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'Value is what you derive from businesses over time and not just bridging of undervaluation'

With markets not seeming to lose breath, we speak to Venugopal Manghat, Head - Equities, L&T Mutual Fund, about the prevailing valuations

'Value is what you derive from businesses over time and not just bridging of undervaluation'

After a dream run since April last year, investors are worried that the markets may have peaked out. That also means a correction may just be around the corner. Lately, spiking bond yields and a revival in COVID cases have emerged as newer concerns. Amid this, we speak to Venugopal Manghat, who manages L&T India Value Fund, a valuation-conscious scheme. He shares with us his thoughts on the current market valuations, where he is betting currently, the rally in cyclicals, among other things. His philosophy of value investing will act as a bonus for the readers of this interview.

On all metrics, be it P/E, P/B or market cap to GDP, the market appears overpriced. How worried are you about that? Is a deep correction imminent?
Yes, the market appears overpriced. However, earnings growth in the last few years has been subdued and this seems to be the first year of a recovery and given the global and domestic tailwinds, the earnings-growth trend could continue in the foreseeable future. Also, valuation is a function of cost of capital, growth etc. COVID-19 has resulted in developed and emerging countries adopting convergent, easy fiscal and monetary policies, resulting in a lower cost of capital. This partly explains the higher valuations prevailing currently, apart from the higher liquidity in the markets and better-than-expected economic recovery. In the near term, the market could see some correction, especially with the bond yields spiking and expectation of higher interest rates, but the positive trend in earnings should support it in a correction. On a bottom-up basis, there are still good opportunities to invest.

Which pockets in the market currently appear overvalued? Which offer valuation comfort?
Within the market, high-quality, consumer franchises, apart from high-growth stocks, appear most expensive. These include a segment of high-quality midcaps as well, especially where free float is limited. Some of the economy-related sectors, including metals, real estate, banking, capital goods, etc., could spring surprises in earnings and may appear relatively better in valuation. Some of these sectors are cyclically at their low points in terms of profitability and return ratios. With better growth expectation, parts of the IT and pharmaceutical sectors also look reasonable. Overall, valuation comfort is higher in small and mid caps vs large caps. Having said this, post the sharp rise in the markets, one needs to follow a stock-specific, bottom-up approach.

What changes have you made to your portfolio against the backdrop of the rally over the last one year? What are you bullish and bearish on and why?
In the market meltdown in March last year, we were able to buy into some of the stocks which were expensive till then. Over the last one year, the market witnessed a severe sector rotation. During the correction, we increased exposure to sectors like IT and pharmaceuticals, which we believe hit a cyclical bottom with respect to growth and are likely to recover. During the last few months, we have balanced the portfolio by increasing weights in real estate, capital goods, metals, etc. We are not as bullish on consumer staples and discretionary consumption on account of high valuations and commodity inflation impacting margins.

How do you pick stocks for L&T India Value Fund? When do you exit a stock?
For L&T India Value Fund, we focus on identifying stocks which have the potential to unlock value over time while being at a relatively lower valuation vs their history or within the sector. As mentioned earlier, growth is one of the key parameters and we try to pick stocks where there is a mismatch in growth expectation between our analysis and the market view. The market tries to project future growth as an extension of historical performance, while we continuously scan for changing business dynamics, including tailwinds, change of management, etc., while assessing potential value. Apart from growth, we also look at the free-cash-flow yield, dividend yield, valuation of subsidiaries, etc.

While we enter a stock, we try and ensure that it ticks our boxes for value. Stocks are bought with a view to remain invested in these for as long as possible and hence we are always looking for opportunities to buy great compounding stocks at bargain levels. However, all the stocks in the portfolio are continuously evaluated and we size our positions depending on the valuation comfort. Stocks are reduced/exited if valuations are unjustified or when there are much better bargains available.

After a long period of lull, stocks in sectors such as PSU banking, metals and mining, real estate, capital goods, and infrastructure have started racing. How do you see the current valuations of these sectors vis-à-vis their historical averages? Does the rally have legs?
Many of these sectors are cyclical in nature and economy-dependent. Hence, their growth, profitability, balance-sheet parameters, etc., may depend on the stage of the cycle. I believe some of these sectors are coming out of deep cyclical downturns and therefore may be interesting. However, the pace of recovery and unfolding of the cycle depends on several factors and needs to be monitored. On a medium-term basis, I believe valuations are reasonable, given the potential for higher earnings growth. Some of these sectors have significant under-ownership as well, given the scepticism on earnings recovery. With improvement in demand and government push, we could see meaningful recovery in both earnings and multiples over time.

Theoretically speaking, valuation is a tricky business as you can look at the same stock through multiple lenses. What are your favourite valuation tools/methods? What would be the pitfalls to watch out for?
We follow both the intrinsic and relative-valuation methods. Discounted cash flows are used where intrinsic valuation is more suitable, while in other cases, stocks are valued using different tools and relative-valuation methods. While there are no favourites, cash-flow generation is key focus for us. What a bargain valuation is, that varies from sector to sector and hence we are not in favour of looking at only low P/E or low P/B stocks. Also, we look at historic valuations and relative valuations within the sector and the market. Purely going by a low valuation can result in value traps. Other pitfalls could be a lack of understanding of cycles and letting recent-past data influence future estimation significantly.

How important is value investing in a growth market like India? When you have growth built into an economy, all you need to do is avoid mistakes and the upside is automatically taken care of.
Value is what you derive from businesses or stocks over time and not just bridging of undervaluation. The basic philosophy of value investing is to identify good-quality companies which offer value and are available at bargain prices, which offer relatively higher margin of safety. In a growing economy like India, faster growth or tailwinds for growth could be one of the most important aspects to look for stocks even for a value investor, provided the stock is available at a bargain price. Higher returns are made when investments are made at bargain levels. Investing in the highest-growth companies at exorbitant valuations often ends up in sub-optimal return in the foreseeable future and does not assure an upside. Hence, I would argue that value investing is a great approach in all markets.

First a crash and then a massive rally - the last one year has really tested investors' nerves. The uncertainty hasn't abated yet. What are your key takeaways from the last one year's roller coaster? What would be your advice to investors?
COVID-19 has been one of the rare black-swan events which impacted economies and markets globally. While in the midst of a crisis, one would not have visibility of the recovery, so it makes immense sense to be clear in your mind and focus on the objective, which is to look for good-quality companies run by capable managements, in strong businesses with long runways and remain invested. Such panic situations may lead to great investment opportunities. Having said that, we are living in a world which is changing, with several disrupting forces, and one needs to be mindful of that. I would reiterate that times of uncertainty and panic are the best times to invest money.