Valuations are now affordable

Sankaran Naren, the CIO of ICICI Prudential Mutual Fund is cautiously treading the current market scenario.

We seem to be facing a situation with a strong possibility of the economy moving on a downward spiral and the government regressing to governance methods used in the 70's and 80's. What is your view of this situation?
One must keep in mind that the current situation has largely been the result of government measures in the past. Some measures taken were capping the Liquidity Adjustment Facility (LAF) to Rs 35,000 crore, not resorting to Open Market Operations (OMO) and increasing the repo rate resulting in interest rates touching double digits. Government measures such as ensuring reduction in gold imports, thereby reducing trade deficit to about $6.7 billion a month, are some measures that have helped the capital markets. The result has been a strong foreign exchange reserve of about $281.29 billion. At the current dollar-rupee exchange rate of Rs 61.98, the country's rupee reserves are very comfortable.

There has been a sea change in FIIs' view on India. Last year, in spite of the country facing the highest level of trade deficit and current account deficit, dismal monsoons and significant deterioration in growth rates, FIIs were investors (specifically between August last year to May this year).

Currently, the country's performance is on an upturn; trade deficit is reducing, we have experienced good monsoons this year and there is a slim possibility of crude prices moving up. What is interesting is that FIIs were investors when macro indicators were adverse. Let's consider one such indicator-- inflation. A year ago, inflation was high and expectations were that it would stay up or possibly even move upwards. What was unexpected was a fall in crude prices, which in turn, actually marginally reduced the inflation rate. This assumption resulted in equity market players dealing with an unexpected market reversal.

As a value investor, does the current situation become challenging considering that your outlook is positive?
We are fortunate to be holding cash rich companies which are currently trading at extremely low valuations. And at this point of time, what is of concern is that if there is a particular public sector unit trading at 7 times earnings and dividend yield, there is a possibility of disinvestment at 6 times earnings and dividend yield. This will result in erosion of value for existing shareholders. Here, the government could intervene and get the corporates to offer dividends that would not require the disinvestment exercise. This will help reduce fiscal deficit without having to disinvest at a low PE. But dividend yield will not actually compensate for magnitude of money that is required. Unfortunately, current regulations to bring public holding to a minimum of 25 per cent had compelled corporates to disinvest at rock bottom valuations. However, this year, disinvestment will be done based on purely business reasons and not regulatory issues.

Besides public sector companies, where do you find compelling opportunities today?
Currently, most small- and mid-cap stocks are valued at far below their intrinsic value. In fact, a number of stocks are available at values that are below even the real estate values of their factories. Reasons for this could be certain environmental approvals pending, cash flow mismatches, etc. These reasons can be corrected, which will result in better valuations. My view is current low valuations are more of a confidence problem than a fundamental problem. A change in focus from reducing deficits to reviving growth will resolve this problem.

Considering the Discovery Fund in particular, in your view, which companies could be value traps and should therefore be avoided?
We have maintained a largely diversified portfolio in our Discovery fund in order to avoid getting adversely affected if a few stocks become value traps. We believe that companies which are dividend paying, leaders in their field, holding valuable assets, with remarkable capabilities to implement projects and are not over-leveraged or exposed to foreign currency loans, cannot become potential value traps.

Considering the current polarisation in valuations with most corporates being under-valued, how do you derive your conviction?
Investing when the sentiment is poor has historically proven to be a winning strategy. In fact, when investors put money in the markets during good times, they have usually faced losses. Historical examples are investing in technology in the year 2000 and infrastructure in 2008.

In your stock selection, what is your advantage? Where do you derive your edge?
Our assessment of business cycles during the period 1998 to 2008 and the year 2008 itself reflect on outcomes when the market turns negative. These periods have helped us assess companies that ride these business cycles. In fact, some of the mid-caps in our Discovery fund are actually at their 52-week highs due to sound management and good business decisions.

It is only knowledge and experience that can help you select the right sectors and stocks. Currently, we are extremely cautious and are especially averse to economic sensitive sectors.

Currently, is there any specific market segment, capitalisation, sector or theme that you find attractive?
We are positive on the growth oriented export sector. As against this, we are cautious about the consumer sector which we believe is currently over-valued. We prefer to consider other attractive sectors that are currently, in our view, under-valued.

Do you come across small and mid-sized companies which you would otherwise like to buy but cannot because of liquidity issues?
It's true that some smaller stocks are unattractive in any situation because of difficulty in accumulation. However, our experience of 2008 and 2009 shows that well-researched companies receive attractive block offers which provide exit opportunities.

What is the silver lining? What do you believe will cause a market turnaround?
Only in a situation of growth can the market turnaround be sustained. Factors such as falling crude prices or favourable political developments can cause investors to believe that growth can be achieved. There are a number of reasons that could trigger growth. At the global level, there could be factors that could affect the Indian markets such as the US government's decision to extend the QE process. The equity markets are being increasingly linked to growth in contrast to the debt markets where investors simply need patience especially in the current high interest situation.