We have two years of good growth ahead of us. As earnings get elevated and the market remains range-bound, you will find valuations getting cheaper and cheaper.
With strong profit growth ahead, stock valuations don't appear too daunting, feels Mr Anup Maheshwari, Head of Equities and Corporate Strategy at DSP BlackRock Mutual Fund.
Even as he sounds a note of caution on commodity stocks, he says he would place his bets on sectors such as banking and software given their strong growth prospects. Mr Maheshwari has had a 13-year stint in the mutual fund industry, nine of them managing equity money. Business Line caught up with him when he visited Chennai to flag off the new DSP BlackRock Focus 25 Fund.
Excerpts from the interview:
Market gains this year have been driven mainly by expanding PE multiples for stocks. Are you concerned that the market is too expensive today?
Not really. I believe that either time or a price correction will effectively reduce market valuations so that they do not appear expensive. In the last 7-8 months the market, in terms of the index, has gone nowhere. If you take the top three index names — Reliance Industries, ONGC and NTPC — their stocks have not performed at all.
In the last two years, we have had almost zero earnings growth. Now that a recovery is happening, profit growth will be elevated over the next two years. The long term average growth for earnings of index companies is 15 per cent, but we are now looking at a 25 per cent growth this fiscal. For FY12 this may be 20 per cent. As earnings get elevated and the market remains range-bound, you will find valuations getting cheaper and cheaper.
If you do the math, today the Sensex (company) earnings are at Rs 870. At the growth rates projected above, this will grow to about Rs 1,100 this fiscal and to Rs 1,300 by FY12. Remember that just six months down the line, analysts will begin looking at the FY12 estimates. At an index level of 17000, this means a PE of 13; the market may appear quite inexpensive then. You have two years of good growth ahead of you; barring external factors like another sub-prime crisis. If growth materialises, the tendency of market participants would be to buy into dips. Even the large caps will be getting progressively cheaper. For long-term investors, this is still a market to be buying into.
I also believe that there are enough opportunities for investors even within the top 200 stocks, where valuations are not an issue. For instance, the market today does not differentiate between companies on the size of their profits.
People often compare the PE of a company with a Rs 30-crore profit with one with a Rs 100-crore profit, and say the former is cheap. But what we've seen is that there are a lot of companies that can start off and quickly get to a Rs 20-30 crore profit. But to get to a Rs 100-crore number requires something special by way of execution capabilities.
If a company has reached that Rs 100 crore, it shows that the business model is scalable and that the management has already proved itself. This is one segment of the market where you may find many opportunities. The PEs aren't rich and yet the growth potential is quite high.
Will companies be able to sustain high earnings growth with material prices rising and interest costs too heading up?
Yes, one portion of that excess earnings growth is coming from the earnings swing in commodity companies. Tata Steel has moved from a loss into profits this year and Reliance will reap the benefits of its gas finds this year.
Of the 25 per cent earnings growth estimated for the Sensex, about 7 per cent will come from the commodity change or ‘delta'. However, there is a significant other element too.
For instance, financial services now make up 25 per cent of the index and they are growing quite consistently. I believe inflation and interest rates are the two key risks to the outlook. Inflation, beyond a point and particularly in oil, is a concern. With oil at $81-82, no one is talking about it; but if it climbs to $90, the alarm bells will start ringing.
Rising oil prices have an effect on inflation, corporate earnings and the fiscal deficit as well, it can crowd out investment.
On interest rates, fixed income managers have the view that interest rates may not go up beyond a point. However, I think these risks can be managed through stock selection.
Commodity stocks have been the outperformers in the recent rally. What's your view on them now?
The sector is very difficult to predict.
The big structural change is that until the end of the 1990s, commodity prices were a function of genuine supply and demand.
This decade they have become an asset class, leading to more investment flows into the commodities. Our view on commodities is cautious. We did not participate fully in this big rise in materials.
Where we've all gone wrong is in predicting the ‘delta' in earnings of commodity companies over the past year. But commodity stocks are usually a momentum play and it is difficult to take a long-term view on them.
On pure fundamentals today, I would say commodity stocks are expensive. However, we have seen in the past that commodity stocks can get dramatically overvalued before they correct.
You've just launched a new fund that plans to focus on just 25 stocks. What underpins this idea?
Our analysis showed that there is a significant return divergence in the Indian market — across market capitalisation, sectors, and companies. When divergence is that high, you need stock selection capability; we run several equity funds with a good record. Therefore, we decided to launch a fund which will pick just 25 stocks out of the top 200 stocks in the market.
When you manage a 25 stock portfolio, there is limited room to diversify or hedge yourself. You tend to go with your high conviction ideas. It is a challenge for the investment team to deliver that portfolio. Currently all our funds are very diversified with 65-80 stocks, as we want our funds to be consistent in their returns. This is a product with potential for high returns, with possibly a bigger swing in returns. It is not meant for conservative investors.
What sectors would you be overweight on, at this juncture?
Banking and financial services will be largest exposure in the new fund's portfolio, given that it is such a large weight in the index. The next 3-5 years appear quite bright for the sector. Energy is the next largest weight in the index, but the view on energy is a little more mixed with government policy playing a big role. Capital goods is another area we are positive on, mainly based on the capex cycle picking up. The IT sector is also a big weight. Over the next couple of years, the sector will be supported by strong volume growth and pricing increases too will follow. The currency factor is negated at least partly by the flexibility that companies have on utilisation rates.
A 1 per cent increase in utilisation rate tends to neutralise a 1 per cent appreciation in the rupee. Take Infosys and look at its numbers over the past ten years.
Despite all the currency fluctuations, their operating profit margins have not varied by more than 1 per cent on account of currency changes.
We've seen a reshuffle of the PEs that sectors enjoy over the past one year. Consumer-oriented sectors such as autos and FMCGs have been rerated while infrastructure and capital goods have lagged a bit.
Where would your preferences lie today?
The call has to be stock-specific. We believe that infrastructure stocks did get a trifle overrated during the previous bull market. Even today, the sector is not exactly cheap. I'm positively inclined towards capital goods and infrastructure, but I'd like to be very selective. I think you cannot play the entire theme today as you did two years ago; you need to invest in specific pockets within the theme.
Source: http://www.thehindubusinessline.com/iw/2010/05/02/stories/2010050251730500.htm
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