'There are attractive opportunities overseas'

Which pockets of the market look attractive after the recent fall? What made mid and small caps fall like a ton of bricks? How should investors now approach SIPs and asset allocation? Rajeev Thakkar, Chief Investment Officer and Director at PPFAS Mutual Fund, took time out for a long breakfast conversation with Aarati Krishnan to offer candid answers to these questions. Here's the interview.

It is said that a new bull market is born when the last optimist throws in the towel. So, after the recent correction, do you see such capitulation in the market?
No, not yet. I don't see signs of that. Yes, there are pockets in the market where value has started to emerge. But during the uptrend, valuations went to such an extreme that a lot of names are not cheap yet, despite the fall. Take the entire consumption space for instance. Leading stocks like D-Mart, Page Industries, Britannia, Nestle India are nowhere close to their 2008 or 2013 valuations or even close to their average long-term valuations.

Are you seeing value in financial stocks which have seen deep cuts?
They have corrected but it is a very tricky space to navigate. Take the case of NBFCs. In Indian banks, RBI inspectors were actually sitting in the banks, looking at their loan portfolios, NPAs and deciding what's needed to be done. But NBFCs were more or less the Wild West, with no such monitoring. The entire game was about loan-book growth. The focus was only on the assets side of the balance sheet and no one was worried about the liabilities. Unlike banks, most NBFCs do not have a strong deposit franchise. In this cycle, they relied on market borrowings in the form of CPs, CDs, etc., to fund their growth. I have a simple question. What can an NBFC do that a bank cannot? Banks, with lower cost of funds, can provide home loans, vehicle financing, personal loans, SME loans. So, what was the attraction of the NBFC business model? It was simply that they managed high growth with more liberal credit standards and interest rates. Now when interest rates in the economy are very low, banks' CASA and retail franchises have limited value. NBFCs can raise money at the same cost from the markets. But with interest rates rising, the tables have turned.

I see that PPFAS owns only private-sector banks in its portfolio and not public sector banks, which do have a strong CASA and retail franchise. Why?
In PSUs, you cannot evaluate lenders in isolation. The government, which owns PSU banks, does not look at them in isolation. It looks at their consolidated balance sheet and does not differentiate between the different entities it owns. That is a risk for investors. This is irrespective of the political party at the Centre. So, you may be looking to buy a Bank of Baroda, but suddenly it could acquire or merge a Dena Bank. Today, there is lack of clarity on who may rescue IL&FS.

Nicholas Taleb talked of the Thanksgiving Turkey problem. The turkey is fed every day and comes to believe that members of the human race are very friendly folks. But then unexpectedly, it has to change its mind when it is slaughtered on Thanksgiving. Just because the balance sheets for some PSUs are looking good right now, there is no surety that they will remain so a few years down the road.

In India, small- and mid-cap stocks have higher domestic ownership, while large caps have more FII ownership. With FIIs in exit mode and domestic money pouring in, why have mid and small caps tanked so sharply? Are you finding buying opportunities there?
If you plot a graph of the mid- and small-cap indices, the fall has been steep for the last 10-11 months, but the rise before it for three-four years was even steeper. We have seen this in previous bull markets, too. The stocks which rise fastest in bull markets are smaller stocks with the least liquidity. This time, a lot of the mid- and small-cap movement was also driven by new-age alternative-investment funds and portfolio-management services. There were many cases where low-liquidity stocks were propagated and then bought by retail investors. When retail investors get into such stocks and see sudden declines, they panic and there is a flight to safety. That's why we are seeing these steep falls.

Many small- or mid-cap businesses did not frankly deserve to trade at the valuations they enjoyed. So, the fall doesn't really make them attractive. We are tuning out the noise around small and mid caps and evaluating them purely around their business prospects.

Have you deployed the cash positions you held in the fund?
Yes, we have started deploying them. The interesting thing about holding cash is that cash allocations actually rise in a falling market. Let us say you have 80 per cent in stocks and 20 per cent in cash. If the market falls by 20 per cent, the 80 per cent will lose 16 per cent and become 64 per cent but the cash will hold its value and take up a higher allocation in the portfolio. Therefore, looking purely at our cash component, people may think we are not deploying cash, when in reality we are doing it. We have been buying every month since September as we have been finding opportunities.

There is a view that cash positions lead to a certain laziness in fund management. When you have leeway to hold cash, you don't look hard enough for stock opportunities. What's your view?
Guilty as charged! But on a serious note, we like to increase our equity allocations when it becomes blindingly obvious to everyone that it is a great time to buy. Laziness does help at times, both at the time of buying and selling. It results in low churn and having money to buy when the market sentiment is terrible.

If the investor has SIPs running and keeps deploying money in a mid- and small-cap fund, and the fund manager also says it his mandate to be fully invested, everyone ends up chasing the trend. Then the entire world becomes a relative-valuation game. In the dot-com boom, people bought Yahoo.com because Pets.com was expensive. But they forgot that even Yahoo.com was in a bubble zone and lost money on it.

You see, in valuing a government bond, there is complete certainty in future cash flows and you can put a precise intrinsic value to the bond. But in equities, you are playing with probability and can arrive at a whole range of values for a single stock based on the assumptions you put in, so it is good to be conservative.

One very interesting perspective on this was in Howard Marks' latest book Mastering the Market Cycle. He says that stock prices often swing like a pendulum between the two extremes of valuation. They spend a lot of time in expensive or cheap zone due to extremes of emotion. But they stay for a very little time at the mid-point, which is the fair-value zone.

PPFAS also invests in stocks listed overseas. Today, do you find more opportunities in the domestic or overseas markets?
I would still say there are attractive opportunities in the overseas market. This is because in developed markets, like the US, you don't have these 'long runway' stories about stocks that are premised on the economy growing at 8 per cent plus for many years. Those assumptions lead to over-valuation in the Indian market.

The high stock valuations that we have seen in India for the last five years were the result of excess global liquidity and near-zero interest rates. As liquidity is now withdrawing and rates are shooting up, should Indian investors prepare for lower valuations on equities. Should we stop expecting our portfolio values to go back soon to the highs we saw in August 2018?
You are right. Investors cannot be anchored to those market highs. In 1995, 10-year G-secs were offering yields of 14 per cent. Tata Steel and L&T were borrowing money at 18 per cent. From those days, Indian G-sec yields steadily fell and went below 5 per cent at one point. US treasury yields have fallen from 14 per cent in the early 80s to 2 per cent. So for a generation, global markets saw lower and lower bond yields. Now that global yields have started rising, valuation multiples for equities need to correct. Yes, as corporate profits grow, the portfolio may eventually go back to those highs. But it will not happen immediately. There may be a time correction and the market may take time to take out those highs.

You believe even small-cap funds are risky for retail investors. Why?
Studies have shown that small-cap stocks deliver slightly more returns than large caps mainly because they are under-researched. But in bull markets, that gets turned on its head. New investors and portfolio managers mushroom. They are looking mainly at small-cap stocks, which get over-covered and become too expensive. Generally, there is a view in India that "I already know everything there is to know about Infosys, TCS and HDFC Bank, so let me look for the next Infosys, TCS and HDFC Bank." But sometimes, the existing Infosys and HDFC Bank becomes quite attractive and you are still chasing the next one!

Should Indian equity investors reduce their return expectations from the usual 12-15 per cent CAGR, especially as inflation in India seems to have come down to 5-6 per cent range?
Yes, it is best to set your return expectations on the basis of a real return over and above the inflation rate. Making your financial plans on the assumption that equities will generate more than a 4-5 per cent real return and debt will generate more than 1-2 per cent real return is risky. If you think inflation in future will be at 5 per cent, it is best to expect 10 per cent from equities. If you make conservative assumptions and are surprised by better returns, that's always good.