Market Rise to Continue

Even as Indian equity markets touch a new high and valuations turn expensive, Harshad Patwardhan, Executive Director and Head of Equities at JP Morgan Asset Management India, says that markets are in a 'sweet spot' and going forward they will be driven by further re-rating and earning upgrades. In an exclusive interview with Value Research, he shares his investment strategies and how spotting opportunities is more difficult now as compared to a year ago.

What will be the key factors driving the markets from here?
Markets have performed well over the last 12-15 months and we believe this trend will continue over the next few years. This view is contingent upon two factors. One is clearly the cyclical recovery in the Indian economy. The Indian economy had bottomed out well before changes in the political climate and was due for a turnaround, the extent of which did depend on the election outcome. Beyond GDP, we also believe the profitability of the corporate sector in India has also bottomed out. Looking ahead, we expect the gross domestic product (GDP) growth to rise from 4.5 per cent currently to 7 per cent over the next few years and corporate profits to also trend upward proportionally to the GDP.

The second factor that will drive markets is structural reforms. Over the last six weeks, particularly after elections in Haryana and Maharashtra, we are really seeing evidence of the government taking the matters seriously. Many structural issues are being tackled, though it would be unwise to think that everything will happen overnight. The government is working to introduce the Goods and Services Tax (GST) as early as possible. It has also made announcements regarding foreign direct investment (FDI) in the railways and defence sectors. It brought life to the whole concept of 'make in India', which continues to garner a following, especially with our PM's visits abroad. Finally, attention to labour laws and modification of land acquisition bills are on the horizon. Again, it's important to keep in mind that these initiatives will not change anything overnight; however, the focus is clearly set on improving the ease of doing business in India, which is great news for the corporate sector. With these structural reforms and the expected rise in growth rates, the government is also looking to contain possible inflation that could result from this growth. With growth and inflation in fine balance, the government can focus on reducing the costs of doing business in India, improving the ease of doing business and ultimately, attracting more investments.

Thus, as stated, our outlook on the equity market is based on cyclical recovery and structural reforms. We do not believe that market valuations are particularly rich. There are certainly parts of the market with highly valued segments, as reflected in the stock prices. But that is not true for the market as a whole. If you look at Sensex on a one-year forward basis, it is trading at 15.8 times earnings, which is still below the peaks we had seen in the last bull market, specifically in 2007-08, when price/earnings (P/E) multiple had reached 21.4 times. We think we are still far from reaching that bubble territory at this point of time and from here, markets will be driven by both further re-rating and earning upgrades.

Looking further at our expectations of earning upgrades, earnings growth expectations is in the high teens. In the previous up-cycle, corporate profits as a percentage of GDP peaked at around 7.8 per cent, and in the downturn that followed, these profits bottomed at 4.2 per cent. We believe that in the next four years, this ratio will go back to its long-term average of 5.6 per cent and that in itself would mean a 22 per cent compound annual growth rate (CAGR) in earnings. We believe we are in a sweet spot right now and have high convictions in earning upgrades as well as re-rating helping drive market performance.

Lastly, it is important to mention that this fundamental view is also supported by liquidity. If you look at the flows from international as well as domestic investors, you will notice that domestic investors were out of the market and have been net-sellers for the past few years. We have seen that cycle turn with positive domestic flows. After a long time, we now expect both foreign as well as domestic investors buying into the Indian market. The last time this happened, in 2004-07, the stock market rallied, delivering more than 40 per cent each year in three out of four years.

Given the situation what will be your overall investment strategy?
Based on our hypotheses we explained earlier, we are overweight on certain sectors such as industrials (which includes engineering, construction and product companies). We also think cement as a sector will benefit in a meaningful way from both infrastructure investment and home building, especially given the government's focus on affordable housing. Third, we are positive on financials as they are clearly much levered to growth. Finally, we are positive on automobiles, which also includes auto ancillaries and passengers cars. These are the few sectors where we have high conviction, and our portfolio is geared for the expected growth in the economy.

On the other hand, we are not positive on the commodity sector, given continued price weakness and the increasing strength of the US dollar relative to other currencies. We are also not positive on telecom and metals on a relative basis.

Markets are touching new highs, have you made any significant changes in your portfolio?
We have been fundamentally positive on the market and economy for over a year irrespective of political outcomes. A strong government has only reinforced our conviction and hence our sector positioning has remained broadly unchanged. Yes, markets are touching new highs on a regular basis, but reactions at the individual stock level are much more pronounced than at the market level. There are many stocks that have gone up several times in the past year. Key to our investment process is to identify those stocks whose prices may have accelerated too fast, actively book those profits and then reallocate that capital.

Given the spurt in stock prices in recent months, are you finding it difficult to spot opportunities?
We are still finding opportunities at this point of time, though it's not as easy as it was a year ago. Last year seemed to be a no brainer for investing in equities, especially in the mid- and small- cap space, given cheap valuations. Over the past 12 months, mid- and small-cap stocks have risen sharply and many are trading at three to five times the valuations a year ago.

Our conviction in equities remains strong, especially with a supportive government along with a very credible Reserve Bank of India (RBI) governor who is committed to tackle inflation. Both the government and RBI are setting the stage appropriately for a sustainable recovery in the Indian economy. Sustainable recovery means that even at the higher growth rate, you might not see the vicious problem of inflation as we had in the last cycle. Together, this should result in sustainable growth of corporate earnings over the next few years. If we go back to 2003-08, Sensex, which is a proxy of large-cap companies, witnessed a compound annual growth rate (CAGR) return of 25 per cent. I would not be surprised if we could see that kind of growth over the next few years.

I would also add that last year whatever you might have bought would have gone up by two-three times. Going forward, that is less likely going to happen. Stock selection will be key in generating returns going forward. That is why our bottom-up stock picking investment process is so important. For example, not all construction companies will do well over the next 12 months as they did in the last 12 months. Our focus will stay on handpicking the companies that will rise above the rest over the long term.

What is your investment strategy for JP Morgan India Equity Fund?
Each of our funds follows a different mandate. The JP Morgan India Equity fund is a multi-cap fund. In this fund, we will buy anything from large-caps to mid-caps and small-caps. If you look at our portfolio composition, our sectoral positioning remains largely in line with our equity funds platform. The main reason is that our world view will not differ when going from one fund to another. In our JPMorgan India Mid and Small cap Fund, our universe is bottom quartile of the market capitalization. In our JPMorgan India Top 100 Fund, it's purely a large-cap fund and we don't invest in mid and small cap stocks. For our funds, the overall difference is in the mandates but our strategy and positioning is similar. We want to identify businesses which will benefit from a positive macro scenario unfolding. If you ask me about our style, we try and find more 'compounding' stories that will keep growing at a rapid pace, hopefully, without the injection of capital.

Beside the lock-in period of three years, what is the key difference between JPMorgan India Tax Advantage Fund and JPMorgan India Equity Fund? (Both the funds have identical portfolios.)
The JPMorgan Tax Advantage Fund and JPMorgan India Equity Fund are both managed as diversified multi-cap funds and are benchmarked to the BSE 200 index. So it is only natural that the portfolio will resemble each other, especially from a philosophical standpoint. But I won't say they are identical because there are some stocks which are only in the JPMorgan India Tax Advantage fund and not in our Equity Fund. The primary difference is that the JPMorgan India Tax Advantage Fund has a taxation benefit and a three-year lock in period, while the other is a pure open-ended fund.

How do you approach mid-caps and small-caps for JPMorgan India Mid and Small Cap Fund?
In the JPMorgan India Mid and Small Cap fund, our universe includes stocks from the bottom quartile of the market capitalisation of stocks listed on the National Stock Exchange (NSE) or the Bombay Stock Exchange (BSE). Apart from that, we also follow a mandate that 65 percent of the assets under management (AUM) have to be invested in the bottom quartile of the market capitalisation at any given point of time and that rule is followed very strictly. Even in this fund, like other equity funds, looking for 'compounding' stories remains the same, but our effort is to find such companies that are small in size. So we want our investors in this fund to gain from faster earnings growth as well as re-rating. Though we look at stocks from the bottom quartile, we do not compromise on 'quality'. We all know that only a handful of people track mid-cap and small companies, so it also becomes increasingly important that we conduct a strict in-house due diligence process which we continuously monitor.

How long is your watchlist which is not part of the portfolio and how do these stocks enter the portfolio?
Typically there would be around 150-175 stocks that would be on our radar on a continuous basis. There are various filters we comb through before a stock can enter our portfolio. We have numerous interactions with corporate management teams, including both my team in India and our team in Hong Kong. We follow a rigorous due diligence process, which includes understanding the business, assessing management and building our conviction in the company. After carrying out such tasks, we meet companies, including their competitors and suppliers, to get a full in-depth picture of the company. Before investing, we also look at the re-investment opportunity by that company, which remains a very important factor in our research. We are looking for companies that can grow five times or ten times in the next five-ten years and we spend a lot of time understanding this aspect because that's where we will find the winners. We also look at financials and valuations, which include return on equity (ROE) and return on capital employed (ROCE). Last but not the least, sizing the bet and managing risk are important factors and we spend lot of time on such issues. This is the process we follow on a regular basis and only stocks with this merit enter our portfolio.

What kind of stocks never enter your portfolio?
One of the most important aspects in our fund management is that whenever we look at any company, we also look at its history of management/ promoters. If historical evidence suggests that minority shareholders have not been rewarded, then we try and avoid such companies. Business economics and management remains key across our funds.

This interview appeared in the January 2015 Issue of Mutual Fund Insight.