The gap between stock markets and the real economy has never been so great. Even if the economy continues to be hit by the second wave, stock prices will rise, making valuations expensive. Swati Kulkarni, EVP & Fund Manager, UTI AMC, shares her view of the stock market and the sectors in this interaction Business line.
The price / earnings ratios of the Sensex and Nifty 50 are at record highs on both a trailing and forward basis. The RBI warned of a bubble in stock valuations. Will there be a medium reversion soon?
I’m not just looking at the price earnings multiplier, as earnings tend to be much more volatile than balance sheet-based valuation multiples. Also, the market is a collection of companies and market valuations may not reflect opportunities in particular segments. Nevertheless, at around 15 percent, the PE ratings are significantly higher than the long-term average. But these multiples have been above average since 2017, apart from the Covid-related correction last year. The price / book value multiplier is also around 10 percent above the long-term average.
The actions taken by the government, as well as the liquidity provided by global central banks, have so far supported equities around the world and in India. Growth is expected to be stronger if economic activity normalizes, supported by fiscal and monetary policies. In the long term, the reforms introduced by the government should accelerate global growth, and low interest rates should be a catalyst for growth.
It is difficult to say when there will be mean reversion. As I said earlier, valuations in terms of P / E ratio have been expensive for a while. If there is disappointment in earnings growth or if talks about tightening monetary policy intensify (if central banks perceive structural problems in inflation rather than the current consensus of “temporary”), equity markets can correct. However, we don’t know when it will happen.
The second wave of Covid-19 hit consumption and demand at least in the first quarter. The savings in the hands of investors have decreased due to medical expenses. How do you assess consumer demand for the remainder of this financial year?
Yes, there are some people in the lower classes whose income is affected who may not have adequate health insurance. But there are others who are not as badly affected by the second wave as they have income security. These people make up a large part of the discretionary spending. So there may be shifts, but the demand is not lost forever. The impact on demand is likely to be temporary; This could be why stock prices started rising again as the second wave subsided.
If you compare the first and the second wave, the second wave is more aggressive in terms of health, but less disruptive economically; people seem to have learned to live with it. The macro indicators such as PMI, rail freight traffic, e-waybills etc. are significantly better in wave 2 than in wave 1. Consumption will therefore have a short-term effect, but will normalize as the situation improves.
Do you expect company margins to come under pressure in FY22 due to rising raw material prices and lower pricing power?
With lockdowns and lower demand in different parts of the country, companies could currently absorb the increases in input costs. It is being gradually, but not immediately, being passed on due to which sectors such as automotive, consumer durables, etc. could feel the negative impact of commodity prices, although companies that hold raw material inventories may mitigate some of the negative impact in the short term.
For the market, the impact could be offset by sectors such as oil and gas, metals, petrochemicals, etc., which will see margins widening due to the rise in commodity prices.
Also, you need to be aware that pricing power and margin impact vary by industry. In the coatings industry, for example, where 80 percent of the market share is controlled by just four players, passing on the increase in input costs will not be difficult. But they may not immediately increase the selling price when demand is weak.
The UTI Mastershare Fund portfolio is overweight IT stocks, particularly the top performers. Do you think this sector will continue to deliver in FY22?
The pandemic has accelerated cloud migration as companies realize they need to stay connected from anywhere to stay competitive. IT spending on this part is a necessity rather than a discretion. The hesitation to move data to the cloud has been overcome. Most IT companies see short-term growth as they develop solutions to migrate customers from legacy systems to digital platforms that enable data analytics and superior customer experiences, helping customers stay one step ahead of the competition.
Mastershare took over the overweight position in IT around three years ago. The growth of the sector wasn’t that good back then, but we liked the strong liquid balance sheets, sustainable cash flow generation and high ROCE. The rating was also comfortable at the time. Now growth has returned, so we remain overweight despite rising valuations.
Financial stocks still make up a large part of most portfolios. Credit growth is still very weak and the pandemic is causing more stress for small borrowers. What does the future hold for these stocks?
There is no doubt that short-term credit risk perception has increased in financial stocks. In general, unsecured personal loans could pose a risk to many banks and NBFCs. The AAA spreads compared to G-Sec are also very low compared to the previous year. In the short term, there is really no incentive to lend to good companies, and personal loans are also very competitive, resulting in poor credit growth.
However, many banks have set aside 1-1.6 percent of the loan book as additional provisions. Banks with less exposure to unsecured retail loans, a high equity ratio and with access to low-cost CASA funds will be better placed and gain market share in the current difficult times. We expect borrowing costs to normalize, which will lead to an improvement in ROE and ROE for banks.
India is among the better growing economies, and the reforms have supported long-term growth as well. With cleaner balance sheets, banks are better placed to benefit from economic growth, and valuation is not very expensive compared to historical trends. In the financial sector, too, there are non-credit businesses with a long growth path given the current low penetration rates such as insurance, asset management, brokers, etc.
How do you rate the outperformance of mid- and small-cap stocks in 2021? Do you need to be careful with the smaller stocks?
These movements reflect the higher risk appetite of the market. Mid- and small-cap stocks peaked in 2017 and have fallen sharply since then, leading to lower valuations. But with last year’s rally, mid- and small-cap indices are valued higher than Nifty50. There is no point in looking at the earnings multiplier as earnings volatility is too high. The trailing price to book of Nifty50 is 3.4 times, while the midcap index trades 3.7 times and the small cap index 3.5 times. In terms of price-to-book value, they are more expensive.
Investors should invest in mid and small caps as part of their asset allocation and invest through mutual funds. The allocation can take place depending on the risk tolerance of the investor.
Going through mutual funds can help contain risk as fund managers use tighter filters. In our mid-cap and small-cap funds, for example, we select stocks on the basis of a high ROCE, consistent cash flow generation, the scalability of the business with a low allocation to turnaround opportunities and manage the position size in order to avoid concentration risks .