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Go with a largecap bias but keep return expectations low

Blog Blog Details
  • June 29, 2018
  • Mr. Gautam Sinha Roy|
  • Fund Manager, MF
Do you think one of the reasons the midcaps stocks have fallen is because of reclassification by Sebi? Is that one-time adjustment behind us or is that an on-going process and will linger for another quarter or so?

Most of the adjustment is done but meanwhile the sentiment for midcaps have turned negative. We are seeing that in deal flows too. Earlier, whenever there was a midcap IPO coming, everybody would be very excited. Now no one wants to look at it, some time the same names too. Of course, valuations expectations are also very high. What I have been maintaining since beginning of the year is that midcap valuations are too high to be sustained. 

Nifty 500 trailing PE was plus 2 standard deviation when we started this year. There is no way that could be sustained. So, there are reasons for the decline. Obviously, reclassification was a major cause but it had a like a domino effect. It created some sentimental negative which created more downsides. That’s how it happened. 

If you were caught at the wrong foot with a lot of midcaps, that would be a really sorry state but we need to have been prepared at the beginning of the year. It was expected. The caveat here is the kind of incidents with auditors resigning and questions on the corporate governance issues on stocks which seemed to be nice till a couple of months back. That created another level of fear. So, there is an environment of fear in the midcap side. Whether it will go away in a quarter or lingers for a while is difficult to say. We will have to wait and see. Meanwhile, a largecap bias and lowered expectations in terms of future returns is the way to approach this market. 

You are not buying the midcaps on decline yet, are you? 

Selectively. We have the buying prices set in our mind in stocks where we see the prospective returns to be interesting enough. That is how we will approach markets and would be pretty much midcap or largecap agnostic. But it is foolhardy to be sitting with very expensive midcaps with earnings growth prospects not being very good. Unfortunately, what happens with midcaps is that when things turn, liquidity disappears very fast. The exit is not that easy but yes we will be buyers at certain point of time. That is something we look forward to from a long-term perspective. 

Where do you find value right now?

Unfortunately for me, the answer has remained the same for quite some time. It remains retail financials, retail banks. In corporate banks, there is tactically one name now but it is becoming interesting. Hopefully, most of the NPA resolutions will be done in another year, year-and-a-half and I am being optimistic here. 

Once that is done, corporate banks will get a lease of life. But, meanwhile, I am sticking with high quality retail banks where earnings growth visibility continues to be very strong. I am also incrementally liking the insurance space -- life as well as general insurance. A bit of time correction as well as a price correction have happened in this space. These are high growth franchises. The penetration level of insurance in India - both general and life protection -- remains low. Life insurance companies in India also have the asset management angle and that is also an interesting story. 

IT is one space that I have been adding aggressively this year. There are three reasons for that. a) Valuations are attractive. We were uncertain about growth prospects earlier as we had seen growth bottoming out. b) US dollar revenue growth and improvement from there also helps; and c) The largecap IT guys are indulging in some very healthy capital return programmes. For these three reasons we are incrementally liking IT. 

There is now a new school of thought that there is a bottoming out in US generics pharma on the pricing front. However, pricing pressure is easing and new launches continue as the USFDA has eased rules for new launches. So, that is another space to watch out for but we have been mostly adding IT stocks. 

Since you have highlighted IT as well as pharma, what is driving your conviction there? If you were to raise an allocation bias, how much would be given to both these sectors which till about two years back had a major overweight in most mutual funds?

Yes, from being overweight a couple of years ago, they had fallen drastically for us. US generics and large IT had fallen to zero at one point of time a year back. We are still not into US generics, but in IT, we have seen that the digital aspect of the business or the new business as Mr Sikka used to call it, is growing at a pretty robust pace of 25-30%. 

Other than specific areas like large US banks, we do not see growth to be very high. What we need for these companies to get back to double-digit dollar growth at the company level is essentially to ensure that the one part which is not growing to come back to growth mode. 

And for that the prospects are good. There are two reasons: one, investment in IT has lagged requirements for a very long period of time and; two, tax cuts by Trump has given these companiessome additional muscle to invest in technology. 

Digital as a technology cycle has started evolving enough to give room for play for Indian IT companies which typically tend to be laggards in any technology cycle. Once the industrialisation of their technology cycle happens, they tend to be overwhelming beneficiaries. From that perspective, growth looks interesting. Earlier also, we were worried about the margin front where they have done a fairly decent job. 

The largecap IT companies are defending their margins in the mid 20s and from here with the additional advantage of a depreciated rupee plus their own margin levers because of scale coming in on the digital side, they should be able to hold on to margins. 

But beyond that, valuations and capital return programmes make the bull case even more stronger. We have seen that start with Cognizant after that letter came in from one of their investors that they could return capital. They did that in a very healthy way which resulted in a very good shareholder returns from that period for Cognizant. 

Now we are seeing large IT companies in India embarking on a similar capital return programme. That makes us quite excited about IT. 

The other theme that I want to discuss with you is the financials. How do you look for value within the financial space? Where is the value play, the alpha generating opportunity within financials? 

It is very difficult to take a positive call on PSU banks even now. Corporate banks like ICICI and Axis are a matter of debate. While the worst of NPA formation is over, maybe that provisioning cycle still extends for a while and in terms of ROEs, returning to normative levels will take time. 

It is an area which should be watched but we should not get too excited about it. Now, the hypothesis that is playing in our mind and which seems to be happening also is that the market share shift for the retail oriented private banks is accelerating and we have seen the credit growth cycle also increasing. We have seen that bond yields have moved up. The credit market is again shifting back from the bond market to banks. 

In this environment banks are obviously in a higher yield environment. Their CASA advantage tends to kick in very aggressively, helping them to capture market share on the lending side. Good and clean banks without NPA issues are actually very well placed to grow very handsomely and that is what we are betting on. 

Valuations are not cheap but they are not very expensive either from either a historical perspective for these banks or from the fact that growth is going to be high, ROAs and ROEs are also pretty decent. 

So, there’s still opportunity there. Similarly, the longevity of growth and the quality of the franchises, the buildup of protection businesses are much higher. In insurance, valuations are not rich across the board. Specific stocks are very expensive but there are stocks which are not so expensive too and you can be selective there. 

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