Macro environment in the country is no longer benign

Sanjay Dongre

Executive VP & Senior Fund Manager


  • Don’t look for a repeat of high returns from equity funds that we’ve seen in last 3 years
  • Macro environment is no longer benign, though bottom-up earnings growth is promising
  • Focusing on stocks with high earnings visibility over next 2 years
  • Mid and small caps still trading at a premium to large caps, despite correction
  • Lot of activity in the infra space beyond just headline grabbing road development numbers

WF: The market’s bounce back in April now puts us as one of the world’s most expensive markets (23X on trailing PE basis), trading at some 15% premium to long term average. Are we once again running far ahead of earnings growth?

Sanjay: So when we look at the market from valuation perspective it is quoting at 17 times one year forward earnings. The average market multiple of last 10 years is about 16 times. Currently markets are trading at above the average levels. So to that extent valuations are not cheap. Therefore our expectations of return from the market should be on the lower side. We may not be able to see a repeat of high returns that we have seen experienced in the last 3 years.

Macroeconomic environment in our country is undergoing a change. Inflation and interest rates have bottomed out. Today they are 100 bps higher than what they were prevailing a year back. Current account deficit is almost 1.6 percent. The benign economic environment that we have been seeing in the last 3 years is not going to remain benign anymore. Therefore news flow on the various economic indicators may impart volatility in the market place.

On the other hand, the probability of earnings being in double digit is going to be higher after 3 years of subdued earnings growth. We expect normalization of earnings in some sectors like banking. So on one hand you have macroeconomic environment which is deteriorating, on the other hand earnings growth that was lacking in the market is picking up. So, we have a balanced picture and because of which volatility is likely to higher in FY19 compared to what we have seen in the last 3 years.

WF: Since the biggest case for Indian stocks in the short to medium term seems to be earnings recovery, can you please share some insights on how exactly earnings growth is shaping up vs expectations in key sectors like financials, energy, IT, auto etc and at an overall market level?

Sanjay: Nifty earnings growth should be in the range of 18-20 percent in FY19 and 14-15 percent in FY20. Part of earnings growth can be attributed to base effects of past year. Most of the growth is expected to come from domestic oriented sectors. As per RBI expectations GDP may grow 7.3% in FY19. Unlike past few years, contribution of manufacturing sector is expected to higher. Sectors like auto, cement, construction, engineering, financial sectors will see double digit earnings growth. The normalization of earnings may also happen in PSU Banks and corporate oriented private sector banks.

Indian IT companies have undertaken initiatives to transform business models, as digitization of businesses leads to higher spend around big data, analytics, mobile, social media and Internet-of-Things. Traditional services are getting commoditised and are facing pricing pressure. Ramp up of few large clients coupled with cost optimisation measures may lead to higher earnings growth in FY19 compared to FY18

In financial sector, retail oriented banks and NBFCs are doing well with earnings growth of more than 15%. For the last 18-24 months, corporate oriented private sector banks are experiencing stress in its loan books. However, these banks are more towards the end of the stress recognition cycle rather than toward start or midpoint of stress recognition cycle. Going forward the credit cost of these banks may decline substantially. Hence the profitability of these banks may come to normalcy in next 12 months period. One can expect the corporate oriented private sector banks to quote at better price to book multiple.

In auto sector, Cars, Tractors, CVs are doing well and momentum is expected to continue in the medium term.

WF: If you were casting a fresh portfolio today, would you be relatively more overweight on cyclicals or defensives and why?

Sanjay: The strong performance of equity market in the last four years is largely attributed to multiple rerating as the earnings growth remain subdued. However the macro-economic environment is expected to undergo change in 2018 on account of slippages in the fiscal deficit, rising inflation and worsening current account deficit. It may weigh down on the multiples at which the market is quoting. Hence the recovery in the earnings going forward is important for the market to sustain at the current levels. Going forward, the earnings growth is likely to play the significant role sustaining the valuations for sectors/stocks. Hence my endeavour would be to remain invested / overweight in the sector/stocks where the earnings growth is likely to be high in next 2 years and remain underweight in the sector/stocks where earnings growth is likely to be less than market earnings growth. Sectors such Auto, Cement, Engineering and Construction, Financials are expected to deliver higher earnings growth in the next 2 years

WF: As a corollary, would you be relatively more overweight large caps or mid and small caps and why?

Sanjay: Nifty is quoting at 17 times one year forward multiple. Despite the correction in the last 3 months, mid /small caps are quoting at a premium valuations compared to large caps. The real serious money is made when these small and mid-cap stocks start quoting at a discount to the large caps.

WF: As the fund manager for the UTI Infrastructure Fund, you must have a deep insight into the sector. Beyond roads which seems to be the poster boy, where else within the infra space are you really seeing traction?

Sanjay: Apart from Roads, Metro rail projects are currently under construction or are in advanced development stage in 12 cities, including Bangalore, Chennai, Jaipur, Chandigarh, Pune, Nagpur, Lucknow, Hyderabad, Mumbai, Ahmadabad, etc. The combined cost of these projects is over Rs 2 lacs crores. Railways has planned an ambitious investment outlay with major focus on network decongestion, network expansion and rolling stocks. In the next 3-5 years, Airport sector may witness higher capex in terms modernization of existing non metro projects and second green field airports in Mumbai and Delhi. Some the dry states are spending almost Rs 1 lacs crores on irrigation projects. Similar spend in irrigation is expected in the medium term. Housing for all may present Rs 5 lac crore opportunity through programmes such as National Gramin Awas Mission, Pradhan Mantri Awas Yojna- Urban and Rural. Construction opportunity can be high for construction players as Govt sets up IITs, IIMs and AIIMs throughout the country.

WF: Market experts used to say until 2016 that for a sustainable economic growth cycle, we need private sector capex to contribute meaningfully. The stock market’s upmove in 2017 and beyond seems to have drowned out that concern. Where are we on private sector capex and how important is it for sustaining the market going forward?

Sanjay: Indeed, the Fixed assets investments are important to sustain the economic growth over medium to long term as consumption led growth is bound to hit the ceiling in medium term. Industrial capex in India has been subdued over the past 5years, as reflected in weak capex spends by Indian companies, corroborated by weak orders for equipment suppliers and muted industrial credit growth. However, capex by consumer-oriented sectors like Autos, Telecom,, FMCG, Food & Beverages and Consumer Durables/Electronics has remained largely uninterrupted. Leveraged balance sheets, low capacity utilization and several macro disruptions in the economy impacted the private investment cycle. Therefore, the burden of investment growth was falling on the government’s shoulders. Government spending on infrastructure, especially on roads and railways, has gone up in last three years. After many years, we are seeing some early signs of pick-up in industrial capex. Post the cyclical downturn in the core sectors, we are starting to witness green shoots of recovery in sectors like Oil & Gas, Steel, and Fertilizer. Private sector capex in the Power sector will be toward renewables.

WF: For an investor coming in new into equity funds at this stage, what would be the key investment argument to enter now and what would your advice be for this investor?

Sanjay: As equity assets class have far higher volatility compared to other asset classes, best way to even out such volatility is to invest through SIP (Systematic investment Plan). As corporate earnings are expected to pick up in FY 2018-20, the equity markets are likely register reasonable returns in the medium term. In such case, investors are likely to earn handsome returns on the investment made through SIP. Depending upon the risk appetite, investor should allocate 75-100% of equity investment to diversified equity funds and 0-25% to midcap/thematic/sector funds.

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