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Note of Caution about Current Valuations & Corporate Earnings

If stocks in a fund's portfolio are not liquid, then the NAV is not a real NAV, says I V Subramaniam, Director, Quantum AMC, and CIO, Quantum Advisors

Even as most Indian portfolio managers have been gung-ho about markets, I V Subramaniam, Director, Quantum AMC, and CIO, Quantum Advisors, sounds a note of caution about current valuations and corporate earnings not matching up to expectations, and about the liquidity risks in mid- and small-cap stocks.

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Note of Caution about Current Valuations & Corporate Earnings  I V Subramaniam, Director, <a href=Quantum AMC, and CIO, Quantum Advisors" >

Quantum's equity funds hold quite a bit of cash now. You've said that you are worried about high valuations. What is the trigger that you're looking for to redeploy that cash?
It's not exactly a trigger as much as finding the valuations that are attractive. Now, there are two things which can make me get fully invested in equities. One, stock prices have to correct and the P/E ratio has to become more sensible for us to invest in stocks, given the kind of earnings growth rate which we are seeing. Or I have to really become convinced that earnings growth will be much faster than what it is right now, in which case I may relook at my numbers for individual companies. Right now, I don't see these triggers. After the elections, we have been meeting many companies and the assumption of massive earnings growth seems to be only on paper. The ground reality has not yet changed dramatically.

Companies are still struggling, either in terms of driving sales or improving margins. Take infrastructure stocks, where the hope has been the highest. We are not seeing any massive pick-up in order inflows. I don't expect capex in the private sector to pick up immediately because we're sitting on a lot of excess capacity across industries. So, whatever capex has been done in the past, that has to be utilised before they start to announce new projects. That's only one example. But if I see automobiles or FMCG, most of the growth has not come not from volume growth but from prices. So, we feel valuations are expensive. I may add the odd stock here and there. But it is not yet time for me to take a macro call, saying that India's GDP will grow faster than assumed.

Isn't the fall in raw material prices globally a kicker to company earnings?
Broadly speaking, what you're saying is true. But you have to look at each individual sector. When raw material prices fall, if the competitive intensity is very high in that industry, then most likely selling prices will also fall. The companies will offer more discounts. So, you may find some volume pick-up, but margins may not necessarily improve dramatically. And falling prices also indicate that globally, growth is not really picking up. That means that our export growth will probably not boom. Exports too drive GDP growth. In some industries like FMCG, companies always thrive when inflation is high because then a lot of these local mom-and-pop brands in smaller towns find it difficult to manage their businesses and just close down. With commodity prices falling, companies will actually have a situation wherein local brands come up and compete. I remember that in 2008-09, when the earlier commodity cycle had come down, automobile companies managed to hold onto their prices. Therefore, you had margin expansion. This time around, I don't think that is happening.

There are some sectors in which we are seeing concrete reforms: the reallocation of coal blocks, the diesel subsidy being done away with and the passage of the insurance bill. Do these create any opportunity for investment?
The insurance act may not be a big trigger. This is a long gestation business and just because a bill has been passed doesn't mean that everybody is going to come to India. So, it's an indication of reforms, but I don't see it having an impact on earnings growth. From coal auctions, yes, utilities could benefit. From diesel and oil reforms, oil companies could benefit. So, we have exposure to oil and natural gas and to utilities. Also, some companies will indirectly benefit, but that won't make me dump a lot of cash into the market yet.

In the last eight-ten years, it has been consumer-facing sectors like FMCG and auto which have created a lot of wealth. When will the turn of industrials come?
It will come when the current capacity utilisation improves. So, first growth has to pick up, which means people's ability to buy should improve. This will probably happen when inflation is under control. When people have more cash and disposable incomes, they will start to spend. As growth picks up, the capacity utilisation of industries will also pick up. Once this happens, then businessmen will also start to plan the next phase of growth. In certain industries, like metals, globally there is a surplus capacity. So, there you have to be doubly careful before you announce capex because the commodity can be imported. But branded products may not be imported, cement may not imported.

Isn't this going to take many years to play out?
The moment sales growth picks up, capex will begin because it takes time to set up a new project. So, as sales pick up, we will have people looking for land, placing small orders. Hence, it may not have to be very long.

Many NFOs are happening in the mid- and small-cap space. Individual investors are also very interested in that space. What is Quantum's view on this space?
From our philosophical standpoint or from the standpoint of Quantum Long Term Equity Fund, we have always invested in companies which were very liquid, which means that trading volumes have to be quite high. Holdings need to have trading volumes of at least a million dollars a day. Some companies in mid caps meet that criterion but many don't. But having said that, to launch a full-fledged mid-cap fund, the menu has to be large enough and we have generally seen that small caps tend to do well only when there is a lot of money flowing into the market. If there is a big correction or if one round of redemption happens, then it becomes very difficult for fund managers to get out of these small companies. The investor is stuck. Therefore, in small caps we may not do anything immediately. But in the mid-cap space, we are open.

In our Long Term Equity Fund, we have many mid caps. If you see our factsheet last month, you will find stocks like Indian Hotel, PTC, ING Vysya. They are presently mid-cap companies but they're also liquid.

If the stocks you own are not liquid, then the NAV is not a real NAV. As you invest, the stock price moves up, your NAV will look better, but the moment there is a correction like the one in 2008, you find that you can't liquidate mid caps and small caps at the price you quoted.

If you look at long-term charts from 2005, the Sensex has done better than both the other indices, BSE Mid Cap and BSE Small Cap, from a returns perspective. But if you look at only last two years, from July or August 2013, then, of course, small caps and mid caps have done better than large caps.

The market is turning quite volatile at the prospect of US rate hikes. How will it impact equities? Though there was a lot of fear ahead of the taper, it was relatively a smooth transition.
The US rate hike will have an impact because not all FPIs who have come into India have come in with a long-term growth focus. A lot of leveraged money has come into the market too. When interest rates go up, the calculation on returns and leveraging will dramatically change. So, it will have an impact.

A substantial portion of the money has also come into the bond market. If there are outflows, this will impact the currency. So, a person who is investing for dollar returns, if the currency wipes out his returns, may also want to exit. Long-term investors may look at this as an opportunity to enter India. But this will not happen simultaneously. So, it could be a very volatile period.

And how do you prepare for it?
You can't prepare for it. What is under our control is the analysis of companies and what valuations you will be willing to pay. If I buy a stock with a lot of margin of safety and there is a stock price decline, I would be happy adding to it because I know fundamentally it is a sound stock. But I don't want to simply look at the market today and say India will grow, so I will keep buying. That will be a big mistake.