investment strategy | portfolio allocation: expect moderate returns going forward; no possibility of expanding stock market valuations: Vetri Subramaniam
January has been pretty good so far, but we’re in the middle of revenue then and the budget is only a few days ahead. How do you think the texture of the market will evolve?
We don’t think too hard about what the market might do immediately or not. From my perspective, the kind of message I would like to share is that we have had a nice rally over the last 18-20 months, valuations have reached quite rich and expensive territory. The medium-term outlook for Indian corporate earnings growth looks quite robust and solid; but there really is no room at the overall market level for valuations to rise. On the contrary, at some point we should expect a normalization of valuations. You have to have more modest expectations of the market at this stage.
Which pockets do you find highly valued or is this an overall market appeal that you have?
There are actually two parts to this. The first is that historically the overall market valuation is certainly expensive – whether you look at the Nifty500 or break it down separately into the Nifty 100 which are the large caps. The Nifty150, which is the mid cap index, and then finally the Nifty Smallcap 250. Each of these segments actually trades at quite rich valuations.
Second, another way to see if the asset class is particularly attractive is to compare it to an alternative asset class which could be bonds. When we look at the forward earnings yield we get on stocks and compare it to what we get on 10-year bonds, there is a historical relationship between the two. Right now, we’re trading quite off the historical numbers, which again makes the case for equities slightly weak. So, at the aggregate level, there is a valuation problem.
You asked about pockets that might look attractive; they are still there. Some of the areas that have underperformed lately – financials, autos, pharmaceuticals – enjoy strong structural growth prospects, but they have seen fairly subdued short-term trends. This is now adequately reflected in valuations and therefore makes these sectors attractive to value investors.
Should we compare historical benchmarks and historical valuations with future valuations, because while valuations may look high, this is a forward-looking data point we compare them to after seven or eight years of depressed earnings?
You’re not necessarily comparing earnings for the last seven years. We compare forward earnings, so we already recognize what companies are likely to earn in FY23. I don’t know how you want to get away from earnings altogether. I think you’ve been in the market too long; ultimately it’s all about the earning power of companies and when you pay a very high price, you basically assume that nothing can go wrong in the next three, five, 10 years. For me, it’s the risk.
Just as we never knew the events that would happen in 2020 or going back before that, it doesn’t have to be that dramatic either. it could be a few years where stock prices cool down, stop responding to rising earnings. So we don’t know exactly how it will play out, but essentially everything is tied to the earnings trajectory and you can’t disconnect it from earnings.
People keep saying that the cost of capital is very low. Of course it can be built in, but one of the reasons the cost of capital is low is that the inflation expectations that are built into the cash flow assumptions that one makes for the business are also lower . Second, the threat of competition when the cost of capital is low is also much higher. It really is a balancing equation. One cannot simply ignore the gains at all times. Those who do this are asking for serious trouble at some point.
The biggest debate, which is perhaps the most common debate, is whether the Fed will raise rates and how that will affect liquidity and valuations. This is the most anticipated event of this year. What is your understanding of market readiness?
You put the context very well there. It was reasonably well anticipated. In November-December, when the Fed abruptly pivoted, a small jolt went through the markets. But it’s important to recognize the context and many of us remember the context of the last time the Fed pivoted, which was in 2013.
In 2013, the current account deficit was close to 5%, the trade deficit was 10%, reserves were quite low and we had high inflation. Today, fortunately, we are not in a similar situation. We have foreign exchange reserves of $650 billion, which is very comfortable in terms of the months of import cover we have. FDI flows have been very strong, the current account deficit stands at around 2% for the year ending March 2022. From all these points of view, India’s situation today is very different. from what it was in 2013. Therefore, I don’t expect such market destabilization as what happened in 2013 because the context and the data points for India are very different this time.
Given that we are so different from where we were during the last financial crisis, since the last time central banks around the world started to scale back quantitative easing, can this outperformance really continue?
I’m not so focused on whether or not we outperform the rest of the world. We will continue to do well and generate reasonable returns, but what do you put into context when you say how good the weather will be? Look at data from the last 30 years; there has never been a year in which the peak to trough for a year, not necessarily the whole year, has averaged around 12-15%. Drawdowns are therefore an integral part of the market mechanism for correcting overvaluations. I would be very surprised if that were banned.
When we talk about the Indian market having generated a 15% CAGR over 30-40 years and maybe around 11-12% CAGR over the last 10-15 years, this has happened despite the drops that have occurred during this period. We do not prohibit stock market volatility or declines. As I keep saying, drawdowns are a feature of the stock market, they are not a bug in the system. If we think of this in terms of the fact that the market will be up every day, every week, every month, every year, we are on the wrong tree.
My message to people would be that it is completely normal for the market to experience setbacks. When things are looking good, when they are reflected in valuations, that’s when the unexpected can drive stock prices down or go through a period where profits are coming in but valuations are starting to fall. reverse. So that doesn’t necessarily mean we’ll see anything cataclysmic, but crashes do happen regularly. There is nothing unusual about this in stock markets, look at the history of the last 40 years.
Finances top the charts with nearly 29% in your portfolio. We are all waiting for finances to recover. Would you like to rebalance your portfolio where you have finances, IT seems to be overstretched and perhaps increase in materials and industries given the recovery in activity?
Look, materials is a really big basket because it includes everything from global commodities to chemicals to paints and that kind of stuff. It is a very large basket. As far as global commodities are concerned, most of the rally from very cheap valuations and bottom price levels is now behind us. This is not to say that metal prices will necessarily crash at some point to the lows we saw in early 2020; but the peak is behind us and as a result they now trade more at reasonable mid-cycle valuations.
We see no reason to expect any major runaway movement there. So until the valuation equation becomes more favorable, metals stocks would not excite us. You also mentioned finances. Yes, this is an area where we tend to be quite positive. The reason is very simple, India’s credit to GDP ratio is still around 56-57%. Forget the developed world, most emerging markets have higher credit ratios than that. If you finally consider India’s economy getting back on the growth trajectory, the demand for growth will also be quite strong.
We believe there are now a handful of financial institutions that are very well positioned to outperform the market and continue to gain market share. I don’t know when the tipping point is, but we’ve learned over time that when the valuation is favorable, you can keep lining up there and patiently waiting.
Aapka bhi aayega number (your turn will also come) is what I would say to those who might be disappointed by the weak finances. The opportunity is certainly there given the low penetration numbers we have in lending to GDP.