Midcaps not really at distressed valuations – unlike 2009 & 2013

Manish Gunwani

CIO - Equity Investments

Reliance Mutual Fund

  • Currency now at fair value, trade deficit numbers are moderating – most of the pain on macros is perhaps behind us
  • Indian economy has continued to demonstrate strength with unwavering Inflation numbers despite negative global cues
  • NBFCs unlikely to create systemic issue – NBFCs that operate in clear niches will continue to do well
  • Midcaps not yet at distressed valuations like we saw in 2009 and 2013. Continue therefore to have large cap bias within flexi cap mandates.

WF: We are seeing a pull back after a sharp correction. Is the much anticipated mean reverting correction now behind us or are we in a pull back within the beginning of a bear market?

Manish – The steep run up in the small and midcaps, where the midcap index returns were as high as ~45%, in the last calendar year has led to a fair correction in recent times. If one were to look at the macro factors objectively, the rupee that has depreciated considerably but the current valuations seem fair. The trade deficit numbers seem to be moderating down, if we are doing less than $15 million per month trade deficit, if we are able to sustain this trend, then broadly, we should be below 2% - 2.5% of GDP in cash terms. This is a fair level in my view, a part of the CAD comes from Gold and this is a debatable topic on whether Gold is actually a CAD item. Gold, in a way is equivalent to cash / money, hence whether it represents capital or consumption is a debatable topic.

Currency depreciation takes time to play out, a lot of import substitution industries and manufacturing units will pick up, exports growth would come through and local produce consumption may improve. Drawing a rough analogy, in the year 2012-13 the CAD was at 5% - 6% with around 20% depreciation, the current move from 63 – 74 translates roughly to about 16%- 17% which seems reasonable considering the base we started off with. Further, I think we have overcome the currency woes, the strength in this whole situation was reflected in the inflation numbers. The YoY growth in crude has been 40%, the currency has depreciated over 10%, despite this the inflation numbers have hovered around 4%. This indicates that the Indian economy has emerged strong. The CPI has typically averaged around 8%-9% over the past 20 – 25 years. Inflation has been contained at 4% - 6% despite a host of negative global woes. Although finding multi-baggers in current markets can be a challenge, the downside may not be severe from here.

WF: Do you see any structural damage to Indian markets from global factors including US interest rates, trade war issues and EM outflows?

Manish – Indian economy seems to be resilient, the major concern arises from global factors, between the US and China, there could be weakness. The concern is not so much about the brewing trade wars. The US economy is under stress with business cycle showing signs of peaking, unemployment at a decade long high – a slowdown is evident, it is to be seen if the country will have a mild fall or will have a sharp recession over the next 2 years. China is also harboring a debt bubble which is likely to burst at some point of time. If one were to look at the macro numbers, then Indian economy seems to have a strong foothold as compared to other economies and global macros.

WF: To what extent are corporate earnings taking a beating from higher interest rates, high oil prices and weak macros? Where do you see earnings downgrades happening and which sectors remain strong from an earnings momentum perspective?

Manish – From a top down view, rupee depreciation typically affects consumption earnings negatively and impacts manufacturing / exports growth in a positive way. It has been seen in the past that when dollar strengthens, crude prices tend to fall, however, this time round the crude prices have also risen alongside dollar strengthening. This is a strange phenomenon, the sectors such as auto and consumer discretionary have the head wind of higher commodity prices and the import costs are much higher due to the dollar strengthening. Especially in the case of Autos, the consumer has to factor in the increased outflow of funds due to increase in fuel costs. The Auto sector is one where there are pressures from both sides – manufacturers are facing a cost push and consumers are being hit due to increased fuel costs. Consumption space including cement and others are likely to face challenges since their logistics cost will impact margins. There are other sectors such as energy, metals, IT, pharma which form more than 50% of Nifty would benefit from the rupee depreciation. On an aggregate basis, in the past while rupee depreciation has been beneficial for large corporations in the IT, pharma and metal space, the current scenario of crude oil price hike will affect consumer durables, Auto in a negative manner.

WF: What exactly ails the financial sector? How serious are the refinancing risks for NBFCs and their knock on effect on corporate borrowing programs? Is there something structurally changing in the BFSI space or is it just some valuation excesses that are getting corrected?

Manish – The NBFC scare is unlikely to become systemic issue as they form a small percentage of overall lending in the BFSI space. The growth in aggregate lending is 10% - 15%, thus indicating that the Balance sheets are growing by leaps and bounds on a yearly basis, any issue with a relatively small NBFC is unlikely to blow out of proportion, unless, there is a negative sentiment which spreads across the market on the backdrop of these events. However, with the buy-ins in the space last week, this can be ruled out. Our view on NBFC has always been consistent, we look for those NBFC stocks which are niche in the space and do something that the banks are already not doing. Housing finance segment is clearly not a niche and banks seem to be a more cost -effective alternate in this space, their cost of funds is a lot lesser as compared to NBFCs. The second issue with NBFC is that bond markets are not so liquid and deep, hence they are unable to support the reasonably large Balance Sheets of NBFC. Further, the organized work force is a very small part of the total workforce. Thus indicating that there is yet a large part of the population within the system who are self- employed where there is a need to provide customized solutions. There is thus a clear role for NBFCs to play in terms of addressing the needs of segments which are not catered by traditional banking channels. Niche players will do well, but one has to recognize at the same time that niche players rarely become scale players.

WF: Which sectors are you currently overweight on? Which sectors are you adding in this correction?

Manish – The sectors / stocks have not changed over the past year, one is a large Corporate Bank which has a healthy Balance Sheet. The banks operating in the retail lending space, the quality of lending and the liability side of the Balance sheet are details that we closely watch. There are many banks which are suffering from credit costs related to infra space over the past 4-5 years. These aspects should flow through the Balance Sheet and over the next 2 years, we see an improvement in the credit costs and for the next 3 years, the projections are likely to be in single digit P/E valuations given their size and growth prospects which will make them quite reasonable in terms of valuation.

Pharma space seem to be doing well domestically, the pharma sector is emerging as a quasi – FMCG space. Whenever the US dollar pricing improves there is a delta to the earnings in the Pharma space. Third sector which we are positive about is import substitution / industrial consumables manufacturers especially in the light of rupee depreciation. With the developments in China where there has been a big pull back on the production capacity due to increased cost of funding, the demographics of China is also becoming less favorable for low cost manufacturing, with the labor cost scaling up consistently like in the case of developed economies. Chemicals, electronics manufacturing, pharma along with industrial consumables which supply to many manufacturing industries are becoming increasingly attractive.

WF: While the large cap correction is more recent, mid and small caps have been correcting for a few months now. Is it time to go bottom fishing in mid and small caps or should one be circumspect in this space now?

Manish – We continue to be slightly biased towards largecap and hybrid (multi) cap. This has been our perspective over the past 6 months as well, we are now encouraging investors to also look at multicap funds. Only thing is that midcap stocks are not really at distress valuations. The situation is not similar to 2009 / 2013 when the dividend yield was very high, there were lot of promoters buying into of stocks. Behavior-wise, the markets are not in that phase, this current correction is preceded by a very sharp run up. The past sharp corrections were not preceded by good market momentum. This is the first significant dip over the past 2 years. Despite this there is considerable polarization in the midcap space where certain FMCG, retail NBFCs have performed well over the past 5-7 years. There are some stocks within the midcap space in Utilities, real estate, midcap cements which are at reasonable valuations. With rupee depreciation, the replacement cost of assets has also gone up, lot of these units require imported equipment to cater to the ever increasing capacity. Hence, in the midcap space there are manufacturing companies which are available at reasonable book value.

WF: What level of equity exposure is your BAF model currently pointing to? How is your BAF product performing in the market place?

Manish – We are at 42.5, the aggregate valuations are a bit stiff at this point of time. We have been between 30 – 60 over the last 3 months. These products have a capital protection bias which has turned out well given the current scenario. The downside on these balanced funds have been much lesser than that of Nifty over the past 6-7 weeks. On a 3 month basis as well, Nifty is down but we have managed to remain flattish. Of course, the fund is positioned such that there will be aggressive capital protection during market downfall and on the upside, there would be participation to gain benefits. The overall intent of the fund is to provide stable returns. The fund is only 4-5 months into the system and we have been able to fall much lower than the broader markets, which is indicative of a good beginning.

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