'Never take the management at face value'

Shibani Sircar Kurian, Senior VP & Head of Equity Research, Kotak Mahindra AMC gives her outlook on BFSI and IT sectors. She also explains the stock screeners her team uses

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Shibani Sircar Kurian leads a team of analysts at Kotak Mahindra AMC. As head of equity research, she is an integral part of the stock picks that are hand-delivered to the fund managers. She also tracks the BFSI and IT sectors.

In an interview with Kumar Shankar Roy, Shibani talks about how trailing P/E valuation metric removes bias, explains the stock screeners her team uses and shares her outlook on banking and IT stocks.

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Apart from being good at maths and finance, what are the other requisites for being a good analyst?
The basic requisite for being a good analyst is the ability to understand financial numbers, read annual reports and project earnings. In reality, equity research goes much beyond. To be a good analyst, one has to be able to understand sectors and their key drivers of value, cycles that they go through, and the key strengths and weaknesses of the companies operating in them. Assessing the quality of management, understanding capital-allocation policies and an ability to predict turnarounds are also some of the traits that a good equity analyst must build on.

In your fund house's newest offering Kotak Balanced Advantage Fund, Nifty 50's trailing price-to-earnings (P/E) ratio is one of the two factors used to decide asset allocation. Why is trailing P/E a good indicator of valuation and why don't you look at the forward P/E?
The trailing P/E captures what has happened and therefore will not undergo any change. Any forward-looking projection will have a human element or a bias to it. For example, in the last few years, we have seen a huge difference between what was projected at the beginning of the year as earnings for the market and what it finally reported. Hence, the trailing P/E ratio eliminates this bias or any error of estimation.

We also believe that the P/E is a better indicator of the market than something like the price-to-book (P/B) ratio. In fact, P/B, when looked in isolation, without looking at the return on equity (RoE), does not make much sense. So, for the P/B to work, you must look at it in conjunction with RoE.

For banking, we are always told to look at P/B. Can we use P/E for banks?
Yes, you can. There are a set of banks where the earnings growth trajectory is very stable or has been moving up. So, P/E as a valuation parameter works well for these banks. However, each sector has its own commonly used valuation parameter. In the case of banks, P/B is often used since the net worth of a bank is the key component in estimating its value. However, as mentioned above, P/B must be looked at in conjunction with sustainable growth and return on equity to get a sense of the extent of overvaluation or under-valuation in a company.

Can you tell us about the screeners that your equity-research team uses?
We follow our Business, Management, and Valuation (BMV) model. When we speak of a business, we are looking at growth - companies that are growing faster than the market; companies that have a scalable business model; and those that are gaining market share. So, that is the starting point of analysis.

Second, we look at the management and corporate governance of the company. This is especially crucial for mid-cap companies where the promoter ownership is very high. Therefore, capital-allocation policies become extremely important to decide whether the right corporate-governance standards are being followed. In fact, we signed up for the United Nations-supported Principles for Responsible Investment (UNPRI), becoming the first domestic asset-management company to lead the responsible-investing narrative in India. This means we are incorporating environmental, social and governance (ESG) factors into our investment framework.

Finally, we look at valuations. We look at valuations from absolute, intrinsic and relative perspectives. Essentially, we look at how stocks stack up against each other in the sector and what the intrinsic value of a stock is. We use various methodologies, including the discounted-cash-flow methodology, residual-growth model and dividend-discount model, depending on the sector.

After you run these elaborate screeners, what is the investible universe that you come to?
Today, the number of listed companies in India is about 3,000. When you come down to companies with Rs1,000 crore and above market value, you have about 700-800 companies. From these, our research team covers about 360-370 stocks, which translate into about 82 per cent of the overall market cap of India. These further percolate into schemes depending on the fund's philosophy and what each fund manager wants to own.

In the case of banking stocks, there is a shift of investments from the public sector to the private sector. What do you make of it?
What we have seen clearly is the shift in market share away from public-sector banks to private-sector banks. This shift is now accelerating very sharply, with a large number of PSU banks being under RBI's prompt correction action (PCA). Also, over a period of time, a lot of risk aversion has set in for PSU banks because of certain events in the recent past. So, their focus is to lend to a select group of highly rated corporates. This means there is a huge opportunity for private-sector banks to gain even more market share. What we have also seen in the case of retail-oriented private-sector banks is that the retail asset-quality cycle has been playing out really well. Today, retail delinquencies are probably at their lowest in terms of stress. So, retail-oriented banks are growing at a pace faster than the market, gaining share in loans and deposit, along with low credit costs and significantly higher return on equity. Their earnings-growth trajectory is predictable and sustainable. So, our view is that this could possibly continue as a structural theme for a period.

How long can this earnings growth continue?
Currently, private-sector banks have a 25-30 per cent market share of loans while public-sector banks still have about 70 per cent market share. We believe over the next five years, the shift in market share in favour of private-sector banks can be quite substantial. Even if the valuations of the private-sector banks do not expand significantly, a lot of the names in the private-sector space, especially the retail-oriented ones, are more of structural compounding stories and need not necessarily be multiple re-rating stories. Also, private-sector banks that typically trade at higher valuation multiples are typically able to raise capital at a fast pace and thereby add to book value. This helps play out their compounding theme even better.

The retail segment of the banks is obviously making them a lot of money. But is retail big enough to move the needle?
The opportunity in retail is still fairly high. The under-penetration is huge if you look at any of the retail-loan segments. In India, the credit-to-GDP ratio is far lower than what it is in many developed countries. There are opportunities in segments, which earlier banks were not even catering to. A large population has come to the formal banking system and now has bank accounts as part of the Jan Dhan scheme. So retail products have a lot of space to grow.

You talked about risk aversion in PSU banks. But have private-sector banks built safeguards so as to avoid making the costly mistakes committed by PSU banks?
We can hope that private-sector banks have learned from the mistakes of the past. Clearly, the focus should be on better risk management, better credit assessment and better collaterals. Another thing is that the banking sector will move to a new accounting platform called IndAS from April 2019 onwards. In the new regime, the way you calculate credit costs will be significantly different from what you do today, wherein bank are following RBI norms of 90-day NPA recognition. In IndAS, you will have to calculate the expected credit loss for your entire portfolio and the probability of default. Therefore, the onus is on the banks to ensure that their risk-management practices are far more robust if they want to minimise their credit cost. This will lead to better practices for the banking sector overall.

You are also an IT sector specialist. You must have come across alarmist views about Indian IT. The last five-six months have been very different. What is your view on the sector?
Over the last few years, the IT sector has seen a large drop in spends by global clients, especially by large banks in the US and Europe. The clients were going through a turmoil of their own, which resulted in lower allocation to IT budgets, and this resulted in lower growth in traditional IT services in the areas of application development and maintenance. Also, there has been a phenomenon of insourcing among clients.

In the last few years, Indian firms have invested in building pockets of capability on the digital side, which is enabling them to win deals now. From here on, our belief is that we will see an improvement in revenue-growth trajectory, but it may not be a sharp up-move. It will be a slow and gradual improvement, with the possibility of high single-digit or low double-digit earnings growth over the next couple of years.

On the margins front, it does appear that most of the companies have exhausted the low-hanging fruits of better utilisation and other such traditional levers. As growth comes back, you will have to hire more, give wage hikes, which means the cost pressures will start to build in.

However, the rupee acts as a tailwind now and better automation could result in some degree of cost control and therefore help IT companies protect the margins to a large extent. Do remember that these IT services firms are huge cash generators. Their cash-flow yields are significantly high. They are also returning capital back to their shareholders. This is providing a downside support at current valuations for the IT companies.

The earnings season is going on. This is typically a time when company managements wax eloquent about prospects. How do you separate the wheat from the chaff?
The number one rule is never to take the management at face value but as just one of the parameters to consider in the overall framework of evaluation. Equity research is not only about listening to management discussions or analyst calls. You need to verify what is being said and match the actions as well. Primary research, interacting with players which are part of the ecosystem like dealers and intermediaries, etc., can give you a great idea of what is really happening on the ground. It is extremely important to understand the industry dynamics. The annual report is also an excellent source of information and gives clues as to how the company is being run and what the key strategic directions are. It gives you data pertaining to cash flows, off-balance sheet items, capital-allocation strategies, etc.

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