MMA and KAS in association with Policy Matters and TIA organised a panel discussion on the stock market conditions. The panellists were: Mr Ganeshram Jayaraman, Managing Director & Head Avendus Spark Institutional Equities, Chennai; Mr Sunil Subramaniam, Managing Director Sundaram Asset Management Company Ltd and Mr Nishit Master, Fund Manager Axis Securities Limited. The discussions were moderated by Ms Vidya Bala, Founding Partner & Head – Research & Product, PrimeInvestor.in.
Ms Vidya Bala: There are many factors that work in our favour, but inflation is a worrying sign. People are buying like there’s no tomorrow. There is talk of premiumisation happening. People buy expensive goods, cars, and two-wheelers. But at some level, we are concerned if the market is overvalued. So, my first question to the panellists is: What is your perception of overvaluation and by those metrics, whether the market is overvalued today?
Mr Sunil Subramaniam: As an asset manager, I don’t have the luxury of thinking if the market is overvalued or not. Why do I say that? Because if I feel the market is overvalued, I should return my money back to the investors. I cannot take equity money and put it in debt. I cannot take the debt money and put it in fixed deposits. An investor who feels the market is overvalued will shift out of the overvalued market and go. But as a fund manager, I do not have that luxury. But to answer that question, I think that valuation is a very relative term. Number two, investor returns are not correlated to valuations. They are made from two separate aspects – the cost of production of a commodity and the price the market is willing to pay for the commodity. Stocks are nothing but a commodity. If you take potatoes as a commodity, there are a number of input costs. 20 rupees may be the cost of producing the potato, but does the market give him 20 rupees always? It either gives him 20 rupees or gives him 100 rupees.
The cost of production is the EPS growth. The market value is the fundamental discounting of future cash flows of companies. Does the market respect those fundamentals? Not necessarily. It depends on demand and supply for that commodity, whether there is a drought or a flood or whether competitors are sowing potatoes in their field. Indian stocks are in a situation where our fate is not in our hands but with FIIs. They own anywhere between 35 to 40% of the free float stock of our capital markets. For them, instead of putting money in a losing country like the US or Brazil, India is a better alternative, regardless of what our EPS growth is, as long as it’s better than their return expectations. They put money in India when the cost of borrowing from the advanced countries is low, when the chance of rupee depreciating vis-à-vis those countries is low, and when the cost of oil is trending down, because we import 83% of our oil requirements.
I work with a three to five-year outlook. To me, the market valuations that we all refer to are one year forward. But I am looking at the returns from my investment three years forward. One year forward, it might appear to be over-expensive because companies may be investing in capex. In three-years’ time, those capital expenditures would pay off. It’s worth investing in that. So, for me, it’s the average of the FY 27 to FY 30 EPS of that company, which drives my decision on whether that stock is overvalued or not.
The next aspect is, the market is equal to nifty is equal to Sensex in people’s minds. For me, the market is a weighted average of the nifty plus the BSE mid-cap index, plus the BSE small-cap index. It’s the overall weighted average, three to five-year forward PE of the stocks in my portfolio, which decides my view on whether a stock is overvalued.
Ms Vidya Bala: What are the signs for you that there is a bubble, and what would you do in such times?
Mr Ganeshram Jayaraman: The market now is enigmatic. The long-term picture is very attractive. I’ve never seen corporate balance sheets as healthy as they are today. They have extremely low levels of debt and focus on capacity utilization and capacity expansion. I was in Gujarat last week and met about 30 small and medium enterprises. Each one of them told me that they are looking to increase capacity. These are in textiles, chemicals, and related ancillaries. They are looking at long-term trends like demography, urbanisation, the government’s priorities on the China plus one strategy and PLI. The long-term view on India’s potential earnings growth looks very healthy.
My short-term view is mixed. Over the next one year or 18 months, I’m not comfortable. I see consumption moderating. For the last 10 years, from 2010 to 2020, there was no capex cycle in India. The exports grew more or less at the same pace and didn’t expand dramatically, but the economy was led by consumption. Post-COVID, the way our consumption is recovering is not looking healthy. I’ll give you some examples. Two-wheeler sales of FY 23 are below FY19 sales. Categories like white goods, consumer durables, kitchen appliances, liquor… I can name 10 consumer categories where the growth is just not adequate enough. 80% of our consumption is mass consumption, and that’s not growing. Sale of passenger cars priced below seven lakhs in the period FY18 to FY23 has declined, but cars priced above seven lakhs have grown 50%. We call it K-shaped. Consumption in apparels, watches, and liquor is just not growing. What makes me wary is earnings moderation and growth moderation.
On the macro side, IT is not hiring, and for three consecutive quarters, the IT sector has shed jobs in cities like Chennai, Bangalore, Hyderabad, Pune, and NCR. It is a very important driver of jobs and consumption. Second, the exports have declined. Rural inflation has been more than rural wages. So, the consumer is prioritizing spending on something else and not on discretionary consumption. In the last six months, we saw a phenomenon where volume growth has not kept pace, but commodity prices cooled off, and that led to margin expansion. Is it sustainable? I can’t predict, but what I am comfortable with is the capex cycle.
India’s Promising Growth
Mr Nishit Master: If you just plainly look at valuations, on one year forward multiples on a PE basis, we will be at around 18 times. The historical average in the last 15 to 17 years is around 16 times. We are close to one standard deviation above average. But if I look at it from a different multiple, which is price to book value basis, we would be at around 2.7 times of one year forward. The historical average for the last 15 years is 2.6 times. So, we are not much different than the last 15-17 years average. One more parameter, which we typically use, is the BEER ratio, which is the bond yield to equity earnings yield. Indian markets typically have performed at around 1.2 times. We are currently at 1.35 times. It probably means that bonds are slightly more attractive in valuation than equities.
But what options do you have as investors now? If I look at the macro setup, most of the major economies are already in recession. The US is slated to be in recession probably next year. China’s revival from Covid has not happened with a big bang as expected. We are looking at an anaemic growth even from China. So, for global investors, there are hardly a few sizeable markets where they can invest and which are expected to grow. The RBI, The World Bank, IMF, and everyone say that India is expected to grow by more than 6%. No major economy is expected to grow upwards of 6%. That’s why Indian markets are at a premium. We might be slightly overvalued. But I think to some extent, there are factors which support these overvalued markets of India.
That does not mean that we might not have corrections. That is part and parcel of equity markets. Most likely, the trigger could be something happening outside India rather than in India. From an election perspective, as long as the market factors in stability of policy from the government, then whoever is in the government doesn’t matter to the market. We believe that with the momentum which we’ve seen in the last few years, policies will be difficult for any new government to change. The pace can slow down, but it cannot be reversed. The corporate leverage as well as the banking system looks very healthy. Many Indian corporates don’t require capital to grow for the next few years, though they are still looking at 16 to 17% growth.
Ms Vidya Bala: We need to keep in mind the changing composition of the Nifty 50 index. Over the past decade and a half, when we speak of valuations of 15 to 18 times, the index had very asset-heavy and debt-laden companies. These companies typically have never commanded high valuations. In the recent decade or so, the composition is dominated by companies that are asset-light, have very clean balance sheets, and are cash-rich (like FMCGs). Perhaps, this may be a reason why the market has been offering 20 to 22 times valuations for a long while now. My next question is: Where would you look beyond the traditional index returning sectors?
Mr Sunil Subramaniam: As an individual investor, I ignore valuations. Why do I say that? The purpose of investing is to create long-term wealth. Long-term wealth creation happens when you beat inflation. India is a 7% inflation land, on an average. Equity is the only consistent asset class that can beat inflation. Your asset allocation is based on your risk profile. But you should always use equity as your wealth-generating asset class. How much you put in equity depends on your risk profile. Having done that, valuations don’t matter when you choose equities. Your allocation to equity should be consistent, regardless of where the current market is pricing those earnings.
Don’t Rely on Averages
The average is the worst possible statistic in man’s history. It’s like saying that the river Cauvery is on an average five feet deep and hence, I will take the risk of walking across the Cauvery. It is a fact that somewhere, its 10 feet and somewhere, it is three feet deep. You can select, within that average, that which is going to deliver returns at any market valuation. You can pick those stocks or sectors or indices, which can deliver to you better. When you look at valuations, see what is the previous peak valuation? What were the conditions prevalent at that point? In my investment horizon, is there a chance that would happen? People use standard deviation and all that. In December 2017 and October 21, the market was trading at more than two standard deviations away from the mean. The conditions prevailing then were a demand for Indian stocks. India as a market will deserve a premium from a foreign investor. That premium may vary up and down. But it is going to deliver you the returns as an Indian investor. So, ignore valuations.
If you want to go outside the index, select your portfolio equally across large cap, mid cap, and small cap. When you do any sector allocation, look domestic rather than outside, because the world is in a slowdown and India is much better. Just to make my point about valuation, I want to share four data points on why valuation doesn’t translate into returns.
In the last four calendar years since 2019, the earnings of the Nifty in 2019 was 4%, and the market delivered 12%. In 2020, it was minus 4.7%, and the market delivered 14.9%. In the next calendar year, it was 16.8%, and the market delivered 24.1%. In the next year 2022, the market delivered 34.9% EPS growth and the market return was only 4%. Remember the market is discounting the future and not the present.
I’ll end up with another statistic. Of all the last 20 years, if you had invested in the market peaks and stayed invested for one year, three years, or five years, your chances of beating 7% inflation return have been 60% plus. That means you have three out of five chances of beating inflation, even at the peak of the market.
So, my respectful submission is, please ignore valuations because they represent an average of everybody’s thinking. Each individual fund manager or person is not investing in the average; he’s investing based on his own read of that company, the sector, the stock, and the timeframe of the future. So have your asset allocation in place. Keep it to a broad market. Newspaper headlines may be about Nifty, but your investment is in mutual funds and it is not about the Nifty. So, diversify across the cap curve and ignore what the public speak about valuations.
Ms Vidya Bala: Is it time to take a different view of how we look at the manufacturing segment?
Consolidation is the New Game
Mr Ganeshram Jayaraman: Absolutely yes. Why have Air India and Indigo each ordered 500 aircrafts? The reason is not demand but it is pre-emptive or predatory strategy. They want to make it a duopoly. The same thing is happening in telecom. It used to be a 10 to 15 player market. In the last ten years, it has become a three or four player market. Consolidation of market shares has resulted in a very unique competitive scenario. I can draw this example for even 20 sectors including pipes, cables, and property. The number of property developers post RERA implementation has come down in each city. The top three or four players in each sector have disproportionately gained market share, and to keep their market share intact for the next decade, they are planning capex. Their balance sheets are in great shape. Their capacity utilisations are in the mid-70s to 80s in some companies.
The capex takes time. It takes three years to get the new capacities in place. The previous cycle was power sector and infrastructure dominated. This time, it’s going to be 30 sectors including small sectors like chemicals. Many relatively lesser sized sectors are seeing capex. All the cell phones are now increasingly manufactured in India. If there is one sector where there is phenomenal traction on the ground, it is the electronics sector and there’s no better place to do this than Chennai. Foxconn employs 50,000 people in their manufacturing locations here. They’re planning to add up and maybe even double their capacity. The environmental clearances granted are up by five times.
What is different this time is that it’s not going to be debt-funded. Everyone burnt their hands with debts. This time, it’s going to be more equity funded and internal accruals. It’s going to be MNC-led capex. Many MNCs I met are planning capex in India. They are increasing their expansion in India. The capex cycle, in my expectations, will be there for at least the next three to five years. What they have to look at is not one year forward price to earnings, or EBITDA or any of these multiples. It’s going to be a very long and a strong growth cycle. That’s our assessment.
Ms Vidya Bala: True. Companies like Bharat Forge are looking at digital solutions. Carborundum Universal, a local company, has been quietly acquiring companies and it has completely changed the way it works. A decade ago, it bought some commodity-based companies and it was valued like a commodity company. That has changed. I’m just giving illustrations of how transition in the manufacturing space is happening and a disclaimer- these are not any recommendations for buying. Electronics is undergoing a significant leapfrog thanks to various government regulations as well. The market has valued all these positives and yet, the valuations in this sector are quite intriguing. Sometimes you don’t even know how you can afford 60 to 70 times to these companies. Companies like MNCs are constantly overvalued. So how do you then go about evaluating them?
Mr Ganeshram Jayaraman: For some of the capital goods companies, the asset turns are large. Their margin profile has changed. Their indigenization of raw material procurement has dramatically changed. Their sourcing from the parent has come down, and their exports to the parent are rising. I find very strong balance sheets. Their earnings growth, having potential non-linearity gives me confidence that even though the stocks have doubled or tripled, they are not at the peak of their cycle earnings.
Ms Vidya Bala: The earnings potential may not always be reflected in the price to earnings. It’s something that we need to understand for various reasons. One, the kind of transition the sector might itself be undergoing and the capex cycle. The second thing that is that we all love to make our money from the small cap sector. We just have 100 companies above 50,000 crores. How does a retail investor go about in any market, looking for this opportunity in small cap?
Management Quality and Cash Flows
Mr Nishit Master: Investing in small caps has its own pitfalls. Information available in the market is far lower than what is available for the Infosys or the TCS of the world. Apart from that, management quality, a lot of times, is suspect. I believe a lot of companies will move from 5000 crores to 50,000 crore market cap, but there still will be a small cap, because the larger companies would have moved up significantly.
When I started my investing career, the small caps we used to talk about was 300 crore to 500 crore market cap companies. Now, that itself has moved to 5000 crore market cap companies, which means it’s already a 10-bagger. The most important thing for me when I look at small cap is- is it addressing a market which is big enough to grow in the future? If the company is in a very niche space, which is a very small area, the growth cannot be big because the company cannot be bigger than the industry it is in.
The second is management quality and management’s focus on cash flows. The single most important reason why companies have failed in India is a lack of focus on cash flows. Promoters focus on growth and revenue but once you stop focusing on cash flows, everything goes for a toss. There are companies which grew revenues multifold by supplying to the government. But the receivables got stuck. Obviously, because of working capital problems, they started defaulting and got sold in NCLT for a pittance. I also believe that when I invest in a small cap company, the promoter needs to have a significant amount of skin in the game. If the promoter himself owns 10 to 15% of the company, then I don’t think he has enough skin in the game.
You must pick up companies which have an ability to generate value either through cost optimization or process innovation. Those companies have a strategy to win in the market. Now, small cap companies have also become as efficient as large cap companies in utilizing the scarce resource. Though we manage diversified equity portfolios, a significant part of our portfolios is small cap driven.
Ms Vidya Bala: If a small cap fund stops inflows, does that mean that the fund is wary?
Mr Sunil Subramaniam: The reason a small cap fund stops inflows is because they would have taken exposure to more than 100 plus stocks already and finding new investable opportunities beyond those is restricted because in small cap, there’s a regulation that you can’t take more than 10% of one stock. Also, there’s a regulation on how much of that free float you can own. Each fund manager has a different perspective. I would recommend everybody to look at SIP as the best way to enter a small cap, because not only do you benefit from the long-term approach of investing, but you also get the rupee cost averaging.
Ms Vidya Bala: How does one go about booking profits at the right time in small caps?
Mr Ganeshram Jayaraman: As a fund house, we have never taken a call whether money should be deployed in large caps or mid-caps or small caps. There are badly managed large caps and extremely well-managed small caps. When it comes to small cap investing, what we recommend is evaluating the management and not valuations. Look at governance capability and credibility.
Ms Vidya Bala: In the next 12 to 18 months, how do you think the markets will move-upward, downward, or sideways?
Mr Sunil Subramaniam: In the next 12 to 18 months, you have semi-finals and a final. Then you have a US election. A reasonable expectation is of low double-digit return from the broader equity markets.
Mr Ganeshram Jayaraman: I don’t make predictions, but I’m not a buyer at these market levels. I’ll wait for a 10% correction before I buy.
Mr Nishit Master: I continue to be constructive on the market. I believe low-teens are what one can look at in markets. In between, you might have a 5-7% correction. There will be pockets which can deliver far higher returns than the normal market returns.
Ms Vidya Bala: As far as I’m concerned, I ruthlessly go about booking profits when I see money. I do not look back as I have the luxury to do it and it’s my personal portfolio. I keep a list of stocks, put them in a basket, and keep observing them. My experience has been that in election years, big opportunities have come.