Economy

Risks outweigh rewards in the Indian context, says Prashant Kothari

Updated : May 31, 2018 08:49 AM IST

Risks outweigh the rewards in the short term, said Prashant Kothari of Pictet Asset Management, speaking about the Indian economy and equity markets.

Speaking on markets he said, "The recent scare was mostly because of the macro issues and also bit of the politics where BJP kind of lost some by-elections and then there was scare that maybe Narendra Modi is not really coming back next year and then we had the bond yields going up which led to a market correction."

"Surprisingly the bond yields went down but have come back up again. Rupee has actually depreciated and you are seeing foreign exchange outflows happening now, he added."

Speaking about the political situation, he said, "I don't think anything has changed in terms of the certainty or the uncertainty of it but the markets have really come back up. So, very short term view would be that the risk reward is not really in our favour, so we would rather be cautious, we would rather be defensive in our portfolios today."

Watch Here: London Eye: Risk reward not favourable for India in the short term, says Prashant Kothari

Edited Excerpt:

Q: How do you see the market now? We had a bit of a scare in the middle of the year and we have almost come back to that 11000 mark on the Nifty again. Do you find the market expensive now or do you see the risk reward evenly balanced?

A: The scare was mostly because of the macro issues and also bit of the politics where BJP kind of lost some by-elections and then there was scare that maybe Narendra Modi is not really coming back next year and then we had the bond yields going up which led to a market correction. Surprisingly the bond yields went down but have come back up again.

Rupee has actually depreciated and you are seeing forex outflows happening now. Political situation – I don’t think anything has changed in terms of the certainty or the uncertainty of it but the markets have really come back up. So, very short term view would be that the risk reward is not really in our favour, so we would rather be cautious, we would rather be defensive in our portfolios today.

Q: Why do you think the market has recouped all its losses because as you said some of those factors which triggered the correction in the first place, have actually not reversed for the better but the market has come back almost 8-9 percent from its lows, how would you explain that?

A: Some of the businesses actually gain because of the currency depreciation. So, you have seen IT stocks coming back up which has led to some momentum in the market.

Also all the other commodity stocks, just because of the depreciation on the currency they also get helped. Market is maybe just focusing on the positive aspects of currency depreciation and not really worried about the negative aspects of it which would also play out in other businesses, other stocks.

The bigger worry would be on the kind of valuations. If your yields are going up, at some point of time you need to discount your future profits at a higher discount rate and which has not yet started happening.

Q: What is the bigger risk of the two that you mentioned, rupee at 68 or bond yields back at old highs again?

A: It is all interlinked. Your currency, your rates, your current account deficit, all these things are linked ultimately. What you are seeing today is that because there are foreign outflows happening, your FX reserves are starting to go down from the peak and therefore Reserve Bank of India (RBI) is trying to defend that. Therefore you are seeing open market operations (OMOs) happening on the other side which is leading to the bond yields going up, it is all kind of linked out there.

In terms of just looking at bottom up kind of fundamentals, maybe the bond yields are more important as of now because that really hurts a large section of the economy in terms of interest rates going up for them as consumers or as corporates.

Rupee is actually a positive factor for many because it helps them become more competitive globally. You could say this is also self-correcting mechanism by which your exporters kind of gain some, your importers lose some and ultimately your trade deficit then maybe comes back in shape.

Q: How have you married all this concerns into your investment strategy right now? You said that you are a bit cautious, have you started including some of the more defensive sectors into your portfolio and cutting down some of what we like to call the higher beta sectors?

A: We have been on that path for 6-9 months because we could see that these concerns are kind of developing there and growing there and we would rather be ahead of the market rather than react to these concerns. So, in the last 6-9 months we have made utilities the large sector in our exposure because we think that these are actually cheap stocks and they have regulated returns. So, the risk to the earnings is very low and these are the cheapest stocks out there. That is one big change which we did.

Q: When you say utilities – power stocks, does it worry you that some of these names like NTPC have actually not created as lot of wealth over the last many years. It trades in a range, it does not lose too much value but does not put on too much ground or do you see it as a capital preservation kind of mode right now?

A: It is a mix of the two. It is largely a defensive posturing, largely capital preservation but we also see the stock as stock which is actually cheap now versus its own history, versus where its fundamentals are, also there are positive developments happening for them.

For example, they are able to now take over the power plants from state electricity boards at just the book value and then they would be able to turn them around and this would be quite value accretive for them. Market for whatever mood it has got, it is kind of missing out on such value creation opportunities out there.

Q: What about IT, we spoke about the fact that the rupee is helping them? They went through a fairly prolonged low growth phase. Are you confident that they have come out of that low growth phase or is it now just a rupee and the feeling that the growth might have bottomed out?

A: I think the reacceleration in their growth if any is very marginal and this is kind of corroborated by whatever guidance we have heard from the likes of Cognizant or Infosys maybe they are growing from a 5 percent growth to may be a 6-7 percent growth rate. So, it is not really a massive reacceleration that we should be paying up a lot for.

Q: But the stocks have gone up 30-40 percent, for that kind of marginal improvement in growth do you think that is commensurate?

A: I think it is also because the market is trying to maybe hide in this names because there are also kind of now understanding these macro concerns rather than being in higher beta names maybe it is better to be in IT names where you have some downside protection, you get some advantage from the currency side of things.

Q: What are you cutting down from your portfolio in terms of risks? As you become more defensive in your orientation, what are you cutting down?

A: One big cut which has happened for us is on the financial space because all these concerns on the macro ultimately play out in terms of how the financial businesses kind of take, so that is one area where we have become much more defensive.

Q: Across the board or in specific areas of financials?

A: It is actually across the board. Also because if you remember last year at the beginning of the year after demonetization there was this nice phase of the market where the stocks were actually cheap including the financials so we mulled upon them, because the market was really pessimistic about the short term kind of business profile for them and which really helped us in 2017.

Now that the market is no longer worried about any of those issues and as you said a bit complacent about these macro worries, I think it is more opportune time to kind of may be reduce our bulk weight out from there. Will hopefully find another time, another opportunity to get back in.

Q: Where do you stand on the corporate banks? The large private sector corporate banks, ICICI Bank, Axis Bank type of names because there are two schools of thought in the market? Some believe that the pain will linger for few more quarters, others believe that this is the time to get in because most of the bad news is out? From a portfolio positioning point of view what is your call?

A: Our investment style is to essentially invest into high quality businesses which can generate good sustainable returns out there. The issue we find out there, I mean I agree with that overall macro thesis that yes maybe the worst of the pain is kind of over.

All the problems have been recognized and therefore the future looks better. Our issue has been that even if you have to extrapolate a better future and turn it into numbers you are not able to see very high returns coming out from these businesses anytime soon which is what is really keeping us away from these names.

Q: A lot of people present the valuation argument that if you are paying four times for HDFC Bank you can pay 1.25 times for ICICI Bank. Do you think that could be a value trap?

A: It is proven to be so in the last 10-15 years.

Q: What about public sector banks, stretching that argument? I mean people make similar kind of hypothesis for State Bank of India saying now is the time to get in. Again there has been many false dawns with PSU banks. Do you own any in your portfolio or you are staying away from that?

A: In the last three years there has been no PSU banks in our portfolio. I think these are really low quality franchises out there and with all this government interference and lack of proper governance management and these are really not businesses being run well for minority shareholders out there. Something needs to be done to change them structurally before we become interested in them.

Q: What about NBFCs that had a great run and then we have seen some concerns coming to the fro? I saw that, I mean I don’t know whether you still own but Bharat Financial kind of names were there in your portfolio where do you stand on those names on that bucket?

A: Bharat Financial specifically it is, just because the merger has been announced with IndusInd Bank it is just a proxy names for us. However, otherwise on NBFCs in general I think there are some NBFCs which are really doing a good business. They are really doing good job in terms of finding that niche, finding that space which has been vacated by the weaker corporate banks and are able to kind of do a good business out of it. So, there are interesting opportunities out there.

The top down worry on any of these NBFCs would be that most of them are wholesale funded and therefore as rates go up if they are not able to reprice their loans faster enough we could see compression in their margins.

Q: You said you don’t like public sector banks, but does that mean that you don’t own anything public sector in the financial space because I think I saw an insurance company SBI Life Insurance in your portfolio. So is that seen differently by you than pure PSU bank?

A: Yes, definitely, so it is run much more in a private sector way if I were to say that. It is a business which is able to gain market share which is again a rarity for public sector businesses in India. While doing that it is not really sacrificing margins, it is posting returns which are almost as good as private sector. So, I think yes, the labelling might be that it is a public sector one, but in terms of operations, in terms of financials it is as good as a private sector entity.

It is cheaper than the kind of the private sector names that we find out. It is an attractive names for us. They have been growing faster than the market and we believe that there is still a run way of growth for them as they continue to penetrate deeper into the SBI Franchise.

Q: Staying with the public sector, I want to ask you about oil because crude has become a big subject to discussion back home and oil prices were not raised for a few weeks again bringing forward all those old concerns. Do you own PSU oil stocks and how have you approached this whole crude business and this pass through of oil prices?

A: We don’t have any oil stocks in the portfolio and again see the issue is the quality of these businesses. I mean you can’t even predict how much of that oil price will come to them or not. So, how do you kind of do your numbers and figure out what you are paying for, how much profits so which becomes a serious kind of constraint on our side, when we want to kind of buy businesses that we understand, buy businesses that we can kind of extrapolate into future and say confidently that yes this much money they will earn and this much will actually come to us as shareholders you don’t have that kind of clarity in this space on the PSU side.

Q: What about the part of the market which is doing well in terms of earnings but is expensive? I mean anything to do with consumer whether it is auto or consumption, you spoke about staples, how do you approach that space now? Do you draw lines saying enough is enough I don’t want to pay 40-50 kind of multiples in these stocks or do you say this is where the growth is coming through and I might as well own them? I mean as a fund manager how do you resolve this dilemma?

b As I said one of the pillars for us is the quality of the business which many of these businesses would kind of filter through. But the other pillar also is to have a valuation discipline out there and if these companies are kind of going beyond our comfort zone in terms of valuations how so ever great the businesses might be we are okay not to own them. So, our approach has been to kind of stay away from these very expensive consumer names which again is been driven by whatever the market mood, maybe the domestic money kind of chasing these stocks and we can surely appreciate the quality of these businesses but we are not able to appreciate the kind of value that the market is pegging them to be.

Q: Where do autos fit in there because they are not that crazy 40-50 multiples nor are they cheap compared to their own historical valuations, the Maruti’s of the world, what is your approach, do you include them in your portfolio or keep trimming them as they go higher?

A: Autos are more interesting as you said because they are not really up there in terms of their valuations. We do find some interesting ideas out there. This is unlike as you said they are the very high priced consumer stocks this is an interesting area to enter.

Q: You do own some of them?

A: Yes, we do.

Q: Anything on the rural theme because that is also coming back into play? M&M started moving after a long time, some of the tractors plays are not doing too badly. Do you believe that that is a good part of the market to be owing or is it too much hype there?

A: I think the numbers are showing that the rural trends are actually improving. When you look at tractor numbers and when you listen to what Maruti is telling or what Hindustan Unilever is telling the rural side of the business is actually growing faster for all these players. I think there is certainly some change happening out there because it is coming out of a down cycle or also because there is some amount of government push, elections also have a role to play out there.

So I think rural story is kind of out there which is getting stronger and certainly it is an area which is of interest to us. Because even now I don’t think the market fully appreciates the kind of change in that consumption pattern which could be there. Market is just focused on the urban consumption names so to say, but rural is getting stronger by the day and that is looking very interesting.

Q: What is the best way to play? I mean some buy fertilizers, some buy crop company, some buy FMCG companies focused on rural what do you think is the best safest bet to play the rural theme?

A: Ultimately, what you want to do is if the rural incomes are rising you want to buy some rural consumption names, so it could be M&M in the portfolio or it could be some let us say you can find some cheaper rural consumer staple play. We have Emami in the portfolio, so I think they are potential names out there which are looking interesting in the rural space as well.

Q: Let me ask you about aviation because that is a controversial theme specially recently after the news on IndiGo and stocks has taken quite a bit of a pounding and I know you own that name. Do you think it is worth betting on it simply because of the strength of theme in India over the next many years or are you worried by kind of negative feedback that we are hearing from the market about concerns and disclosure, governance etc. for the biggest name there?

A: The theme remains strong. India is such an under penetrated market on aviation. They have maybe 0.03 flights per capita or something compared to let us say 2.5 of US so it is hugely underpenetrated. You are seeing the market growing at 20 percent for few years now and the projection are that will continue to grow in double digits for maybe next 15-20 years very easily. What you have is also that the business structure has changed. There are some players who are operating in a very low cost model who are very capital efficient and therefore are able to generate profits unlike airlines of the past.

I think these are very strong businesses to kind of back. Yes, there are some issues in terms of let us say disclosures and stuff, but I think you have to kind of make some kind of balance out there in terms of whether you want to participate in that huge long term opportunity or not and then maybe find ways to kind of be comfortable on the governance side of things. Ultimately, these companies are also owned heavily by the promoters themselves and essentially your interest are then aligned with theirs because they are also looking to make as much money as you are.

Q: Let me ask you about politics, ultimately you are a fund manager and your focus in on stock selection, but the macro environment this year is quite interesting. We spoke about some of the issues and then everybody is thinking about what will happen in 2019 and it may have a bearing on portfolio performance and overall returns from the market too. How do you see 2019 and do you see that being a decisive kind of an event for equity performance in India or is it just background noise which you are bets avoided?

A: It will be an important event for sure. Honestly, if I try to think about it today it is very uncertain. So, it is not something that I would kind of try to make a bet upon either way because one year is very long in politics and it is not something that we will be comfortable kind of just betting our clients’ money upon. I think our stance would be to kind of be more bottom up focused a still. Just trying to figure out which stocks offer us the best risk reward and just in case something wrong happens something unfortunate happens out there the money should be kind of protected to the best way possible.

It will be a tricky kind of a situation because you will see state elections happening towards the end of this year and that will again kind of give some direction to the market with a right or wrong is something that will be decided only in May next year. So, yes this is how we will kind of see it. We will play it just by focusing upon our discipline in terms of finding those quality names, finding then at good valuation whether or not there is a political change or not ultimately these are the businesses which need to perform on their own merit.

The country needs a good governance structure and stuff, but ultimately these businesses have lived for the last 20-30-40 years through various governments, various regimes and there is a reason they survive they sustain the thrive which is what we believe in and ultimately if you can find them at better prices just because of a political change that the market is worried about better for us better for unit holders.

Risks outweigh rewards in the Indian context, says Prashant Kothari

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