro improvement, one cannot expect significant improvement in asset quality in near term. "Mid-size banks will be more vulnerable to competition than larger banks," Upadhyaya told CNBC-TV18.Below is the verbatim transcript of Harsha Upadhyaya's interview with Latha Venkatesh and Sonia Shenoy on CNBC-TV18.Sonia: The earnings season has not gotten off to a great start with both Infosys and Tata Consultancy Services (TCS) reporting numbers that are not that impressive, what would you do with the IT space first up and between the Infosys and TCS trade, what looks like a better option now? A: Clearly IT results have been much below market expectations. The growth rates that everybody was expecting at the beginning of the year, has not really come through over the course of the year. We have always been saying that rupee depreciation alone cannot drive earnings for IT sector. So, it may remain little defensive in a volatile market.However, from a one to two year perspective it is unlikely to outperform in a big way. That was our view, even few months back and we continue to hold the same view. In many of our portfolios we continue to have underweight position on IT sector because clearly the pressure on a few geographies and a few verticals still continue and pricing pressure also continues in many cases. Latha: What is the view on the market itself, we are getting debilitating global news, have you revised your say 12 month Nifty forward returns? A: Our view was always that second half is going to be better than first half in terms earnings momentum. We believe that September quarter results are unlikely to excite the market. It is going to be more or less similar to June quarter numbers which was just about marginal growth on a year-on-year (Y-o-Y) basis. Similarly, September quarter results will also be lack luster. So, to that extent in the very short-term, we do not see any local factors which can drive the market on the upside. However, in this phase of consolidation it is a very good time for investors to allocate more money into equity because FY17 and FY18 are likely to be much better years as compared to FY16. So, from a one year forward basis we have not downgraded our expectations. However, over the next few months period, markets are going to consolidate at around the current levels. Sonia: I know you don’t want to comment on individual stocks but I just cannot help but ask you about DCB Bank and the kind of fall that we have seen in that stock. My question is a little more broad based, we see some of these banks showing slight chinks of asset quality pressure, not too much, but one or two quarters of disappointing performance. Would you start to get worried or would you look at these as a buying opportunity for the longer term?A: On the asset quality side, clearly there is a differentiation between private sector and public sector banks. Even within private sector banks, the private sector banks which are more inclined towards corporate lending, have larger asset quality issues because the retail side has held up quite safely. So, to that extent that is one of the parameters that we look into whenever we are buying or holding a particular stock. Our view clearly remains that while on the macro side things have started to improve but that has not translated into meaningful reduction in NPA levels in any of the banks. The pressure still continues. We have seen some amount of interest rate cuts and transmission into the system so gradually that should reduce some of the interest burden and hence the cash flow pressures that many of the companies have.Maybe over a period of time gradually we will see some improvement but at this point of time it is very unlikely that you will see significant improvement in asset quality issues anywhere in the banking space. So, accordingly we are not looking at that as a driver for banking stock performance in the near-term.Latha: DCB, your associate company, I know you have Chinese walls bit your associate company Kotak Securities has downgraded to a sell and seen the big problem as it is doubling its branches and therefore the impact on the cost to income ratio as well as return on interest (RoIs). Do you think that this entire small and midcap banks are now a spot of bother because with the advent of payment banks they will have to spend perhaps expand their branches. Is that a sector problem and not just a DCB problem?A: From a long-term perspective maybe they are getting squeezed between the newer banks that are going to come in and also the larger banks which already have a dominant space in the banking sector. So, to that extent, compared to larger banks the mid-size banks will be more vulnerable for any new threat or any new competition that is coming into the sector. It is going to be a very gradual increase in competition; it is going to happen overnight. So, to that extent it is very difficult to generalise and say that all midcap or mid-sized banks will be under pressure. It depends on each of those companies in terms of how they take care of the competition. Sonia: The other pocket that is seeing intense pressure today is some of these auto ancillaries like Bharat Forge and now there are higher concerns about slowdown in orders in some of the export markets that could impact their earnings. How do you approach names like these? A: Yes, those worries have started to gain momentum. Over the past few months we have clearly seen some client specific issues as well as geography specific issues in terms of growth that was largely dependent on Europe or few of the clients is under pressure today. So, to that extent you have to be cautious on this space and any incremental purchase in this space has to be looked at carefully both in terms of growth prospects as well as the valuation because this is one space which had done very well over the last one to three years time period. So, to that extent the valuations are not very attractive even after the fall. So, you need to be little more careful in selecting the companies in this space. Latha: Post the TCS numbers are you generally changing the mix in your funds, will you be weighting down on IT as a sector?A: As I mentioned, we have been running underweight on IT sector in many of our portfolios. So, in this earnings season we have not seen anything that would change our positioning. So, we continue to remain circumspect in terms of the future growth of IT sector. While it will grow at decent pace, it is very unlikely that it will outperform the market in terms of earnings growth momentum going forward as we expect some amount of gradual cyclical recovery. So, it is better to be in domestic cyclicals which are very good in terms of financial strength. I think that space will give you better returns than IT over the next one to two year period. Latha: In the run up to the Q2 numbers announcements what sectors should one go overweight on? A: The disparity between many of the stocks within the sector itself is increasing. I can give you enough examples where two stocks in the same sector have performed very divergently and that would also depend on which kind of geography they are approaching, which kind of business they are approaching. So, while overall we seem to be overweight on pro-cyclicals with better balance sheet strength but within that space again, you will have to differentiate between various companies depending on the business prospects and valuation. So, to that extent we are not looking at adding or reducing positions in a big way during this earnings season. It is better to wait for the clarity and if there is too much volatility around the result season on the announcement dates, if it presents a good opportunity maybe we will look at some of those stocks if we like them. However, at this point of time we are not really trying to change our portfolio position.