Equity markets ended on a flat note, but not after what has been a roller coaster week. The benchmark BSE Sensex, for instance, jumped near 286 points on Monday, crashed over 350 points on Wednesday, only to recover 578 points on Thursday and closed 30 points higher on Friday.
It is largely been a similar story across broader markets in 2018, with many uncertainties on the domestic as well as the foreign front. While investors have been worried with the fiscal slippages, the levy of long-term capital gains tax and banking frauds back home, an escalating trade war between the United States and China, speculations over faster interest rate hikes by the US Federal Reserve among other things have also left them nervous.
THE WEEK caught up with Harsha Upadhyaya, the chief investment officer, equity at Kotak Asset Management – the fund house manages close to Rs 1.25 lakh crore worth assets under management – to get his views on where the equity markets are headed this year, and the areas the fund house remains bullish on.
Equity market investors have had a roller coaster ride this year. Is there more to come?
A market that has given 30 per cent plus returns for the large cap companies, 45 per cent for mid-caps, not showing even a greater than 4 per cent volatility, is kind of unprecedented. Usually, you associate equity with higher volatility than many other asset classes and potentially over long period of times, it should deliver better returns. But, here was a case in 2017, where volatility was extremely low and returns were very strong. Correction had to happen at some point of time. It coincided with some murmurs about global interest rate cycle turning, crude oil becoming firm, our own local issues of LTCG introduction and some recent political developments. After having seen first bout of volatility, we believe, this year will be more of a year of consolidation for equity markets, where in we see more moderate returns compared to 2017 and also higher volatility compared to last year. From a medium term perspective, we still are very constructive.
Are we seeing earnings recovery picking up pace this year?
The earnings recovery is very visible now, the quality of earnings has improved. Three years back, roughly half of the corporates were showing earnings growth on an annual basis and half of them were showing decline. But, today, nearly 75 per cent of the companies are showing annual earnings growth. Only a small part is showing a decline, most of it in sectors like public sector banks, telecom and pharmaceuticals. We should start seeing better earnings growth now that phase (demonetisation and GST) is behind us. When you look at India's average capacity utilisation, in the last peak, that used to be about 80 per cent. Today, it hovers around 72 per cent, which means there is excess capacity on ground and as and when the demand picks up, without re-investing further, you will be able to get that profitability. The reforms that have taken place, will also add to more formalised way of growing the business, which is always good for organised branded players. We have already seen that in couple of sectors, where the unorganised pool is large, for example jewellery. While, the jewellery market has not grown in the last twelve months, the branded players within the jewellery market have shown significant growth.
How much of this earnings recovery has been priced in by the markets already?
Definitely, ours is not a market which is very attractive on valuations. Valuations have remained above historical averages for quite some time now. If you look at one year forward earnings, we are trading close to about 18.5 times now, which is not the peak valuation, but at the same time, it is not something where you will take a large equity allocation call. It is higher than the last ten year's average. So, that is a reason we believe there could be a phase of consolidation. At the same time, we don't see markets crashing because fundamentals are improving. So, the downside also seems limited.
Which are the sectors that will do well?
Most of the domestic sectors have started to show improvement. One is a basket driven by increasing consumption. You can put consumer durables, auto and FMCG in that bracket, and also some of the enablers like retail-focused private sector banks, because they aid consumption. The second basket is where there are supportive government policies and where activity is picking up. Affordable housing, road construction, railways, the entire gamut of construction for example. That is where policies are supportive, there is a need as well and things are coming back. It may not be the same set of companies that you used to see in the 2003-2008 cycle, because most of them still have their balance sheets ruptured. This time around, it will be those, which have cleaner balance sheets, it may not be pure infra companies, but enablers and allied sectors like cement, capital goods, engineering.
Then, the theme of increasing financialisation in our economy. There is a clear move away from physical assets to financial assets. So, we are positive on all the capital market intermediaries, whether its a broking house, asset management company or insurance firms.
How do you see the PSU banking space, in the wake of recent frauds?
Even before the bank recapitalisation and after, we always remained underweight on PSU banks as a fund house. Our view was that while recapitalisation will help things to a certain extent, by providing capital to repay the balance sheet. But it is not just about giving capital, but also having different set of roles and issues around governance and all that, which has come out in the open, after what has happened in Punjab National Bank. We continue to remain underweight on the sector. Already, 11 of the 21 listed PSU banks are under the RBI's prompt corrective action framework (PCA), which itself is going to marginalise them, at least for some time. Now, with the recent developments, there could be few other banks that could go into that list, which essentially, means that the entire PSU banking pie is unlikely to grow. That is where we see a lot more opportunities for private-sector banks, where the asset quality issues are not as wide spread. At least capital has been adequate in those private banks where there have been some asset quality issues.
The IT and pharma sector have been under performers for some time now. Any recovery visible there?
As of now, if you enter pharma sector, as a whole, its a blind bet. The longer it takes (for the approvals), it is going to jeopardise companies' profitability for the future because some of the research activities that they may have done, may probably go waste or will give lesser profits. At the same time, the issue faced by Indian companies focused on the US generics business is that there has been a sharp price erosion in that market. On one hand, your existing profit pool is shrinking because there is more competition and price erosion is happening and on the other side, your ability to launch new products and try to build another stream of profits is also stunted because the regulatory hurdles are not cleared. Because of these two issues, we will be very stock specific in the pharma sector and unless there is more clarity, won't go majorly into the sector.
On the IT sector... I think in this phase where there has been more volatility in stock markets, this was one industry with at least some reasonable level of earnings, lower than market, but stable. People who feel the other pockets of the market are over priced, who want to be a little defensive, are moving into IT. At the same time, nothing much has changed in IT as well, in terms of business growth. It is just that a bit of under-ownership and fear of markets showing more volatility has led to some money going to the IT sector.
With most of the consolidation now over, is stability returning to the telecom sector?
Where ever there is competition and fight for gaining market share, even with lesser number of players, the pricing power doesn't come and profitability of the industry is always under pressure. That is what is happening in telecom as well. There are three large players, but all of them are trying to either retain or grow market share. In that phase, it is very difficult to say if we have seen the worst of price wars.
With pain in so many sectors, overall from a fund house perspective, the basket for investment has kind of reduced then?
Until you see a broad-based recovery, while it has improved from 50 per cent to 75 per cent, still a long way to go before you call it multi-year improvement in earnings cycle, until that it happens, it has to be based on the visibility that you have. I am not saying contra-investing does not work. Then you are assuming that things will turn around and the patience levels and investment horizons have to be lot more. As a fund house, we have always been growth at reasonable price investors. We continue to do that. Even if you leave out some of the sectors, there is reasonable sectoral plays and stock plays that are available. So, we will have to work around that. From a positive perspective, things are lot better than three years ago, so you do have lot more stocks (to invest).
Between the large caps and mid and small caps, historically, they used to trade at a discount to large caps. Now that situation has reversed. The premium was very high in January, that has corrected a bit. But, at the same time, given the expectation of our fund house, we expect more volatility, right now we are not jumping in and buying more mid-caps. So, we will have a cautious and a gradual view in terms of increasing investments in mid-caps.
How worrisome is the fiscal deficit issue?
We are not so worried about central fiscal deficit. Give or take a little bit, it is at least following the glide path, maybe with a lag of around year and a half. What is worrying is many state governments, because of elections or other political reasons, have resorted to a lot of farm loan waiver announcements. When you look at combined fiscal deficit at the centre and states, obviously, things have worsened. That is something to be cautious about.
Will the investors also be watchful about the election outcomes this year?
When you look at 25-30 year period, the elections don't really matter much. But, during those 3-5 months, there will be lot of noise around the expectations, outcomes... So, markets could remain volatile, which ties in with our base view of more volatility this year. The market though, will be good for portfolio construction, for stock picking, it will be good for investors also to realign their asset allocation. In a one-sided market, either you are becoming too greedy or too fearful. You don't get the opportunity to think and take decisions. This year, it will provide those opportunities where any rational investor can take those decisions.