Leverage Volatility For Long-Term Investment

Navneet Munot
Chief Investment Officer 
SBI Mutual Fund

What is your take on the present investment climate?

In the markets, expectations always run ahead of reality. Not long ago, almost everybody had written off India as a near basket case on the back of bad governance, slowing growth, possible stagflation, worsening twin deficits, and to top them all, a weakening currency. Most of those issues now seem to be passé. The much talked about tapering is now embedded in all its possible outcomes.

While there is merit in an argument that the market seems to be factoring a more optimistic outcome from most of economic and political events, one has to view this as a short cycle occasion within a longer cycle in existence for India. As regards a pick-up in the investment cycle, these things do take time but we are surely getting close to a bottom.

How do you rate FII activity over the recent past, and how do you expect it to shape up in CY14?

FII activity is a second level derivative of the money flows and investment climate of the developed world. A lack of plausible options in the EM peer set makes India a natural beneficiary in a world seeking relative returns. Last year, FIIs maintained their faith in Indian equities when almost every factor on economics, politics, policies and currency was adverse for India as an investment option. This makes us more bullish in the period before us, where India finds itself in a sweet spot of a bottoming out economic and earnings cycle and near-average valuations. A recovery, if any, would only increase the depth and breadth of FII participation in the market.

What is your take on inflation and interest rates for CY14? Do you foresee both of them coming down?

The RBI’s policy stance in the recent past has been guided by two major overarching factors: volatility in the rupee and inflation expectations. It has successfully navigated the necessary course correction through innovative initiatives that have attracted more than USD 34 billion in inflows over the past three months. These measures have brought some much-needed stability to the currency.

With this, the RBI has had to particularly focus on inflation of late, as both core and headline inflation have taken a significant turn for the worse. To the extent that we expect inflation to remain at elevated levels in the near term, the apex bank is likely to hike the policy rates at least one more time in the next few months. It also would like that the real rates remain attractive for some time in order to boost savings and restrain consumption. The RBI will have to remain hawkish to suppress ‘inflationary expectations’. After the elections, the government may also like the regulator to remain hawkish, tackle inflation, try to support growth through other measures and live with higher rates.

While it natural to get stressed over rising inflation, slower GDP growth and low IIP levels, this creates a right concoction for a better follow-up year as the new government rolls out its policies. In the short term, the regulator can opt for rate hikes to counter inflation, which provides a good inflexion point for a bond rally for the follow-up year.

Does the concept of ‘buy and hold’ still hold true, particularly in the present scenario when sector rotation is happening at such a fast pace?

One needs to be pretty sure of what one wants from the market. It is like farming – you can have crops that give you returns three times in a year, while there are crops that may yield nothing for the first three-five years only to grow annuities for generations. A market which is witnessing great volatility is certainly paradise for an investor with a ‘buy and hold’ category as he/she can patiently accumulate his/her favorite cookies at a good margin of safety when ‘Mr Market’ goes crazy. In its story of evolution, the Indian market is at an interesting point as it offers many such companies at an early stage of their transformation. The art would be to identify the right business model backed by the right management.
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What is your take on the present valuations of the Indian markets?

As things stand, the markets are trading at a 15-year mean of around 17x its earnings. The expected two-year earnings growth is around 12-14 per cent. While the cost of capital has marginally gone up, India is certainly offering trough cyclical RoEs – which can recover in the medium term. The elections offer a good probability of revival of growth and governance (2G). As one dives into the broader markets, the valuations are even more attractive.

What is your outlook on the Q3FY14 results, and how do you see the earnings of India Inc. panning out in H2FY14?

Quite a few of the businesses have benefited from a weaker currency, both in terms of incremental demand on the back of their improved competitiveness and the flow-through benefits of cash flows. Within manufacturing, engineering exports, chemicals and textiles are the initial beneficiaries. Domestic consumption, however, would take some time to come back. One should not expect any runaway revival in the operations of India in the second half. Our interactions with businesses do suggest that there is still some pain existent on the ground.

Overall, we expect corporate earnings to bottom out in the next quarter as one witnesses improvement in margins driven by a reduction in input costs, as more capacities go onstream, and as revenue growth picks up resulting in better bottomlines.

With the GDP number for Q2FY14 coming in at 4.8 per cent, do you feel we are looking at some revival in the economy going forward?

The sub-5 print on GDP is an important alert. However, India has demonstrated tremendous resilience in the face of such pressing situations. It has certainly brought back the missing urgency in governance and policymaking. The regulatory machinery has awakened to steamroll almost every roadblock to get the investment cycle back on track. Large corporates shunning investments onshore have started announcing their large long-term capex plans. Not to forget commitments from large MNCs to buy out quality local franchises/associates irrespective of high valuations. The elections would be a vital cog in this scheme of things.

What is your advice on playing the markets till the 2014 General Elections?

With the recent election outcomes giving a clear mandate in favour of growth and governance, one can safely extend the presumption that these two would be the cornerstones of things to come in India over the next several years. The new government, irrespective of its form, shape and structure, would have a share in providing the necessary momentum in the early part of the cycle.

Next year, I will assume ~15 per cent earnings growth with a slight re-rating of the market in view of a better political and policy environment. Equity markets do not deliver linear returns in line with the earnings growth every year. However, a ~15 per cent further run from here could be a reasonable assumption.

After the recent post-election euphoria, I do not rule out the possibility that the markets will repeat a similar response in case the political outcome in the general elections is in line with the markets are anticipating. Lots of returns of the next couple of years may get front-loaded in 2014 itself.

Which are the sectors that you are currently betting upon?

India is like a diversified sumptuous thali – you have enough variety and plenty to choose from. We remain positive on companies driven by good managements that operate in the space of niche consumption, media, export competitiveness and import substitution. We expect the next cycle of growth to be driven by investments, and a whole lot of companies in that area are attractively priced. There would be new set of companies benefiting from increased internet penetration.

Can you spell out the challenges that the Indian funds industry is currently facing?

The return of the domestic investor to the capital markets is a definite possibility in the medium term. Domestic investors would need to revisit their affinity to real assets, given the lower real returns in that segment going forward. The financial sector would also be challenged to rebuild the lost trust of its customers. Product innovation needs to benefit equally to the investor as to the manufacturer/service providers. Financial sector reforms in terms of disclosures, regulations, compliances and operative structures will have to play their own constructive part towards developing the necessary template for the same.

What advice would you like to give retail investors at this juncture?

Patience and discipline are very important munitions to succeed in investments. In the current stage of the market, it is important to use volatility as fertile bed for long-term investments before the friend in form of trend settles in.