What is your outlook for the market?
We are cautiously optimistic. The market has come down to 6,100 level after going close to 6,700 points, but remember that the market has given almost 95 per cent returns in the last two years. Having risen from some 3,000-point level, it is quite natural to see a 600-800 points correction and some amount of volatility.
If you look at the fundamentals, the Sensex went to 6,100 levels in 2000 and the forward price-earnings multiple for the market at that time was over 30 times. It also went to 6,000-plus levels in January 2004 and the forward P/E was about 17 times. At the present 6,200-6,300 Sensex levels, and estimated Sensex earnings of approximately Rs 500, the forward P/E for March 2006 works out to little over 12 times. So, the valuations are reasonable. This is at a time when India's fundamentals are better than ever before. The macro factors are positive and the corporate earnings growth has been good. If you look at the last seven years, the earnings growth has been an average 19 per cent for the top corporates. If the P/E multiple remains the same, then the appreciation from the investors' point of view should be in line with corporate earnings growth. We are looking at 16-17 per cent growth in corporate earnings next year too.
That means at little over 12 times, the market has a fair degree of possible appreciation. Assuming a P/E of 15, we have a base for a 20 per cent appreciation going forward. But let me put a caveat to it: everything else has to remain the same.
What can affect the returns from equity markets going forward?
One risk is the escalation in crude prices internationally. This can have an impact on inflation, which could lead to higher interest rates. We have already seen interest rates going up in the past few months. Apart from that, high crude prices could lead to a slowdown in the Chinese economy. China has been a big driver of growth in a lot of commodities and there has been a big demand of crude from China. Any slowdown in China would mean that a lot of global commodities including crude could come down significantly. Today, almost 35 per cent of the Sensex earnings are dependent on commodity stocks. To that extent, if commodity prices come down, it will have an impact on the overall earnings outlook for the Sensex as well.
There is a big trade deficit in the US economy and how it will move is a big concern. Any significant impact on the US economy and the dollar will have their repercussions in Asia. Since China and India are both big trading partners of the US, this will have a direct bearing for us. A rise in the US interest rates will have an impact on money flows too. These are some of the areas that we will have to watch out for. At this point in time, we may not have a fair degree of handle on them, but clearly we are seeing the foreign institutional investors (FIIs) are looking at India more seriously. It is no more an emerging market allocation to India. India has become a mainstream market like China and people see it as a growth story for the next two-three decades. If you are a multinational and want to grow globally, you must have an India and China strategy. Last year, we saw that 28 per cent of the emerging Asia allocation coming to India. A record high investment of $8.6 billion came in the country and at least the same level of inflow is expected this year too.
Besides, there are pockets of opportunities where the dividend yields are good. We believe that long term growth of returns will be over 15 per cent. There will be space for both conservative as well aggressive investors in the market.
What sectors are likely to do well?
We see telecom companies doing well. Telecom Regulatory Authority of India has an ambitious target in terms of growth rate and the market has also been growing at 50-60 per cent a year. As long as that growth rates continue, the companies in the sector will do well.
The rally in banking should continue as the valuations are at a significant discount to the market valuations. Banks have also cleaned up their non-performing assets. The growth rates are better than the market growth rates, even though they may not be very high. We also expect reforms in the sector. In the last 30 years, the growth in deposits has been 17 per cent a year, which means that it is not a cyclical industry.
In the last few years, there has not been any major capex by Indian corporates. But companies have announced huge capital expenditure (capex) plans. Thus, capital goods and engineering companies should continue to do well this year too, though you need to be careful about the entry price.
Mortgage finance is another area that investors should look at. We have seen a 36 per cent growth a year for the last six years. Given India's demographic profile of more than half the population being below 25 years of age, there is a huge unmet housing demand and the fact that interest rates have halved over five years, demand for mortgages is expected to continue.
India has become compliant to the TRIPS agreement and has introduced product patent laws in the country. With this the regulatory environment changes significantly for research-driven companies. This will result in some long-term opportunities in sectors like pharmaceuticals and crop protection.
With a good amount of interest in India and vibrancy in the business environment, there has been a surge in business travel. Hotels are fully occupied, and this is a sector where putting up new capacities is not easy. We see a window of opportunity for the next three years.
I also think that there are pockets of opportunities in the software sector, especially in the mid-tier companies where the growth strategy, visibility of earnings and corporate governance are in place. Most of the mid-tier companies are available at significantly lower valuations compared to the market. At the same time, they are offering higher earnings growth than the market.
We also expect the two-wheeler industry to do well. Growing middle class, rising income levels, and better opportunities for people in software and BPO, we could see a very good demand growth for motorcycles.
The broad investment philosophy that we have been following for the last few years is to buy businesses at a reasonable price, which are being run efficiently by managers who have a solid track record. The focus is to understand the business, look at its competitiveness vis-à-vis other players, how many years will it take to scale up, whether it will improve market share over a period of time, what are its unique features, etc. If we are comfortable with the business, then we evaluate the management. We look at the management's track record and how transparent it is to minority shareholders. But even if there is a good business being run by efficient managers, we may still not buy it if it is not available at a reasonable price. For investors to make money, the businesses have to be bought at a very reasonable price, because if you pay full price, what do you make? We will not invest unless the valuations are attractive. When I say valuations, I do not mean the P/E alone. We look at a lot of parameters like return on capital employed (ROCE), return on equity (ROE), the ratio of enterprise value to earnings before interest, depreciation and taxes, free cash generation, enterprise value to sales, market capitalisation to sales, etc.
At the end of it, when you construct the portfolio, it is important to diversify and de-risk on a sector and a company. The overall aggregate valuations of the portfolio also have to be looked at in terms of the P/E, the ROCE, the ROE, etc and all these need to be weighted too. These numbers are then compared to the market.
We do not buy into any stock unless we meet the management. We also have a core list of stocks where the fund manager has the freedom to buy or sell depending on his view on the market, the sector or the company. But if he wants to buy a new stock, it has to come into the investment universe. This happens after a detailed research report is prepared and the idea is debated intensely within the investment committee. Only after all the members are satisfied will the stock get included in the investment universe.
We are extremely process-driven and research-driven AMC. We have a team of eight people on the research side and the portfolio managers also have sectoral responsibilities. I too consider myself to be part of the research team rather than a CIO.
There is also a message that I would like to send across to investors. We believe in investing and not trading. We buy value and not market trends. We look for bargains amongst quality stocks rather than average stocks. We like to buy low. We firmly believe that the buying price is an extremely important thing to look at in the whole investment process. We try and avoid acting on market sentiment. We do a thorough homework and track all the stocks in our list very closely. We also believe in diversifying by companies and industry. These are the things that we remind ourselves every now and then. We also believe in learning from our mistakes. Everyone makes mistakes, but you have to be humble enough to accept them and learn from them. If you can avoid making wrong choices in investing, then you are 50 per cent home.
What changes have you brought after taking on as CIO?
The investment philosophy and the investment process remain more-or-less the same. I have managed the offshore fund quite successfully for last few years. We have received the best India-dedicated offshore fund award from Standard & Poor's for 2002, 2003 and 2004. This fund has outperformed the market, benchmark and its peers significantly. All our domestic funds, especially the Birla Advantage Fund and the Birla Mid-cap Fund are doing quite well for the last six months. Our challenge is to ensure that we are able to replicate the good work that we have done in our offshore fund to our domestic funds, and we are aware of it. We have strengthened our research team significantly. Earlier we had two analysts and two portfolio managers. Today, we have nine people in research (six research analysts, two portfolio managers and I).
Yeah. Honestly, I do not look at being first or second in terms of performance when I manage a portfolio. I do not look at what my competition is doing. Our endeavour is to deliver superior returns at all times to the best of our abilities, and making the best of the research that our team generates. We have strengthened our research team and we want to capitalise on our research competitiveness. We hope to continue our performance of the last six months. The challenge is to sustain the performance level, and I should be humble enough to say that all the times all the calls will not go right, but our goal is to deliver superior returns to investors at all times. I must mention here that Birla Advantage Fund has delivered 23 per cent returns since its launch in 1995, as compared to 7 per cent returns by the market in the same period. This is a fantastic return by any standard. Yes, that could have been better and our endeavour is to improve the performance.
Is it difficult to find stocks for your largest equity fund--Birla Dividend Yield Plus, considering that the markets have been rising in the past two years?
We were the first ones to innovate and come up with the concept of a dividend yield fund. We knew that this product was in the interest of the investor, and that it would have relevance throughout the full market cycle. This product works at all times. It is not like a sector fund that you have an infotech fund and tech stocks do well for a particular period of time and that fund will be in favour. And when the sector is not in favour, the fund doesn't do well.
Birla Dividend Yield Plus invests in stocks that have significantly higher dividend yield compared to the market. As such, it will have far more of a 'value component' than the broad indices. This fund will do well over a period of time. Globally too, value funds have generally done well. But I would not say that this is a pure value fund. It follows the rigour of our investment philosophy and is passed through all the filters. We have consciously avoided stocks that give high dividend if we think that the valuations may not sustain, or if the business model is not right, or if the management quality is suspect. It has given fabulous returns since inception.