WF: We seem to be in a pre-election rally, bringing back memories of 2014. How sustainable is this rally in your view? What has changed on ground to fuel optimism from FIIs and domestic investors?

Sanjay: Historically it has been observed equity markets and currency markets have reacted negatively 1 year before General Elections. Couple of months before the elections both the markets tend to stabilize. This may be premised on certain expected outcome of the results. This time around too we are witnessing similar trend. Unless and until the election results are in complete contrast to expectations, equity markets are likely to be determined by fundamental factors. In the last 3-4 years macro had improved while the earnings were tepid. In recent times macros have relatively deteriorated compared to recent past but are still better than what they were prior to 5 years. The saving grace is the earnings. Despite two major shocks - Demonetisation and GST, corporate earnings seem to improve. One may argue that they are lower than expectations, yet the growth rates are improving.

Over CY18 we have seen FPIs reducing their significant over weight position (In MSCI EM portfolio) to equal weight to marginal overweight position. This was on back of Deteriorating Macroeconomic indicators and volatility in currency. With the currency more stable and earnings growth improving, we expect the FPIs to be favourably inclined to Indian markets. So far we have seen only passive money flow. India dedicated flows are still a trickle. The fence sitters may be waiting on side-lines and are likely to take a call post-election results.

Domestic investors are driven by the flows. Penetration of MF/Equity is still much lower than average of similar demographic country and there is good scope for further inflows. This is not withstanding slowdown in flows that we have witnessed in recent times. The economic foundation that has been laid with the structural reforms and improving earnings growth is what is sustaining the equity markets.

WF: How do you see valuations in the large, mid and small caps spaces now? Which of these appear relatively more attractive now?

Sanjay: Over the last 12 months Large cap index (as represented by BSE 100) is up 11% while midcap (BSE Midcap) and small cap (BSE small cap) is down 6% and 15% respectively. Both midcap and small cap are lagging behind large caps even after the rally that we have seen in recent months.

As per Bloomberg, street expects earnings for large caps to increase by 12% during FY19 and 27% during FY20 respectively. Consequently valuations have now declined to~22xFY19 and 17x FY20. However, we note that street estimates are also getting revised downwards. Forward estimates have been cut by 11% over the last one year and hence some moderation in estimates may be expected.

Midcaps, as highlighted above, have corrected by 6% during last one year. They are trading at significant premium to large caps over the last 3 years. This premium was on expectation of faster earnings growth and the fact that domestic flows were strong. Currently Midcaps are trading at~23-24x FY20E. Street estimates factors nearly 30-40% yoy growth in earnings between FY18-FY20.

Earnings estimate continue to see cuts as seen over the last few quarters across market capitalization. So while headline valuations have corrected, underlying numbers are likely to see some deterioration. We would be selective in midcaps, focus on low debt companies and high ROE /ROE improvement stocks.

WF: The last quarter’s earnings numbers were a little disappointing. Where do you see strong earnings growth coming through and which sectors continue to face earnings headwinds?

Sanjay: The December corporate earnings were in line with expectations adjusted for one-off gains/impairments for Tata Motors for the Nifty Universe.

Corporate Banks, IT and Consumer delivered a strong performance, while Autos and Cement disappointed. Overall, the direction of earnings revision is still trending down, dominated by a big miss in some of the large-caps in global cyclicals like Tata Motors.

The Financials may drive domestic cyclical growth in earnings going forward. Corporate Banks showed a material sequential improvement in the slippage/asset quality trends. This provides good visibility on the earnings outlook, as Corporate Banks were one of the key drivers for the earnings miss over the past few years. NBFC Universe delivered an in-line performance, but saw some moderation in the growth estimates owing to the prevailing stress in the liquidity and cost of funds environment.

The most noticeable data point has been the improving US business revenues for pharma companies. While one quarter is not sufficient to conclude a trend reversal, but it is something to keep in mind given the sector has been a big underperformer over the last two years.

Profit growth of global cyclicals - the primary engine of earning growth for the last few quarters - is likely to moderate further, as metals are likely to encounter tough phase. Energy sector is also likely to see some downward pressure on the back of expectation of slowdown in global growth. Auto & Auto ancillaries may see slowdown in demand and earnings.

WF: What is the asset allocation strategy in your recently launched Baroda Dynamic Equity Fund? What is the current proportion of equity in this fund? How are shaping the equity composition of this fund in terms of thematic and sectoral preferences? How will the allocation be made across cap sizes?

Sanjay: Baroda Dynamic Equity Fund is an equity oriented scheme which will have minimum Gross equity exposure of 65%. The net equity exposure will be determined by Proprietary back tested Fundamental model. Non-equity portion is invested in debt instruments.

Baroda Dynamic Equity Fund uses four different fundamental parameters which cover not only P&L but also balance sheet, cash flows and prevailing yields namely 1) PE ratio, 2) Dividend yield, 3) Price to book value and 4) Earning yield gap. The model focusses only on relative value of each of the fundamental parameters. Comparison is made relative to its own history.

Equity portion is managed as a multicap fund- diversified across sectors and stocks. In the beginning as a strategy, our large cap exposure was higher and gradually we built up our mid cap exposure.

At the time of launch, Large cap accounted for near to 90% of our equity exposure. Over the last 3 months, we have found quality midcaps and have increased our Midcap exposure to about 15-20% as on 28 February 2019 . It is interesting to note how the net equity exposure has gradually increased from ~48% to current level of ~53%. The model ensures that the investment manager maintains a certain discipline in investments by doing the right asset allocation. The asset allocation is done by the model and sector and stock selection is done by the investment manager.

Our call on being overweight on Corporate Banks and underweight on Auto and auto ancillary has played out well. As on 28 February 2019 the fund is overweight on Consumption, Pharma and Banking sector and we continue with our tactical negative view on Auto and IT sector. Our negative view of Cement, Metals and Telecom sector is reflected in our portfolio.

WF: What do you see as the key risks of investing in equity markets today?

Sanjay: Market participants are hypersensitive about the outcome of the elections. History has demonstrated that these are just passing events. In past whether we had absolute majority, or coalition or a third front, markets have marched on.

Key factors to watch out are macros. Within that I would keenly track the fiscal deficit number and GST collections. What would excite the foreign investors would be continuations of bold reforms like IBC and GST.

Bulk of earnings growth in FY20 is skewed from Corporate Banks, a large automotive company and Telecom companies. All of them are due to base effect. Even if we strip out these, we should witness at least double digit earnings growth in FY. However, this may be lower than what market is expecting.

On Global front, escalation in trade tension should not impact the tentative growth that the world is witnessing currently. Major global economies are trying to shrink their balance sheet. This would mean that benefit of easy monetary policy would no longer be available for capital hungry EM.

Finally India is quite sensitive to energy prices. Currently crude prices are quite benign with the present dispensation having struck few favourable deals. If this was disrupted and cost of importing crude goes up then it may reduce India’s attractiveness to foreign investors.

Disclaimer : The above is not an offer to sell or a solicitation to buy any mutual fund units / securities. Any views or opinions expressed in this article alone are not sufficient and should not be used for the development or implementation of an investment strategy. Information provided above does not seek to influence the opinions/behaviour of the recipient(s) and shall not be construed as investment advice to any party. All investments in mutual funds and securities are subject to market risks. Parts of the views may be based on information received from sources we consider reliable. Neither Baroda Asset Management India Limited / Baroda Mutual Fund / Baroda Trustee India Private Limited, nor any person connected with it, accepts any liability arising from the use of this information.

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