Difficult to imagine equity markets moving substantially higher: Emkay MD

emkay krishna kumar Krishna Kumar Karwa, managing director, Emkay Global Financial Services

India's equity markets may be headed for a consolidation phase, after largely outperforming other emerging markets. While, the downside looks limited given the strong inflows into domestic mutual funds, the trade war between the US and China, rising crude oil prices that will put pressure on the margins of companies and hardening interest rates are speed bumps restricting the upward move, said Krishna Kumar Karwa, managing director of Emkay Global Financial Services. In an exclusive interaction with THE WEEK, Karwa says despite the recent correction, small and mid-cap stocks would continue to deliver superior returns from a longer-term perspective and advocates having “sprinkling”of these stocks in an investor's portfolio.

Excerpts from the interview:

Indian equity markets have been resilient in spite of macro-economic challenges looming large. What is your assessment?

The biggest challenge today is global. The global trade war will create its own challenges, because you don't know the second derivative or third derivative impact of that. Today in a globally connected world, it is not only China and the US ot the tariffs that impact their products, but what goes into those products from which countries, you will not realise it today, it will happen over a period of time. So, suddenly six months or twelve months down the line, a corporate will say, I got impacted because my buyer was a supplier to a certain company that got impacted. We are already seeing an impact of that on emerging markets (EMs). Most of the EMs are down 8-10 per cent. To that extent, we are so far resilient. We have outperformed, thanks to our strong domestic micros and domestic (fund) inflows, which continues to be robust. That is what is helping our markets. If you look at the Nifty, it is robust, but in the small-caps, mid-caps etc., there has been severe correction in the last three to six months. Maybe Nifty is not the true reflection of the overall.

Given the outperformance, from here on, where do you see the markets heading, given the macro-economic concerns, hardening interest rates and foreign institutional investors selling?

It is difficult to imagine the markets moving substantially higher on a broad basis. It will continue to be a traders kind of a market. We don't see market going down 10,500 (Nifty) levels also. It can go substantially above 11,000 level, but it looks difficult. It is kind of range bound market. You have domestic political expectations, the current account deficit and all that coming into play, the ability of the government to manoeuvre is also very limited because it is an election year... At the same time there is the domestic liquidity. Lets see whether we continue to outperform EMs. We are kind of positioned for consolidation now.

In the backdrop of the correction in mid and small-caps, do you suggest one should increase their holdings?

If you have a decent amount of risk appetite, then the small-caps and mid-caps over a longer time frame will deliver excellent returns. If you look back at a five year time frame, you will see that small-caps, mid-caps will be giving you superior returns than the large-caps. That's the way it is, as large-caps are discovered, stocks—small and mid-caps are relatively undiscovered. So, that's where the opportunity is. But, its all about your risk appetite and time frame. Today, it is unfashionable to talk about small and mid-caps, because they are in a correction mode. But, if you have a sufficiently long time frame for investing, then you will make good returns. You should have a balanced portfolio, so maybe, have a good sprinkling of the small-caps and mid-caps and then you have the large-caps.

How difficult is it to identify the quality in small and mid-caps?

It is purely bottoms up investing that works as far as the small-caps sector is concerned. How difficult is it? It is a continuous effort. The risks are always high because they are hidden gems, means that you don't know much about the promoters or the business models have not yet gone through cycles, all those risks are there. Subsequently, only after investing, after three to four years, you realise if you got it right or wrong. There are challenges, but investors should do the due diligence... On an overall basis, if you look at it, you will get some of them wrong, but the ones you get right, if you hold on for sufficiently long time frame, then it will cover up for your failures. Investing in small-caps is the most difficult, it is an art. Generally, people feel that investing is easy. It is simple, but not easy.

What is your assessment of the quarterly earnings? Can we see a further pickup this year?

Broadly, we found that there weren't too many earnings downgrade (in the fourth quarter), which means that expectations of analysts are being met; to that extent the numbers were on track or slightly better. Typically, in the first half of the results season, you do find the numbers generally being much more robust. Net-net, I think, excluding public sector banks, sectorally, there weren't too many disappointments.

On the outlook, every year analysts start with a 20 per cent plus kind of earnings growth expectations and then they keep on reducing. We believe, on an aggregate basis, this year again there should not be more than 10-15 per cent earnings growth.

What are the challenges restricting earnings growth?

Rising interest rates will have its own impact on profitability of corporates. Secondly, because of rising oil prices, raw material prices you will start seeing pressure on margins...These are the two challenges that you possibly see. Demand wise, domestic demand is not a challenge currently, but then the impact of rising interest rates takes its time to seep into the system. Currently, everything seems to be robust, but three-four quarters down the line, we don't know if it will remain as robust. Fourthly, your valuations get impacted. Ultimately, stock prices will get impacted. We believe that currently the 10-year G Sec (government securities) yield is at around 8 per cent, should be headed for 8.3-8.4 per cent. That is our view on interest rates. Even the US Dollar is headed towards 70.

Do you expect another interest rate hike by the RBI in August?

Should be. We were ahead of the curve, we had talked of hardening of interest rates six months ago and it is now panning out. Now it has become a consensus view (that is rates will rise). The very fact that the currency with people is back to pre-demonetisation levels, about Rs 18-19 lakh crore, that much amount of money has gone out of the banking system. That itself is creating a liquidity tightness in the system.

FMCG companies have seen strong growth in the last quarter. But are valuations comfortable?

Currently, those are the sectors showing good growth. In an inflationary environment FMCG companies tend to do well, because of their ability to pass on (input costs) and margins expand. From a business perspective these companies will do very well. But from a valuation, it is a challenge to justify investing in these companies. But, that is where the opportunities are. Sometimes technical factors come into play. For instance, now with SEBI directive (on rationalisation of mutual fund schemes), large-cap funds have to invest in the top 100 companies only; out of that if you want to invest in FMCG companies, you need to go and buy into these companies only. So on a historical basis, valuations look expensive, but in FMCG sector, there are limited companies where you can deploy large sums of money.

In the banking sector, any signs that we will be out of the woods, or will the NPA problems persist?

Last quarter, probably, all banks would have provided for and disclosed what had to be disclosed. My judgement is that now it should be very minimal, unless you have new NPAs cropping up. What ever is discovered should have been disclosed by now across the industry. Communication from all public sector banks suggests that they seem to be having robust recoveries at least for the last two months. The large private new generation banks, their growth is robust 20 per cent plus. NBFCs into asset-base financing are seeing robust growth, MSME (micro, small and medium enterprises) financing companies are growing very well. This is being led by robust micros, and inability of the PSU banks to lend. The challenges seem to be in housing finance, where the growth seems to be under pressure.

If you are an aggressive investor, you will tend to go and buy some of these PSU banks as their valuations are interesting. Maybe, they will not grow but recover. You can play a recovery game over there. We are not advocating that. Average investor, you can invest in all these private banks, they will do well. Valuations are expensive, but, they have shown the resilience.

Within private banks, what is your view in the case of ICICI and Axis Bank?

These are large institutions and larger than their individuals. So, who ever comes in to run the Axis Bank (after Shikha Sharma), or what ever happens in the probe at ICICI Bank, they have the capital adequacy, they have the ability to lend and they will grow and their valuations are reasonable. So, hopefully, you should be able to make money over a period of time.

Can a depreciating rupee help IT and pharma companies?

Never buy companies because currency or any one factor is going to go in their favour. You have to look at it from an overall perspective. IT companies inherently have challenges as far as growth is concerned, rather many of the bigger companies have settled down into high single-digit or very low-double-digit kind of growth. After the sharp rally, valuations of many of them are getting into the 18-20 times and have now become expensive for the growth that these companies have. They are solid companies, but from here to make money in them will be difficult.

For pharma companies, the tide seems to be bottoming out. Be it the consolidation as far as the US buyers is concerned, the US FDA issues, everything seems to be settled. The high price to equity ratios these companies enjoyed were because of their robust earnings. Their business models will now have to transform. There might be some trade opportunity coming up. Let us see who transforms to the next level like specialty drugs. As far as pharma is concerned, it is a work in progress.