‘There could be a 10% downside to global markets in next few months’

S Naganath, president & chief investment officer, DSP BlackRock Investment Managers, has watched the Indian stock markets for more than two decades. In an interview with Shobhana Subramanian, he observes that while there could be a bit of weakness in the equity markets? sentiment, given the fact that some economies overseas are in trouble, a strong economy makes the Indian market relatively more attractive.

How do you read the appetite for mutual funds right now?

When we started making the presentations for our NFO?DSP BlackRock Focus 25 Fund?in late April, the turnouts were good, we got a good response and so we expected to raise around Rs 1,500 crore. But in May, the global equity markets were in turmoil. Despite that, we?ve managed to collect Rs 670 crore and retail subscriptions have been good. After a bit of a lull in the last six to eight months, interest seems to be reviving, but it will depend on global and regional market conditions. The ban on entry loads may have been an issue for a few months after it was introduced in August last year, but it?s not an issue any longer. Investment in mutual funds will now be more a function of whether market conditions are stable or there?s volatility.

But we?ve seen outflows from equity schemes in all but two months after August last year.

That?s true, but I would say that one shouldn?t really attribute this to the issue of the ban on entry loads. We should not forget that last year?s rally in the Indian market has been a sharp one, much like it has been in other markets, including Asian and developed markets after the big decline starting late 2008. The kind of percentage gains that have been seen in such a short time have not been seen in a very long time. So, when you have a market that is up 80-90% in a phase of six to eight months or so, it is naturally the case that many investors may have wanted to take some profits. I would argue that this would have explained quite a bit of the outflows or redemptions.

Despite the mutual fund industry having been around for such a long time, the kind of inflows into equities seems small.

I?m very satisfied with the growth that we?ve seen. When we started the business way back in 1997, raising Rs 50 crore or Rs 100 crore in equity funds was a considerable feat and crossing Rs 1,000 crore in the aggregate was a milestone. I think the industry has shown phenomenal growth in the last five years and today we?re at Rs 7.5 lakh crore and equities are at around Rs 2 lakh crore. It is a huge achievement. So, you?ve had four or five years of phenomenal growth and there could arguably be a period of consolidation before you move on to the next phase of growth.

But a very small share of household savings is in equities?

Clearly, if you look at the trajectory in the developed markets, then obviously investment in equities?whether directly or through funds?has been much higher. But in India in the last five years, there has been an increase in allocations to equities incrementally. Now, these things don?t happen in short periods of time; when you look back, they happen over decades. It has to do with the secular trend in the market, the level of comfort and risk appetite that one develops and with the variety of instruments available. We?ve made a good start and it?s possible that the year-on-year growth may move up and down, but five years from now, I?m very confident the numbers should be much better than what they are today.

Insurance companies seem to have attracted a lot of equity money in the last few years.

They?ve certainly offered stiff competition, but I would say that it?s something that occurs in a marketplace. Looking ahead over the next five to ten years, I?m confident no matter what the competition, whether from direct equity or other financial instruments, equity funds will continue to grow quite handsomely. Also, don?t forget that unlike in other products, in our case these are open-ended funds for the most part. So, when there are redemptions, money goes out and equally when there is bullishness, money comes in. There is a constant dynamic flow of money, it?s not a static pool.

Would you say then that the asset management business can become profitable today?

Well, I can?t make a generic statement. It could be considered profitable if the mix of business in terms of the products that you have contributes to profitability over time. One has to keep an eye on costs, distribution costs mainly, and one has to achieve a certain degree of scale. Clearly, if you have a smaller AUM (asset under management), it goes without saying, it?ll be difficult to break even.

A business has to achieve scale in a reasonably short period of time with a good product mix?fixed income typically has lower margins than equity funds.

Have not the distribution costs come down?

The general trend in distribution expenses now is to have a less proportion of what is called the upfront commission and a greater proportion of trail commission paid on an annualised basis. That model is what we think will be eventually beneficial both to distribution channel partners and also to the asset management companies. The cost of advertising and marketing hasn?t changed much, it depends on how much profile and publicity the fund wants. Distribution costs have come down a bit and, more importantly, the constitution of that distribution cost?in terms of less upfront and more in the form of trail?is beginning to gather momentum.

How do you read the market?

We think that conditions globally will be somewhat turbulent and volatile simply because we see that the issue of sovereign credit crisis is not likely to subside soon. We?re seeing sell-offs followed by sharp rallies. Some amount of this volatility is also reflected in currency markets, for example, the weakness in the euro. It?s also reflected in bond markets where the spreads have been increasing. We think there is a fair amount of nervousness about the ability of the European Union to address the issues in a manner in which the market volatility begins to subside. We think that concerns will continue to linger and until then, currency, bond and, therefore, equity markets will be under pressure. The issue is how the large deficits run up by some governments, whether historically or not, will be financed. And if bond market investors are worried and if economies are sluggish, resulting in lower tax revenues, putting further pressure on deficits, there could be more concerns in developed markets. All of this could contribute to the near-term weak sentiment in the equity market sentiment. We, therefore, feel that there is a possibility of a 10% downside to global equity markets in the next three or four months.

Does the Indian market completely track what?s happening globally?

Certainly, all markets would be vulnerable should there be a weakness in equity markets around the world. However, the good thing for India is that our fundamentals are very strong. Our macro fundamentals are great, our economy will continue to grow at 7.5-8% per annum for the next three to four years, our deficit is under control and could be lower than what has been pencilled in by economists, thanks to the revenues from 3G auctions. Corporate earnings have been strong and analysts are expecting a 25% growth this year and possibly 20% in the next. Based on that, our valuations for 2010-11 appear to be somewhat fair, but if we look at earnings for 2011-12, the market would appear to be fairly cheap at a multiple close to 13-13.5 times compared with the long-term average of 15-15.5 times. That should make Indian equities very attractive to investors.