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Treat equity investments like bamboo tree

Earnings revival may be slow but should happen with adequate liquidity, lower interest rates and increased government spending, says Nilesh shah, Managing Director, Kotak Mahindra AMC

One waters the bamboo tree for four years and nothing happens. The seed remains in the ground. In the fifth year, the bamboo tree goes to touch the sky. In equity, the fifth year can be any year, says Nilesh Shah. In this interview to Value Research, he asks investors to keep faith in the India story.

Treat equity investments like bamboo tree

Year 2015 was brutal. Most people went wrong in predicting the market direction in equity as well as fixed income. What caused this?
Beginning calendar year (CY) 2015, we predicted that equity would do well, though not as much well as in CY14. In the first half of CY15, the Nifty went up by about 9 per cent. However, it ended the year down by about 4 per cent. Most of our equity funds did well by outperforming benchmark indices between 4 and 8 percentage points, but overall returns were not up to investors' expectations. In hindsight, we went wrong in predicting the impact of China, below-average monsoon and a delayed recovery in corporate profitability. We predicted that interest rates would be cut in CY15. The RBI did cut repo rates by 125 basis points, but ten-year gilt yields remained almost unchanged. We underestimated the deficiency in monetary transmission. CY15 again taught us that markets are unpredictable.

Why is China important for our market? What other global factors should we watch out for in CY16?
China has a disproportionately higher share in global growth and commodity markets. Last year China produced more than half of the global steel output. It consumed more cement in the last two years than what US has consumed in the last 100 years. China is dumping goods to keep its massive capacities running. Our corporates get adversely impacted by this dumping. China has a large weightage in emerging-market indices. Their fall adversely impacts the index performance, resulting in redemption pressure. Indian markets suffer collateral damage due to redemptions by global emerging-market funds, resulting in FII outflows. China has a Rahu effect on the Indian economy through dumping and a Ketu effect on the Indian market through FII outflows. China is also looking to depreciate its currency, despite holding $3.2 trillion of reserves. Any currency depreciation by it will require a competitive reaction from our side, which will keep fresh FII flows on tenterhooks.

The US Fed raised interest rates by 25 basis point in December 2015 after almost a decade. Unless the pace of Fed rate hike is more than that factored by the market, any correction in equity or debt markets on account of the US Fed rate hike will be an opportunity to buy. If we are lucky, we may benefit from delayed Fed rate hikes due to Chinese turmoil.

How do you expect the equity market to move in CY16
In CY15 the rural economy, exports and private-sector investment were on the back foot. The rural economy is under stress due to the second-consecutive below-average monsoon. Exports suffered from weak global growth and relative appreciation of the rupee against emerging-market peers. Private-sector investments were on the back foot as many leveraged bets of the past did not give a good experience to entrepreneurs and bankers. We estimate that in the first half of CY16 these trends will continue.

The FY17 budget will be crucial. On the one side, the FRBM (Fiscal Responsibility and Budget Management Act) target of 3.5 per cent fiscal deficit to GDP has to be maintained. On the other hand, the Seventh Pay Commission's recommendations and One Rank One Pension scheme, which are going to cost about ₹1,10,000 crore, have to be provided for. The government has to spend on roads, railways, defence and other infrastructure sectors to support the economy. The government has to provide for the recapitalisation of PSU banks, considering the NPA situation. If the budget raises taxes and borrowing, then the markets will weaken. If the budget monetises assets like SUUTI holdings, then the markets will strengthen. India has never suffered a hat trick of below-average monsoon. La Nina augurs well for a good monsoon in CY16 and should support the revival of the rural economy. Passage of key bills like the bankruptcy code, GST, labor reforms and land acquisition, along with administrative reforms to increase the ease of doing business, will support the market uptrend. India has to repay $30 billion of FCNR (B) deposits in September 2016. While we have adequate reserves, a large outflow can impact the rupee. A sharper depreciation of the rupee will have an adverse short-term impact on interest rates as well as FII flows. The tenure of the current RBI governor is coming to an end on October 16. An extension of his tenure will be viewed positively by FIIs.

Revival of corporate earnings will be the biggest driver for the markets in CY16. Earnings revival is likely to be slow but should happen with adequate liquidity, lower interest rates, good monsoon and increased government spending.

What sectors should one look at in equity markets?
Current Nifty valuations, at around 15 times FY17 earnings, are hovering around fair value. At this level, one can have a normal allocation to equity. The best way to invest in equity will be through a systematic investment plan (SIP) or a systematic transfer plan (STP). Unless you can become a Kumbhkarna, don't invest in one go. Currently, large caps, having witnessed FII selling, are better placed than mid and small caps from the outperformance point of view. In CY15, stock picking was very critical to generate performance. In the banking sector, PSU banks and corporate-lending-focused private-sector banks gave negative returns, while retail-focused private-sector banks gave positive returns. We expect CY16 also to be a year of stock picking. Within that limitation, we estimate that sectors that are linked to urban consumption, like auto, consumer durables and affordable housing, will do well on the back of the implementation of the Seventh Pay Commission recommendations. We are bullish on the sectors linked to public spending, such as construction, capital goods and cement. The dark horse for CY16 could be rural-consumption-related sectors if the monsoon is normal. If you can't spend adequate time on research, then it will be better to invest through mutual funds. Air B&B becomes the world's leading hotel company by converting your house into a hotel room without owning it. Uber becomes the world's largest cab company without owning a taxi. In this era of disruption, one has to devote enough time to stock research.

FIIs have been selling Indian equities since mid-2015. Will they continue to sell?
FIIs were net buyers of Indian equities worth over $6 billion in the first half of CY15, driven by inflows in India-dedicated funds and ETFs. In the second half, we saw selling by FIIs of $3 billion, especially from pension funds and global emerging-market funds. If FDI flows are an indicator, there is hope that FIIs will turn buyers of Indian equities sooner than later in CY16. We need to market investment successes like Maruti Suzuki, which is today valued higher than its parent, Suzuki Japan. Maruti has been one of the best-performing auto stocks globally in dollar terms. Many of our IT companies over last ten-15 years have delivered better returns in USD terms than Microsoft, which made Bill Gates the richest person in the world.

Domestic investors have been pouring money in equity funds. How soon can they expect the achhe din to come for them?
Domestic investors have supported the equity market by investing about ₹72,000 crore in equity mutual funds in CY15. We have collected more money in equity funds in last two years than in the previous ten years. Investors have got much lower return than their expectations. We owe a great deal to them. We need to engage with investors to make them keep their faith in Indian economy as well as equity markets. If they redeem, then we will lose them for a long period of time. My request to your readers is that they should treat equity investments like a bamboo tree. One waters the bamboo tree for four years and nothing happens. The seed remains in the ground. In the fifth year, the bamboo tree goes to touch the sky. In equity, the fifth year can be any year. Keep faith in the India story.

What about fixed income? Why gilts are unchanged in spite of the RBI cutting policy rates?
We expect the RBI to cut repo rates by 50 basis points evenly spread across CY16. Inflation and adherence to fiscal targets will be a crucial factor for the RBI to further cut policy rates. India has never suffered a hat trick of below-average monsoons. La Nina augurs well for a good monsoon in CY16, supporting a moderate inflation trajectory.

We will have to watch the quantum of borrowing programs in the budget for FY17. If the gross-market-borrowing program increases by ₹50,000 crore plus, then it can put upward pressure on the yields. Banks which are the largest buyers of gilts are running excess statutory-lending ratio (SLR) to the tune of ₹6,00,000 crore plus and hence their appetite will be limited at lower yields.

The government has announced Project Uday, whereby the dues of state electricity boards will be replaced by state-guaranteed bonds without an SLR status. Many investors will find such bonds attractive, thus putting upward pressure on the SLR bonds.

We expect majority of return in CY16 to come from coupon income rather than capital appreciation. We estimate that credit-accrual funds are likely to be better performers in CY16 as they have a high carry. One obviously needs to be aware of the credit risk in such funds.

What about gold? Is there any sense in its rally in January 2016?
Gold prices have fallen by almost 40 per cent from the top in dollar terms. The fall is limited in India due to the levy of import duty and rupee depreciation. When people buy gold in small denominations, they pay a significant premium ranging from 5 to 40 per cent. Gold ETFs are a better bet than physical gold in smaller denominations. Doing SIPs in a gold ETF is certainly safer than doing SIPs with jewellers. Since gold has rallied in January 2016, it might be worth waiting for a correction before investing in it.

This interview appeared in the March 2016 Issue of Wealth Insight.