Underweight on IT sector because of exposure to Europe, US: Aniruddha Sarkar of Quest Investment

Aniruddha Sarkar of Quest Investment Advisors

The Information Technology (IT) sector’s exposure to Europe and the US, which are confronting recession fears, makes Aniruddha Sarkar, Chief Investment Officer and Portfolio Manager at Quest Investment Advisor, underweight on the industry. Although valuations in the space seem attractive, it’s not the time to take large position on IT stocks.

The portfolio manager is bullish on the industrial space, including capital goods and defensive stocks along with the auto space. He believes investors need to look not just at the valuations, but also the earnings upside.

Overall, Sarkar is underweight on IT, pharma, chemicals and metals. He remains overweight on industrials including capital goods, defense, the energy and auto sectors.

The money manager also distinguished between the balance sheets of banks in India and the US, where the failure of Silicon Valley Bank (SVB) has set off a bout of turmoil.

“In the Indian banking system, almost 60 percent of the deposits are from households. Unlike that, when we see the case of SVB, practically 100 percent of the deposits were from corporates or rather the startups over there,” Sarkar told Moneycontrol. Edited excerpts:

Do you think SVB’s collapse and the US banking crisis has any bearing on Indian equity markets? Public sector bank stocks were among the worst performers on Monday. Do you think the drubbing was justified?

In the market, something which really works is investor sentiment, which comes first, and only after the initial reaction, which comes from sentiment, do you get to see the real logic or fundamentals coming into the picture. Now, if you see what happened in the SVB case, it was not something wherein the bank went overboard in lending and there was a big hole in the balance sheet. It was basically a basic error on the part of the management to match the assets and the liabilities, the ALM mismatch. And that is something which I would say is not a very, very fundamental reason for the whole banking system, even in the US, to fall. This is something which can be addressed by the US Fed easily.

And the good part of that is that this would actually make the US Fed think now before doing any subsequent rate hikes…On its impact on the Indian banking system, I would say we are much, much better off. I think we are in a much, much better shape compared to any of these banks in the US. Our balance sheets, if they are tested even now, that there is no concern with regard to any of the factors that are there in US banks. The interesting data point, if I have to highlight it, in the Indian banking system, almost 60 percent of the deposits are from the households. Unlike that, when we see the case of SVB, practically 100 percent of the deposits were from the corporates or rather the startups over there. So that is something which gives you a decent comfort that the balance sheets in the Indian banking system are much more secure because of the household deposits being there.

A report from Nomura suggests a Reserve Bank of India (RBI) policy pause in April in contrast to the expectation of a 25 basis point hike (100 basis points = one percentage point). How do you read this and do you expect financials to recover or bounce back?. Do you think they are well insulated? How are the valuations stacking up for you overall?

After this event of the last week, as I mentioned, people are now asking the rationale for the continuous hikes in interest rates, because the whole idea of hiking interest rates was to bring down inflation. Now if you look at the inflation rates, I think we are way, way above the comfort zone even now. Like yesterday, the inflation data shows again we are at 6.4 percent. And if I look at the whole, this entire quarter, I think we will be sitting north of 6 percent. And something similar continues in the US market also. So, I would say I'm in that camp where I think the central banks will take a pause. If not a pause, the hikes will be much smaller than what was earlier envisaged. Another interesting thing, which is now gradually building up, I would say the thought processes is that RBI needs to gradually move away from following the Fed because I think the Fed has its own problems. They inflated their balance sheets, pumped in too much of the liquidity during the pandemic and that is something which RBI has not done. So I would say we need to take a look at how we need to react to what macros we are exposed to. And that is where my belief is that in the MPC (Monetary Policy Committee) meeting, I think we might take a pause on the rate hikes because growth is equally important for us.

DIIs (Domestic Institutional Investors) have been giving that required amount of support to the markets while FIIs (Foreign Institutional Investors) have been sellers. Where are the markets headed with geopolitical concerns, higher inflationary scenario and anaemic growth?. What do you make of it? How do you expect the FII trends to kind of behave going forward?

See, I think if you look at the flows of the money from both domestic and FIIs, very few people actually are aware that since the subprime crisis of 2007-2008, FIIs have been net sellers in Indian markets, whereas DIIs have been the net buyers to the tune of almost four times the selling figure of the FIIs. Now where we were in 2008, from the lows of say 2,700, 2,800, we are at 17,000, 18,000 on the Nifty. So that shows that in spite of a massive outflow of FII money over the last 14-15 years, Indian markets have remained very, very strong. The good part is that domestic participation in Indian equities has gone up exponentially. And that is something which I would say is a very good kind of long-term trend for the markets because domestic money is not something which is hot money. It doesn't have much alternatives to deploy in different countries. FII money has alternatives. They can deploy in the US, other emerging markets, the Europe, XYZ.

And that is the reason, if the domestic participation is going up via the mutual funds, direct equity, BMSS, AIS, I would say that's a very healthy sign. Even our Employees Provident Fund allocation towards equities has also gone up substantially in the last so many years. I think these are all the long-term money, which I would say is going to give a lot of economic, as well as the markets comfort in the long run. Having said that, yes, in the short run any sharp negative news in the US market will definitely impact FII outflows. And if I look at this year itself, calendar year, FIIs have taken out roughly around $2.6 billion and we are practically around the same level where we were in the beginning of the year. So we were at around 17,600 to 17,700. We are at roughly 400 points below that. So I would say FII money in the short run can outflow because of the panic which we're seeing there. But yes, with any sign of the US rates peaking out, I think that would give a very positive sign to emerging market equities.

The consensus expectation is that Fed might just slow down rate hikes given the kind of crisis that the US banking sector is facing right now. How do the valuations look right now in terms of the overall emerging market basket scenario?

See, addressing this point, firstly, I'll mention about the US Fed. I think practically no one has any idea where the Fed is going to head. And when I say no one has an idea, I would say even the US Fed has no idea where they are heading. If you look at the fund managers poll, the bankers poll, which typically gives you an indication where the expectation is, just a week back, almost 75 percent to 80 percent of the people were of the view that there will be 50 bps hike in the FOMC (Federal Open Market Committee) meeting, which is scheduled at the end of this month. As of yesterday that 75 percent-80 percent has gone up to almost like a 90 percent to 95 percent believing that not more than 25 bps hike will happen. So that shows, within a week, the outlook has changed completely.

Having said that, as you rightly mentioned, and what I just mentioned is that in case there are any signs of peaking out of the interest rates in the US, I think FII money definitely is going to start flowing back into emerging markets because I think that is something which had initially kind of been the major trigger for the outflow of money from the emerging markets including India. On the valuation front, that is where the big comfort lies. In fact, we have been telling investors that don't look at the noise which is around, as of now, because I think what has happened is for most part of say 2020, 2021 and say the most part of 2022, Indian markets have outperformed all other emerging markets in the global markets. Last four months to six months, India has kind of underperformed, MSCI underperformed, many other emerging markets. Now what has happened is during this period, earnings have grown. Markets have underperformed, price corrections have happened, and that has brought valuation to a comfortable level.

Which are the space where investors can probably hide in? Do you think that could be IT? Do you think that could be something like in hotel stocks? Which are the pockets now you see the traction in technically?

See, IT, I will say it's too early to enter that, and it looks attractive on the valuation front, but I would say it is too early to build a large positions there. I would remain underweight on IT for the very fact that it has the bulk of its business coming from the Europe and US, and if those markets are not in a good shape, I think we need to wait for IT exposure (to lessen). I would say the good valuation pieces would be industrials, which includes your capital goods, energy stocks, defense stocks, autos. These are the areas where I would say one needs to look not just at the valuations, but also at the earnings upside. These are the pockets where the next 12 months, 18 months definitely we are seeing a lot of earnings upgrades happening. If you look at the order books, if you look at the executions, I think they are at all-time highs. I would be underweight on IT, underweight on pharma, underweight on the chemicals, underweight on the metals, overweight on industrials including capital goods, defence, overweight on energy, overweight on autos.