'Premiums in mid and small caps don't sustain; be cautious'

Summary: Despite global uncertainty, Indian equities remain at elevated valuations. But Franklin Templeton’s Senior Vice President and Portfolio Manager believes these levels are justified. In this conversation, he explains the factors driving India’s valuation premium and why today’s valuations look more reasonable than they did a year ago.

Indian equities have enjoyed a long-standing valuation premium over other emerging markets. Ajay Argal, Senior Vice President and Portfolio Manager at Franklin Templeton Emerging Markets Equity – India, believes this distinction is not accidental. Supported by stronger GDP growth and consistently higher return on equity, he argues the premium is backed by fundamentals rather than sentiment.

At Franklin Templeton, Argal manages seven schemes with a collective asset base of over Rs 30,000 crore. Of these, the Templeton India Value Fund and Franklin Build India Fund are rated four and five stars by Value Research, respectively.

In this interview, Argal shares his perspective on why India’s high premiums are justified, his QGSV (quality, growth, sustainability and valuation) framework for picking stocks and the rationale behind his funds’ significant large-cap tilt.

India has enjoyed a valuation premium over other emerging markets for a while now. With global uncertainties still high and valuations stretched, do you think this premium is still justified?

Historically, India has consistently enjoyed a premium over other emerging markets, with strong reasons to support this distinction. To simplify, there are a couple of main factors.

One is growth, which has been higher than most other emerging markets over a long period of time. During this period, there were phases when it seemed we weren't experiencing that kind of growth. However, when you look at longer time frames, such as three years, five years, 10 years, 15 years and even the last 25 years, our growth has been consistently higher. Even now, if you look at various economic projections for gross domestic product (GDP) growth, which then flow into topline growth for companies, India remains higher compared to other economies worldwide.

As we are all aware, a global slowdown has occurred, resulting in slower growth for most economies. India's GDP growth has also declined, but it remains the fastest-growing large economy, which is reflected in faster topline growth for companies. That's one reason, and we don't see it changing anytime soon, at least not over the next five to 10 years.

The second reason is return on equity (ROE). The ROE of the Indian corporate sector, particularly in the listed space, has consistently been higher than that of most emerging markets and, of course, developed markets. In developed markets, the cost of capital is lower. In India, on the other hand, the cost of capital has been higher, and remains high, although it has decreased. More importantly, ROE has been high because company founders have always been very focused on return ratios. That, again, is driven by capital deficiency. Capital has not been readily available. The capital market in India has developed over the last four to five years; however, before that, it was not as well-developed, making it challenging to raise capital. Even now, the bond markets are not very deep. Earlier, when India was not on such a strong macroeconomic footing, obtaining money from outside always involved risk. When you added the forex hedging cost, the cost of capital was not low. That's why ROE has always been high.

For these reasons, India has commanded a premium. Over the last 10 years, the average premium has been around 60-70 per cent in terms of the ballpark P/E (price-to-earnings) multiple of India compared to emerging markets. At times, we've traded at 110-120 per cent premium as well, like last year. Now we've come down, but only to the average premium. So yes, we are still at a premium, but in our opinion, it is not exorbitant anymore. From a relative perspective, we are definitely better off compared to last year, when valuations were a bit higher.

Last year, you highlighted how mid- and small-cap stocks were trading at extreme premiums to the Nifty. Even after some correction, flows into these segments remain strong. Do you think fundamentals have caught up now, or should investors still be cautious?

It's a bit of both. As you rightly highlighted, there has been both correction and growth, especially in mid-cap stocks, and more specifically, the mid-cap stocks that form part of the mid-cap index as defined by the regulator.

Those companies have actually shown fairly decent growth. Their growth has been higher than that of large caps, at least in terms of profit growth, and especially in the last 12 months since the market peaked last September. In that sense, there has been an improvement in valuation.

However, at the same time, there is still a premium for mid caps, possibly around 30-35 per cent, versus large caps. And when I say 30-35 per cent, I'm comparing the mid-cap index to the Nifty index.

If you examine small caps, the situation is somewhat different. Small caps have actually had weaker growth than large caps. They have also corrected, but because the growth hasn't been significantly different from that of large caps, their valuation premium has remained at about 10-15 per cent compared to large caps. As I had highlighted the last time we spoke, they typically trade at a discount. From that perspective, both mid and small caps still appear on the higher side in terms of valuation; however, for mid caps, this is somewhat balanced by their higher growth.

It is always advisable to remain cautious, as such premiums have not been sustained historically. There are two ways this can correct: through an actual market correction or a time correction, where growth continues, but returns don't rise as much. That's basically what we've seen in the last 12 months. So, we would still advise caution.

Through our bottom-up investment process, utilising the QGSV (quality, growth, sustainability and valuation) framework, we are currently generating more ideas in the large-cap space compared to the mid- and small-cap spaces.

You've often described your style as Growth at a Reasonable Price (GARP), using the QGSV lens (quality, growth, sustainability and valuation). In today's market, where liquidity is abundant, valuations look stretched and domestic flows dominate, how are you applying this framework?

The QGSV framework has been tried and tested for many years. It's the framework Franklin has been following for 20-25 years, having seen various cycles and worked across them.

If you break down QGSV, one part is sustainability. We need to examine whether the growth is sustainable. By sustainability, we mean whether the growth is temporary, lasting only one or two years, or long-term, spanning three to five years. Typically, when we build our bottom-up models on a stock-specific basis, we examine more extended time frames. We even have 15-year, 20-year and 30-year models. Of course, they are only as good as the assumptions, but they provide a framework and some guidelines on what kind of growth is needed to justify the current market price.

So, we still apply the same framework of valuations. That's where the 'reasonable price' in GARP comes in. This is very important because, as we've seen in the last few months, growth from many sectors has not been very encouraging, which is why there has been a lot of sector rotation. It's not as if one particular sector has shown euphoric growth. In this environment, it becomes even more critical to anchor ourselves in solid valuation parameters.

Our framework combines both qualitative and quantitative factors. Quantitatively, we examine sustainability, valuation and growth. Qualitatively, we assess a company's management's track record, the industry's evolution, the company's current position and whether it has consistently delivered on its financial targets in the past. In times of euphoria, companies may not get punished enough for disappointing results because liquidity is abundant. But in relative terms, companies that meet these qualitative and quantitative checks offer better odds of success. Hence, we continue to adhere to this framework, and we are still generating a sufficient number of investment ideas. Over the cycles, this approach has consistently proven effective.

Both your Value and Focused Equity funds have strong long-term records. However, they have lagged in the past year. Do you see this as a style cycle at play, or a signal to reassess some portfolio calls?

It's a bit of everything. The signal to reassess a portfolio call is a continuous process; we are already doing it.

As you rightly highlighted, in the short term, there may have been some performance challenges on a stock-specific basis. However, even otherwise, we conduct attribution analysis on all our funds every month, and sometimes, even more frequently. We are fully aware of which stocks are performing well for us and which are not, and that provides us with a dashboard to evaluate what we want to do with those laggards. It doesn't necessarily mean we will exit them, but it prompts us to re-evaluate whether we are making any mistakes or whether there is some new information we haven't factored in.

As you've also noted, when looking at the longer time frame, we are in reasonably good shape. For instance, in the Focused Fund, on a three-year, two-year and even one-year basis, we are roughly around the median. Ideally, we would like to be towards the upper half of the second quartile. Right now, we're not there, and we acknowledge that. But on a five-year basis, we are in the first quartile. That reflects our style; we aim for sustainable performance. In the short term, we aim to be in the upper half of the second quartile and in the long term, we aspire to establish ourselves in the first quartile firmly. That's broadly how we are positioned in the Focused Fund.

In the Value Fund, as you have rightly pointed out, style has played a big role. Over the last 12-15 months, value stocks have not done well. As I mentioned during our last meeting, at that time, value stocks and growth stocks were trading at similar valuations. However, as we know, value stocks don't exhibit the same growth as growth stocks, making it look challenging. Even now, there has been some correction in value stocks, but in many cases, it is still not enough. And if you examine competitor performance, the key difference is that we run our Value Fund strictly on a value-based philosophy. From what we observe, many competing value funds are being managed in a manner similar to diversified funds.

We have adhered to this discipline, but the type of stocks we have been buying haven't performed well recently. If you examine value-oriented indices, they have underperformed the broader indices, such as the NSE 500, by anywhere between 6 and 8 per cent over the last year. So yes, style has definitely had an impact on the Value Fund's performance.

You run all your funds – Focused, Value and Dividend Yield – with a noticeable large-cap tilt. What's the underlying rationale for maintaining this tilt across different strategies?

That is not by design. Due to the current growth-versus-valuation dynamics, our bottom-up investment process is generating more ideas from the large-cap space.

And it's not just in the funds that I manage. If you look at our Flexi Cap Fund, which I don't run, it has a similar large-cap weightage. Thus, it's really the investment process itself that places a lot of emphasis on growth and sustainability, and at the same time ensures all of this comes at a reasonable price. Currently, those parameters are generating more large-cap ideas. But that doesn't mean it will always be the case.

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