Had the government tried to price some of these PSU stocks expensively, there may have been a much lower appetite from investors
As the stock market indices touch new highs, Taher Badshah, CIO (Equities) at Invesco Mutual Fund, talks about the reasons for and the sustainability of this rally. He is positive about many public sector undertakings and gives his take on how the government is pricing IPOs. He finds value in select mid- and small-caps. He goes on to suggest that it is too early in India’s cycle to go for passive investing. Excerpts from his conversation with Moneycontrol’s Venkatasubramanian:
Q: We are in a strange situation where economic indicators (GDP growth, IIP, auto sales etc.) are weak, even as markets touch new highs. What do you think is fuelling this rally, given that corporate earnings too haven’t fired?
A: In a sense, this slowdown does have a global context. But I agree with you that economic indicators and growth numbers have disappointed. The slowdown is evident across segments. Market expectations on growth have been quite poor for the past few months.
However, the corporate earnings numbers have been a little better than expected. For example, the recent quarter’s numbers for autos and corporate banks were better than what the Street was hoping for. Operating and pre-tax profits, margins have come in reasonably better than expectations. The commentary from the managements too was positive.
The reduction in retail inventory has also been viewed positively, indicating a revival in demand.
Ultimately, market movements aren’t just about discounting the future. They are also about expectations versus reality. The expectations on growth were really low and manifested in the period between July and September. Across large, mid- and small-caps there was weakness.
I agree that some of the high frequency indicators (IIP, monthly auto sales figures etc.) are weak. I will not debunk those numbers. But given the limitations that these data series have, I believe that the best proxy to judge the economic trend is corporate earnings. The top-line figures, margins etc. give a better picture on the trend.
There have also been some actions from the government’s side, which was missing earlier, in the form of corporate tax cuts. While I wouldn’t say those are big-ticket reforms, but these are good signals for the market and the economy as a whole.
Some of these measures are qualitative and you may not be able to immediately ascribe a number to them, except for the corporate tax cuts move, which the markets immediately responded to with an assessment of the potential tax saving.
The move to help the housing sector, consolidation of public sector banks and easing of input tax credit norms too helped, apart from of course removing the enhanced surcharge on FPIs (foreign portfolio investors).
In the near term, the liquidity situation too has improved globally. Emerging markets in general will benefit out of that. Even the US Federal Reserve has changed its rate stance.
So, this liquidity fuelled rally is likely to continue. In the next two to three quarters, we expect the government’s measures, the low base effect, improved liquidity in the domestic system, better transmission of interest rates etc. to boost economic growth. It is like a relay race and after three quarters, corporate earnings will take over from there.
Q: Given the possibility of increased profits due to the recent corporate tax cuts, is there scope for a re-rating in the market, or do you feel that this aspect has already been discounted?
A: The tax cuts have obviously boosted the PAT (profit after tax) numbers. The market has factored in the additional five percent boost to profits on an average. The markets were beaten down and hence rallied in order to adjust to potentially higher profits for corporates. We were already trading at high PE (price earnings) multiples, so I wouldn’t say there is a case for re-rating as much as the market adjusting to higher earnings resulting from the corporate tax cut. But markets viewed the tax cuts as a sustainable factor for the long term as well.
Q: From January 2018, we find that most rallies are led narrowly by just a few stocks. In the process, many of these stocks have turned expensive as investors seem to prefer certainty in earnings. But are we overpaying for quality and when will there be broad-based rallies?
A: A wider market participation will happen only when there is a more broad-based growth in the economy. There are pockets where valuations are stretched. Some of the stocks trade at valuations higher than their own long-term average. It is happening more in the large-cap space, but I wouldn’t say it is not happening in the mid-cap segment.
But there are large-caps that still have value – for example, a very large incumbent telecom player, a leading cigarette company etc.
Though mid- and small-caps haven’t rallied as much as large-caps, in the last few months, the gap has narrowed somewhat. Earlier, the differential used to be 8-10 percentage points. But if you zoom in on the trends over the past couple of months, you will notice that the trends have converged somewhat.
Nowadays, there are quite a few mid-cap stocks that go up 10-20 per cent in a single day. That was not the case three months ago. That is not to say that all mid-caps are flying. But every day, there are at least a few stocks that are rallying significantly in the space, which wasn’t happening earlier. The trend will become more pronounced once the economic cycle makes a comeback.
Those mid-caps that have delivered and have managed to grow by maintaining a stable balance sheet, have been rewarded.
Q: Many analysts and fund managers are of the opinion that there is value in mid- and small-caps. But given the weak fundamentals and debt burden, is there a possibility of getting into a value trap?
A: We don’t see broad sector trends as such in mid- and small-caps. When we look at individual companies in the space, we do find opportunities. We find them in industrials, utilities, consumer goods and select PSUs (public sector undertakings). There are also some commodity companies that we bought into. Of course, we have to be careful about value traps in any market, more so in the present times when there is a disruption of businesses in different forms.
There are now a few additional layers of diligence that we are doing, and which is taking a significant amount of our time. One is how much terminal value the market is ascribing to the company, because we can’t be sure if a company would exit 10 years from now or would be replaced by a different entity.
The other aspect on which we are keeping a careful eye on is balance sheet. We do not want growth that comes at the cost of the balance sheet. Also, we check if there is indirect risk arising out of promoter leverage.
We have seen that happening with a leading entertainment company and more recently with an IPO candidate and the stocks were battered.
Then there are regulatory risks also that we take into consideration. So, these are the additional checkpoints we have so that we don’t fall into a value trap.
Q: You mentioned PSUs. How does the space look? There was recently a ticketing platform that came with its IPO and had a bumper listing. Is the government being too conservative with valuations while carrying out disinvestments and stake sales?
A: We feel that this is an opportune time for people to look at PSU stocks. There are pockets of value that have emerged. There is likely to be a further up-move in these stocks, given that the government has indicated its road-map for disinvestment across sectors. It is obviously happening due to the compulsions on the government’s budget and the fiscal situation.
There have been many instances of disinvestment/strategic sales where considerable value has been created, which will have a positive rub-off effect on PSU stocks as a whole for the future. The better-quality companies would then be able to command higher valuations.
Had the government tried to price some of these stocks expensively, there may have been a much lower appetite from investors for these companies and the stocks wouldn’t have done so well in the markets.
Q: Given that most economists and experts have said that the current slowdown is due to poor demand, do you think that personal income tax cut is the way forward? Is there fiscal space for it?
A: As a country, we have been at a higher rate of taxation compared to global averages. Not just corporate tax, even capital markets related taxes and income tax rates are high. Not just this government, but others in the past have looked at taxes to enhance their tax revenues. Lower tax rates could also lead to enhanced tax revenues for the government.
With the corporate tax cut, the mind-set of the government has changed. I think they will go ahead and cut personal taxes as well. But they may time it in order to satisfy two things. One is the government would be looking into the recommendations of the direct tax code. Two, they may want to time it so that the fiscal deficit is not hurt as they wouldn’t want to give too much away in the same year.
Q: Given that large-cap funds have struggled to even match benchmarks in the last few years, is passive investing, especially in the large-cap space, likely to gain traction?
A: Passive investing is a nice tool to have in terms of building your overall portfolio. But I do not think that it will be a dominant trend. We are still a country that has high potential to generate alpha. These discussions do come up when growth cycles weaken. But as a country, we are still very much in the growth stage and therefore it would be too early to talk about passive investing.
I was speaking to my Asian counterparts and even in a mature economy such as Japan, they are able to generate reasonable alpha.
Q: Do you think the Supreme Court’s verdict in resolving the Essar Steel bankruptcy case would set a good precedent for many other cases stuck in the tribunals and can banks and financial institutions now look forward to some write-backs and recoveries?
A: The Supreme Court’s decision to distinguish between operational and financial creditors is welcome. It will definitely mean more write-backs for lenders. That would mean more earnings for these banks. In the next couple of years, especially in FY20, 75 per cent of the incremental earnings is going to be driven by corporate banks, helped by these write-backs.This will make process of debt recovery and the unwinding of the whole NPA (non-performing assets) move faster.Not sure which mutual funds to buy? Download moneycontrol transact app to get personalised investment recommendations.