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| 7/12/2012 9:00 PM Thursday

With respect to the Indian markets and Indian investors, how challenging do you find fund management?

Fund management is like parenting. It’s extremely challenging but at the same time enriching.

Are stocks like bonds?

Keen observers already know that stocks and bonds, in economic substance, are similar. Both represent claims on some productive enterprise. Stocks represent floating claims, while bonds represent fixed claims. The ability of stock claims to float ‘up’, and compensate for rising prices (inflation) has become an important reason for their relative attractiveness. In fact, for most parts of the last two decades, this ‘up’ factor has resulted in a significant premium paid for stocks. Corporate bonds, on the other hand, having no ready answer for the scourge of rising prices, have always sold much closer to their par value.

So how far ‘up’ did stock claims actually go? Looking back, between 1995 and 2000, the average annual return on book equity of the BSE 500 was 14%. Between 2000 and 2005, it was 16%. From 2005 to 2010, it was 18%. And for the last two fiscal years it has dropped back to 16%. The returns for few exceptional years were somewhat higher (2007), or lower (2008) than the 5 year averages, but over the years, and in aggregate, the return on book equity has tended to hover around 16%.

So it turns out that stocks after all have offered a somewhat ‘fixed’ claim of around 16%. And this fix, albeit loose, makes them quite comparable to bonds. This may be disappointing news to those stock investors who think growth in earnings, automatically means higher returns on equity. They fail to see that the cost of incremental capital used to generate higher earnings keeps their share of claims from continuously floating up. And, if stocks are purchased at a substantial premium then it puts even more downward pressure on their claim.

So how are they different - stocks and bonds?

Conceptually, stocks also offer their holders an implicit ability to reinvest earnings at 16% - until eternity. Bonds, in contrast, mature, and involve a periodic renegotiating of this reinvestment option. The eternal reinvestment characteristic of stocks can be good or bad. It was good in 2003 when corporate bonds were yielding 6%. In that environment, the right to reinvest automatically at 16% offered enormous value. It was a situation that left very little to be said for cash dividends and a lot to be said for earnings reinvestment. In fact, the more money, investors thought, likely to be reinvested at 16%, the more valuable they considered their reinvestment privilege, and the higher premium they were willing to pay.

If during this period, a high grade non-callable bond with a 16% coupon had existed, it would have sold at far above par. And if it were a bond with a further unusual characteristic – which was that its coupons could automatically be reinvested - at par, in similar bonds, the issue would have commanded an even greater premium. In essence, growth stocks retaining most of their earnings represented just such a bond. When their reinvestment rate on capital was 16% while bond rates were 6%, the stock premium naturally grew. However, as bond rates eventually rose, the trade-off between stocks and bonds narrowed. And the premium shrank.

There is a difference between managing funds on the debt side and on the equity side. What is the difference that you fi nd while managing a debt fund?

There is no great difference between money management in both these verticals. It requires the ability to comprehend data, analyze, add or kill risk depending upon the data flow.

Debt funds are not that popular among retail investors. What is your take on this?

Given the lack of social security systems in India, the concept of fixed income investing is more popular in India. That is why Indian favourite instrument to save is fixed deposits of banks. Unfortunately, general awareness for debt mutual funds remain low and most of the investors consider fund investing as an alternate to stock investing only. But it’s beginning to change. We, at Birla Sun Life, have been making attempts to popularize debt funds. As a matter of fact, we manage much larger retail AUM in debt funds than equity funds.

Do you follow any particular investment philosophy at Birla Sun Life?

The outcome of fund management we seek is to earn you the best returns while minimizing the risk. In debt investing, there are three kinds of risk; credit risk, duration risk and the liquidity risk. The whole idea of fund management is to minimize these risks. It is not to eliminate them, but to minimize them so that the returns are optimal. Markets are mostly smart, but often they misprice securities. Our objective is to look for dislocations and exploit opportunities across credit and duration points. We avoid both euphoria and despondence, and continuously look for absolute returns. We also try to avoid relative performance traps because it promotes short term thinking. Our idea is to look for secular trends and position funds accordingly.

What is your take on the growth, infl ation and interest rate fronts, and how do you see them panning out going forward?

Economic data in the month of June has not assuaged the rude shock that investors got in the last week of May when Q4 FY12 GDP printed at 5.3%. To put this number in perspective, India grew at 5.6% in the worst quarter of the 2008 crisis. In fact, a number of our high frequency indicators have slowed down quite a lot in the last 2 months. For example, car sales which was growing at ~12% in the first 3 months of the year, is now growing at 3% in the last 2 months. Similarly, the sales of commercial vehicle were growing at ~6% in the first 3 months of the year but has been shrinking at -11% for the last 2 months.

Our base case growth forecast for FY13 remains one of “muddle through environment at close to 5.5-6.5% growth rates”. That said, there are downside risks developing to even a 6% growth in FY13.

On the inflation front, headline WPI increased marginally from 7.2% in April to 7.5% in May. The key development on the inflation front was that headline WPI for the month of March was revised significantly upwards from 6.9% to 7.7%, a revision of 80bps. Overall, provisional WPI numbers have been revised upwards by an average of 50bps in the first 3  months of the year. These revisions indicate that WPI might be running closer to 8% rather than 7.2%-7.5% provisional numbers for the last 2 months.

Moreover, one of our lead indicators for inflation (Manufacturing PMI output prices) has been trending upwards for last 2 months, indicating short term upward pressures on inflation. That said, non-food manufactured products inflation (RBI gauge of core inflation) has moderated from 8.4% in Nov 2011 to 4.8% in May 2012. Our sense is that there is a good probability that core inflation moderates over next 4-6 months especially due to the moderation in global commodity prices and slowdown in domestic demand.

Our base case over last 2-3 months has been that slowing growth and moderation in core inflation will allow RBI to cut rates more aggressively (75-100bps) than what market expects over next 6-12 months. While our view remains the same, the timing of the rate cuts is a bit uncertain. As explained above, there is a good likely-hood that inflation figures for Apr-May might be running closer to 8% than the 7.2-7.5% provisional numbers. Also, some of our short term lead indicators for inflation are trending up. Thus, RBI might delay its rate cuts by a few months till the moderation in global commodity prices and demand slowdown cools core inflation further. Overall, our expectations remain that RBI will cut repo by another 50-100bps over next 6-12 months.

What is the impact that you see on the debt markets when the rates cool off?

Our key call over last 5 months has been that the “current environment is better to own 1-3 year corporate bond”. The key rationale predicating this view was that as RBI starts its easing cycle 2 things will happen. Firstly, Liquidity conditions will ease resulting in a compression in front end spreads and Secondly, as RBI starts cutting rates the yield curve will bull steepen and thus again benefiting investors owning the front end of the yield curve.

In the front end, our call that “that both 3mon and 6mon rates have peaked at 11.5% in March” are now deep in the money. 3 and 6 month rate rates have rallied 235 bps and 220 bps respectively from the highs in March and 1 year CD rates have rallied ~175bps. We still think there is significant opportunity for 1-3 year rates to be 100-125 bps lower over the next 6 months.

Is it the right time to invest in debt funds?

Yes it is.

How long do you see this scenario prevailing?

See the shelf life of low growth/low inflation is around one to one and a half years. So, I think you can invest in these products for at least one to one and half years.

The bond markets have not developed as expected. What, according to you, has gone wrong, and what steps should the government or the RBI take to develop it?

Shorter term markets have developed well. Mutual funds have been the key actors in developing short term debt market. Corporate debt markets have not been that popular except for countries like US and some others. Our sense is that, markets will also grow going forward.

So, do you think that going forward, there will be a pull between the debt market and the equity markets?

Though, the long term attractiveness of equity is well established, the recent experience in stocks investing has put off a lot of investors. Many have begun to question the utility of stock investing. Don’t make that mistake. Stocks are must if you want your capital to earn substantial real returns over long period of time, just that one must choose the right time frame to assess the earned returns on stocks, i.e. at least 5 years. More importantly, stocks must be wrapped in good debt instruments. Investors have participated in debt only through fixed deposits of banks, but there exists superior instruments of debt investing. Fixed Income funds do a better job of ensuring not only certainty but also superiority of real returns (due to better tax incidence and agile investing). Go figure out some good funds to invest in debt, I am sure you will find many Birla Sun Life funds in your list.

Do you think that there are limitations for a debt fund manager as compared to an equity fund manager?

Not really. The short term markets are pretty deep and I don’t think that there are such limitations as compared to equity fund managers.

Going forward, how do you feel the key factors like gold and crude prices will pan out?

We have been of the view for more than one year now that the commodity prices, crude included have peaked out and they may decline secularly over next few years. That will be good for our country. As far as gold is concerned I consider it as an insurance product and I think it has become prohibitively expensive. A general vote of no confidence against most of the currencies across the world has led to this kind of appreciation. Because it’s too pricey the returns in gold will be much lesser as compared to other fixed income products over next 5-10 years.

How fast do you think that the government will be able to dissipate the twin defi cit gap, which is another major factor for the market?

The biggest nuisance the government has created over the last three years is higher government expenditure most of which is directed towards salaries and subsidies. I guess the PM is aware of that. No one is saying that government shouldn’t spend. But it must refrain from wasteful spending. India needs a lot of government investments in education, healthcare and infrastructure. The current account deficit too is a symptom of supply constrained economy that India is. Our government has facilitated a lot of consumption by way of high spending but production or supply hasn’t caught up, which reflects in high trade deficit. Restrained governance appears to be the only solution to both the problems.

What is your take on the Euro zone crisis?

The long term solution for Europe will be fiscal union. Are they going to bring that? Yes, but this will take a lot of time. Our thesis is that Europe is going to struggle for the next many years but it does not mean that it will disintegrate.

How does it impact our markets?

From a capital account perspective Europe is important as European banks have a lot of exposure here with respect to ECBs and FCCBs raised by Indian corporates. If these banks continue to de-leverage, there will be funding problem for the Indian corporates.

What is your advise to investors in the Indian markets at this juncture?

I think there is some sort of disappointment for entrepreneurs and investors as they are not able to generate better returns. My sense is that the concerns are somewhat overstated, as India remains a sound investment story for next two decades at least. The fundamentals remain strong. Due to low leverage, younger population  and relative poverty, we will continue to see better growth in the next many decades. So go and invest in this story.


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