A Time for Patience and Consolidation | Value Research Investors must have a horizon of 3-5 years, believe Vetri Subramaniam and Vinay Paharia of Religare Invesco Mutual Fund, in this interview with Vibhu Vats
Interview

A Time for Patience and Consolidation

Investors must have a horizon of 3-5 years, believe Vetri Subramaniam and Vinay Paharia of Religare Invesco Mutual Fund, in this interview with Vibhu Vats

Returns in the market now will be largely driven by the underlying earnings growth rate, so investors must have a horizon of three-five years, believe Vetri Subramaniam and Vinay Paharia of Religare Invesco Mutual Fund, in this interview with Vibhu Vats.

A Time for Patience and Consolidation Vetri Subramaniam and Vinay Paharia of Religare Invesco Mutual Fund, in this interview with Vibhu Vats

How do you determine valuations in the case of mid- and small-cap stocks?

Vinay Paharia: Determining valuations is a part of our investment process. We have a fairly detailed investment process that is executed by a fairly robust and large investment team. We have an 11-member investment team as of now, which tracks, on an active basis, a universe of around 300 stocks. These stocks are tracked on various parameters that allow us to determine valuations. These valuations are a moving target, based on business performance. These parameters change from company to company and sector to sector. But an important component is that we determine a range of fair values for each individual company for a three-five-year time period. We buy into a stock when we believe that we can generate reasonably good returns in the company at the current price levels over a period of three-five years. This decision to buy is based on that company's range of fair values and its prevailing market price. Hence, there is no set definition of valuations, but it is the range of fair values that are calculated for a three-five-year time horizon.

Vetri Subramaniam: To add to what Vinay has said, one of the things we do in the investment process is that we break up companies through different categories based on the kind of return-on-equity (ROE) growth profile they have. And then we look at the valuations metrics that are appropriate for each of these companies. For example, if it's a very high-growth company, we would look at a price-to-growth kind of ratio to give us comfortable valuations. For a company with reasonable growth rates, maybe in line with the industry, we would look at the simple P/E ratios relative to growth. And if it's a company with a lot of asset value, we would tend to look at price-to-book kind of measures. In a nutshell, valuations are specific to the kind of business. But on a general basis, you will find that the fund's portfolio has a growth bias. Hence, typically, in the last seven years, the portfolio's P/E multiples have been at a premium to the benchmark CNX Midcap Index.

When do you decide to exit from a company?

Vinay Paharia: Exit decisions are broken down predominantly in three cases. The first is when the core investment argument or the investment rationale weakens. Secondly, we would exit from a stock if we identify another good opportunity that is better than the one being evaluated. And lastly, we exit from a company when the valuations move up to excessive levels.

Vetri Subramaniam: Another scenario when a stock is exited from is when the company is de-categorised by our team. A fund manager can own only what has been categorised. Hence, de-categorisation would automatically mean a sell. Of course, this sell is not immediate. But over a month or so, we would want to exit from that stock.

So if something is out of the universe, then you will certainly have to exit from it?

Vetri Subramaniam: Yes, and it also has to come through the relevant analyst. Each of our team members has sectors to focus on. If a company needs to be de-categorised, the analyst looking after that sector would discuss this with the entire team and then the de-categorising decision would be taken.

In the last one year, we saw the valuations of mid- and small-cap stocks narrowing as compared to large caps. Is this something which shows that some trouble is brewing up and the market will come down from here?

Vinay Paharia: Normally what happens is that mid- and small-cap companies, being smaller in size, are much more sensitive to changes in the macroeconomic environment as well as the interest-rate environment. So, whenever there is an expectation of improvement in the macroeconomic environment, we see higher expectations of improvement in mid- and small-cap stocks. They also tend to do much better in a benign interest-rate environment and vice versa. We are seeing both of these things in the environment right now - in fact for the past year and half. This is why mid- and small-cap companies have done better than their large-cap peers. And you're right, the valuation discount has definitely reduced for mid and small caps vis-à-vis large caps. So, the discount, as we speak now, would be about 5-6 per cent as compared to the historical average of about 16-18 per cent on a trailing-twelve-month basis.

So in this market scenario, can we expect mid and small caps to again outperform large caps?

Vinay Paharia: Once again, the investment outlook has to be fairly long term. As Vetri said, the P/E re-rating has already happened. So, now returns will be largely driven by the underlying earnings growth rate, which means earning returns the hard way. That will only pan out over a fairly long period of time, which is three-five years. So while mid and small-caps can do better than large caps, the holding period has to be of at least three-five years.

Are there any particular sectors that you think are going to outperform or you are bullish on?

Vinay Paharia: From the fund's point of view, the portfolio is constructed on a bottom-up basis. So sector allocation is a result of stock selection. As of now, we have overweight positions in two sectors - consumer discretionary and financials. Our overweight positions are driven by valuations comfort and reasonably good earnings growth available to the companies in these sectors. The biggest underweight position is consumer staples. It is largely driven by our valuations discomfort. Here, by consumer staples, I mean FMCG companies.

What is your outlook for the equity markets going ahead? Can we expect the same kind of returns as the last year again?

Vetri Subramaniam: Yes, calendar year 2014 was extremely strong. But we have been saying since the last quarter of 2014 that valuations have moved up to a significant premium to the long-term prospects on a trailing basis. So, the scope of valuation expansion from these levels is very limited. Therefore, any further progress in the market will be driven by earnings growth.

If we look at the journey the market has made from late 2011 to the early part of 2015, the market has moved from almost a 15-16 per cent discount to its long-term average to almost 27-28 per cent premium to its long-term average. The market has almost doubled if you look at the Nifty. Nearly 2/3rd of that was accounted for by the change in P/E multiples and only a third of that by earnings.

Hence, our sense is that this is going to be a challenging year. Earning growth numbers were very weak for FY15. Even for the current year, we think that things might look up a bit from these levels but it's still a difficult time for earnings growth in several industries. So, I believe it's going to be a time that calls for patience and consolidation. The P/E re-rating got done by the early part of this year. Now it's time for consolidations and earnings growth to come through. Therefore, any investor coming in now should have a three-five-year horizon. We tell people to look at the market from a five-year perspective and avoid looking at the rear-view mirror in terms of the last two-three years.


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