FMCG stocks are expensive and there is very little room for an error in judgment, believes Chirag Setalvad, senior fund manager?equity, HDFC Mutual Fund. In an interview with FE’s Devangi Gandhi, Setalvad says the generalisation that mid-caps are riskier because of their weaker fundamentals is unfair. Excerpts:
What do you think is the reason for the relative resilience shown by the market to the RBI’s latest tightening measures?
A slowing domestic economy, improving global demand and a weak currency are encouraging exports and restricting imports. As a result, the current account deficit seems to be gradually coming under control. The deficit run rate has come down in the last few months and this is reflected in the stronger rupee. The negative sentiments towards the rupee were probably overdone, and the current market reaction seems to be a correction of that. The RBI has announced a string of measures to support the rupee. Despite the RBI?s tightening measures, global liquidity continues to be ample (the Fed tapering has been deferred), which along with a strengthening rupee has helped support the equity markets.
In the recent past, the rupee movement was tracked very closely by the equity market? What, according to you, are the key fundamental factors right now?
Because the rupee has turned so volatile people?s interest has turned towards this variable. While the rupee is an important variable, there are several factors that are probably more important. These include the pace of government decision making, high interest rates and infrastructure related issues. The movement of commodity prices particularly that of oil and gold is also important.
According to me, the most important variables are the government?s decision making and investments in infrastructure. These impact the foundation of growth and have a long lasting impact. Putting in place a regulatory environment which is conducive and consistent would make a difference. Consumption is acceptable and it really is investments which need to be perked up.
How do you look at defensive sectors given that some of these stocks have turned very expensive?
FMCG, IT and pharma are generally considered as defensive. My view is that FMCG stocks are expensive and that there is very little room for an error in judgment. At the same time, some slowdown in consumption is visible. Valuations are high and short-term and even medium-term returns may be sub-optimal. In the case of pharma companies, barring a few names that are quite expensive, there are quite a few companies where valuations are reasonable given that growth prospects both in India and overseas remain good. In the IT space, demand is picking up, wage costs are under control and the rupee depreciation is helping. There are IT companies available at reasonable valuations in both the large and even more so in the mid-cap segments.
The mid-caps seem to have fallen out of favour despite low valuations.
It is not surprising that in times of uncertainty, investors are gravitating towards perceived safety?large cap, quality names that offer liquidity and visibility in earnings. However, my experience is that you typically make more money in stocks which are being neglected. Mid-caps have been relatively ignored and thus provide a fertile ground for investment opportunities. Today neglect is also visible in beaten down sectors such as banks and capital goods across market capitalisation. For a period of one to two years, investments in these sectors are likely to give better returns.
There is a perception that mid-caps are riskier because their fundamentals are weaker, management quality is poorer and commodity prices and interest rates would have a greater impact on them. Thus, they should have a more difficult time navigating an economic downturn. However, I think this generalisation is unfair. Many mid-cap companies have a strong business model, very good management and healthy cash flows. On the other hand, even a larger company may be run by poor managers, have high leverage or be a price taker. It depends on the type of business, not the size of business. For example, high leverage is size agnostic; one can find examples of large companies with huge leverage and small companies with no leverage.
This misunderstanding creates a healthy opportunity as both good and poor quality companies are judged unfairly. It is true that mid-caps can be more illiquid. Therefore, it needs conviction and patience and ability to tolerate volatility. But if you are willing to withstand this, mid-caps can give you better returns. Lastly, in mid-caps, there are opportunities across sectors. Mid-cap IT companies are available at attractive valuations considering their prospects. There are good opportunities in the pharma sector as well. There are also opportunities in auto ancillaries, light engineering, bearing companies and in various miscellaneous sectors.
What is your outlook on the banking sector given that asset quality concerns have cropped up?
I think banking stocks are attractively priced, particularly the public sector and smaller private sector banks. Obviously there are concerns, mainly on asset quality, which I think are getting more than adequately reflected in valuations. Banks are trading anywhere between 0.3 and 0.8 times their book values compared with much higher valuations historically. Even dividend yields look attractive as they stand anywhere between 7% and 10% for certain banks. They are obviously attractive for a reason; but there are concerns regarding credit growth, asset quality and interest rates. During adversity, you get cheap valuations. Investing in these times is typically very rewarding, as once things stabilise, returns can be outsized. However, investing when a sector is going through a tough patch is not easy as its needs conviction and patience. It is important to look at normalised conditions and to stress test one?s assumptions.
We look at what has been the stable profitability of a bank over a cycle on yardsticks like margins, return on equity, return on assets and credit growth. On a normalised basis, current valuations look very interesting.
In the recent past, the market has traded a tad below its historical average valuations. What do you read into this?
Today the market is very polarised so one has to consider the details behind the averages. On one hand, you have the FMCG sector and a few other companies that are quite expensive while on the other hand you have capital goods and banks which are very cheap. While the market is on average at 14x one-year forward earnings and trades at average valuations, you would find stocks trading significantly above and below that average and significantly above and below their historical valuations as well. When there is a lot of disparity on a stock-specific basis it presents a lot of opportunities.
In August, the closures of equity folios slowed down, with a net inflow of about Rs 450 crore. Do you think retail investors are likely to return to the market soon or the activity would continue to be guided by FII inflows?
In the recent past, an improvement in sentiment may have led to greater retail participation. But, that can reverse very quickly. To have a secular improvement in retail participation you need the market to give sustained returns. For that you need a more positive economic and political environment.
At the end of the day it all stems from the fundamentals; if the fundamentals are strong, the flows would follow. FIIs don?t set the long-term trend, the underlying business performance does that. FIIs do play an important role but more so in the shorter term and they tend to accentuate a market trend with their participation. However, I don?t think that they set the trend. So if the economy does well the market will do well regardless of whether the FIIs are buyers or sellers and vice-versa.