What do you tell your customers – keep or go greedy?
It’s more like “keep”. We believe that the risk reward for India is still not attractive enough. Various things are happening; first and foremost, we have valuations that are unfortunately not in favor of India. Just to give you some numbers; the Nifty, based on estimates by our Kotak research team, is currently trading is still trading at around 19x year-on-year and around 17x FY24 earnings and relative to the MSCI EM, the stock market index emerging markets, we are still at a 70% premium to other emerging markets.
Historically, the average for the past 10 years has been around 40%. So from a valuation perspective, India is still not cheap in the eyes of most global investors and on top of that, layering the fact that we are still in a rate environment rising interest rates, interest rate hikes could potentially turn out to be much worse than what the market is pricing in. It’s like a cap on valuations.
It also acts as a drag on the markets despite earnings growth. We could end up seeing more earnings downgrades as the global economy potentially slows. In Europe, we have already seen downward revisions to GDP growth estimates. Similarly, in the US and Indian environment, it is difficult to see how valuation multiples can become more attractive. We are unlikely to see revenue increases.
In this context, it is difficult to be too optimistic at this stage. The risks are more on the downside in the short term. India’s long-term structural history remains intact. The investment cycle will probably kick off in earnest in the next six to twelve months. The banks have cleaned up, the macroeconomic framework is much better now compared to, say, 2013 when we had the last forex crisis. So overall the longer-term story is still good, but in terms of absolute valuation and relative valuations, we’re not there yet.
So what to do, sit down?
It depends on each investor’s investment time horizon and ability to weather any short-term market downturns. Foreign sales are expected to continue. As for our Indian market, it was a huge outperformer, helped in part by strong local flows, but bear in mind that we also have rising interest rates in the domestic market. So over the next three to six months, they might start making term deposit products a little more attractive.
Unfortunately, the market has not generated positive returns and, on the contrary, has generated negative returns over the past six months. Nifty is down around 12-13% in the past six months and because of that, retail flows to stocks could potentially slow down in the coming months and there’s not much of a buffer against overseas sales almost incessant happening.
In this context, capital preservation is more important at this time. We will likely have better opportunities and keep in mind that the only risk of this view is frankly more global in the sense that either oil prices fall very sharply as the global economy slows down or there is some resolution or clarity on the geopolitical risk there. , which impacts all sorts of commodity prices and overall risk appetite. But none of those look like likely outcomes right now.
Therefore, be defensive, hold your money for now, and wait for better entry points.
When we say defensive, we traditionally think of IT and pharmaceuticals. Has IT corrected enough for a new entry and can the pharmaceutical industry really replicate the glory days of 2020?
For IT, there is a risk that if the US economy and even Europe experience a slowdown, it will impact discretionary IT spending. This is why in IT too, we must differentiate ourselves. In midcap IT, valuations have really stretched. Some of the stocks had risen 35 to 40 times PE. You have to be very careful. We would be very cautious in midcap IT.
The valuations of large cap IT stocks have not been as wide and they have also corrected quite a bit over the last two months and more importantly they are much more resilient, customer concentration risk is not so high, earnings visibility is much better, resilience is much better, and valuations, more importantly, are much more acceptable.
Also keep in mind that if things go wrong we will usually tend to see the rupee weaken a bit as this will help to offset some of the potential drop in income or prices. So we’re still fine with large-cap computing, it’s mid-cap computing that we would pay attention to.
As for pharma, we are unlikely to see a repeat of 2020, but in this type of uncertain and potentially volatile global macro environment, pharma is a relatively safer defensive bet. But again, you also have to be a bit more selective and focus on companies that have relatively higher Indian operations, where the exposure to generics isn’t that high but where the valuations in the pharma industry are are deteriorated. In the short term, the pharmaceutical sector is not going to perform very well in absolute terms, but on a relative basis, it should do quite well.
What are some of your top underweight positions and where are you leaning from, if you haven’t already?
Our main underweight would be consumer discretionary. The view is that in both cases we will see a slowdown in the global economy and the domestic economy as rates rise. In the case of India, just as we were coming out of Covid and the reopening of trade was continuing, we were hit with a huge spike in commodity prices, oil prices and potentially we’re also looking at a downturn exports, which is beginning to recover.
So consumer discretionary and that means things like the passenger vehicle segment, even the short-term utility vehicle segment, consumer durables, air conditioning and white goods, and so on. would be a segment where, with the slowing economy, the first impact will be felt. So that’s an area we would watch out for and the valuation multiples of some of these stocks are also quite high despite the correction of the last few months. Durable consumer goods would therefore be one of the main ones.
In other sectors like metals, valuations have deteriorated, but there is still potentially more downside to global commodity prices, especially metal prices, as the global economy slows. So while valuations have turned attractive, we think there is still a lot more downside risk to earnings there. So even in metals we would be a bit cautious.
Other sectors I would be cautious about would be mid-cap IT companies, where valuations were quite stretched, as well as some mid-cap chemical stocks. These are all export-oriented parts. Valuations have extended considerably during the bull run we saw in these sectors last year and we could see a pretty big correction as the global economy slows as Fed rate hikes kick in and valuation multiples compress.
In February you talked about how one of the big disruptors would be the cement pack because of ESG. It happened. We also saw the big glitch that happened. What could be the other disruptors?
The cement was more in a longer term perspective of more than five, seven years. This trend is still very present. We have to watch and there is obviously a big disruption in the form of a new entrant and a change in ownership there. But the other upheaval remains the automobile sector. The EV risk is very present and it remains to be seen whether the incumbent automotive players, whether in two-wheelers or the passenger car segment, will be able to deal with the threat.
Our view is that people in the two-wheeler segment are probably better prepared, but that can be very disruptive. Existing ICE engines are quite profitable products for these companies and this is one.
Second, we could see disruptions in the financial space as fintechs emerge. While fintech valuations have corrected very sharply, banks and financial institutions that are not investing in technology or acting together in terms of DNA, product mindset and integration with their basic banking capabilities, could be left behind.
So there are the usual things there and obviously the oil and gas, the energy space is seeing disruption from solar and the shift from fossil fuels to green energy. These are other areas to watch. Thus, the risk of disruption is always present. Nothing has really changed. It’s just that the time frame is somewhat long, but the markets tend to be quite efficient and they will price in the risk of disruption long before the time when the disruption starts to become more evident in the earnings numbers.
What are you overweight on? You were optimistic about banks and everyone was waiting for banks to take a big step forward, especially private banks.
We still like the banking segment. The big change this time around, compared to past cycles or past global downturns, is that our banking sector has already been through quite a rough time during Covid. Thus, the NPL books have been cleaned up. We expect credit costs to come down quite sharply and even in a rising interest rate environment, even if deposit rates go up, we don’t think it will be as much of a problem for the big private banks that have very high liabilities, deposit deductibles and loan repricing will help offset some of the net pressure on interest margin that we will see.
Loan growth is where there might be some disappointment as the economy slows, but overall bank valuations are actually quite attractive, so in the medium term, long term as well as short term, the banks seem relatively well.