Cautious at Current Levels; Volatility Will Bring Buying Opportunities: Mahesh Patil

This has been a good rally for the market after we touched a low in February. The market is up around 27 percent from that low and it has been driven by a global rally, more so in emerging markets. Emerging markets have seen good inflows and India has also rallied in line with that. India could probably do better because we have seen things actually improve at the ground level. Globally, growth and earnings have kind of slowed down but India has seen at least a marginal improvement. On the corporate earnings side, things are looking better after the last quarter. The valuations have moved up because of the rally, but across the world because of the easy liquidity, we have seen valuations across assets classes move up. So valuations would remain a bit stretched in this kind of environment. So it's important to see whether we get decent earnings growth numbers this quarter. I would say earnings have been a mixed bag but fairly in line, and as the outlook improves, I think the market should be able to track this growth over the next few quarters. The markets might be susceptible to global shocks. Global markets have been climbing walls of worry. Data points haven't been all that good. So there could be some reactions on the global front. I think we are aware of that. We will also react if there is a global selloff but I think we are in a much better position. I would say this is a time where markets would consolidate. I'm a bit cautious at these valuations but I still wouldn't be out of the markets.

We have seen a bulk of these actually play out. We have seen 150 basis point interest rate cut in the last year. I think the transmission of these rates will happen with better liquidity. That is what the RBI governor has been talking about. We think there is a possibility of another 25-50 basis cut in the next one year because we are pretty bearish on the inflation front. Recently, we have seen some spike in inflation because of food prices. I think that should moderate so that's pretty much factored in. Even commodity prices...oil had touched a low, that to some extent has already been factored in. So I don't know if some of these global factors would be key drivers for the market. I think from the domestic side, the pickup in the broader economic indicators..we have seen some green shoots in the economy in a few sectors like auto, especially commercial vehicles, in the core sector cement demand has picked up, even oil consumption has improved. If that sustains, and we get the benefit of good monsoon in the second half, I think earnings outlook would improve, and that will be a trigger for our markets.

If there is a correction because of global factors, automatically you will get the same stocks at better valuations, which have been a slight concern at this time. We don't think global factors will have any big impact on India. A lot of the growth in India would be driven by domestic factors. Even a lot of sectors which are linked globally, like IT or pharma, their earnings are not so vulnerable to any kind of slowdown. So I think it would be a good opportunity really for investors who have been waiting on the sidelines. I believe there is a good amount of cash waiting to enter the markets because not many have been able to participate in this rally. So I think if there is a correction, you will see that money coming into play and that will provide support to the market.

Earnings overall have been balanced, in line with expectations. 53 percent of the companies have been slightly better and the rest slightly lower than estimates. So on an aggregate basis, they have been pretty much in line with our thesis of full-year earnings growth for Nifty at around 14 percent. We don't see a change in that but if you go down to the sector level, there have been a negative surprise from the IT sector where growth expectations have been lowered for the industry to around 10-12 percent, 200 basis point lower than what we were expecting earlier. Also, I think there are concerns about the impact of Brexit. So there could be some concerns on the IT sector as we move forward.

The flows for the overall mutual fund industry have slowed down a bit. If you dissect that into two parts, the recurring flows from the SIP books, that is pretty strong and steady. So the overall SIP book for the mutual fund industry is now more than Rs 3,000 crore on a monthly basis. So that number is pretty much intact. There could be some lump sum investment which has seen some volatility. So there has been a slight slowdown compared to what it used to be six months ago, when the run rate was somewhere around a billion dollars of monthly inflows, it would be down by about 25-30 percent, but still I think there are investors who have been able to keep the belief in the markets despite the volatility that we saw last year and early part of the calendar year.

Markets have recovered a fair bit after the February lows. I think funds have been able to do much better and that's primarily because the breadth of the market has been much stronger. So you have seen a lot of the companies outside the benchmark, in the midcap space, arguably because of better growth outlook  and better earnings growth, have done that much better. I think the experience for the investor who has been in the market for three years or so, has been still pretty good and that's what has kept the faith in the markets. The alternatives for the investor in an environment where interest rates are coming down, we have seen small savings rates also being cut recently. One year fixed deposit rate is closer to around 6.5 percent. So in this kind of environment, the alternatives for investors to invest are coming down. Real estate is not doing that well. So I think that also is a reason investors are still comfortable investing in markets. I would also say that the industry itself is driving a lot of investment education. There are efforts going into it. We see a lot of new investors coming in, in the last one year, and that trend will continue and that will be supportive for domestic flows also.

You are right. The NBFC sector has fared well in the last six months or one year and there are various reasons for that. A lot of NBFCs have been in the niche areas of mortgage financing, vehicle financing or consumer financing or microfinance companies or unsecured lending. So in areas where banks are not well penetrated, NBFCs have been able to grow because of their niche focus, at a time when credit growth has been weak. So you have seen overall credit growth for banks has been 10-11 percent, whereas NBFCs have been able to grow their books by focusing on the retail side where growth has been very strong. Retail has still been an underpenetrated market. The leverage at the individual level is still pretty low and what has happened this time around in the cycle compared to the earlier cycle in 2008, is that the delinquencies on the retail side have been much slower, probably because of learnings from past experiences and also because of the credit bureaus which have been able to get more information on the credit history of the individual borrower. I think all these factors have led to a better credit score and lower delinquencies, and as a result, you have seen strong performance in terms of earnings for NBFCs. Wholesale credit rate has come down because of better liquidity. At the shorter end of the curve, the rates have come off so that has also meant that cost of funds for the NBFCs, which normally depend on the banks and also on the retail market, have come down which has led to better margin. Yes, valuations have gone up. But structurally we have seen these companies are in a much better shape with better growth outlook. So there could be some moderation, but by and large, we still like to see this as a long-term secular story and we would want to continue to hold on to these.

So the microfinance space comes with its own problems. A few years back, there were problems in one state and that had its own cascading effects. This is kind of an unsecured lending, so if something goes wrong it can impair your book. But over a period of time, we have seen this industry has come to be regulated by the RBI. Secondly, this industry has realised the risk of being focused in a particular market. So they have diversified across geographies. This sector is catering to a segment which would have gone to a money lender or others where the rate of interest is very high - 30 percent or so. The lending rate is still higher, around 20-25 percent, but that's the only credit which these individuals can borrow and there is a need for these small borrowings to meet their working capital needs. That opportunity has been tapped by these companies, and so they have been able to grow at a very fast pace. But one has to watch some of these names, because whenever there is a high growth rate, of 50-60 percent, one has to be a bit careful, look at the risk factors. But this is a sort of community lending. So that ensures that within the community - and this is a model that has been tested in various other markets also....So while there is, when there is a frenzy, too many players coming into the market offering free money, there is a tendency to overexpose a particular individual and that is something we are monitoring. But we clearly think there is a business case for microfinance companies which are catering to a segment which was otherwise been ignored. So you have to look at the risk management practices of some of these companies, and how diversified they are across geographies. We are cautious but I think there is still is a story there. Knowing that there is a blow-up that could happen, one has to keep one's ear to the ground, to see if there are any risks that are coming up, to take any corrective actions.

We have participated in some of these stocks and they have done pretty well for us. At a certain point in time, based on our valuations, we have booked some gains in some of the names. But purely based on valuations, we do not see any major risks in these stocks.

If you look at the oil and gas space, there are two parts to it. The upstream companies and downstream companies, and you are referring to the downstream companies. It is a combination of oil marketing and refining. So what has happened in the last one year is that we have seen that oil marketing companies, after the decontrol of diesel and petrol prices, have had the freedom to change prices depending on the fluctuation in oil. Initially, the market was sceptical if the government will allow them to increase prices especially when oil prices would go up. And they have amply demonstrated that when oil rallied prices rallied from a low $27 to $50-55 per barrel. That has reposed confidence that they are really working in a free environment. So then it boils down to the kind of marketing margins that they have. Which is fairly decent. And as a result of the regulations on the subsidies they have today, their working capital has improved significantly. So the borrowing cost has gone down. As a result, their overall profitability has improved. Their return on capital ratios has improved from sub-10 percent to mid-teens or higher teens. And that is the reason for rerating of oil marketing companies. The refining margins have also been pretty good recently. Especially in a lower oil price scenario we've seen that some of these public sector refiners, which normally did not have very high refining margins, have been able to benefit more and their losses are much lower. As a result, we have seen very strong numbers. The valuations are still pretty reasonable for some of these names. They are not at lofty valuations when compared to the broader market. So I think it is still a reasonable space to look at and what will drive these companies in future is the volume growth. India is still a growing market, so demand for petroleum products will still be strong. And as long as you are able to maintain independence in pricing power, stocks should do fairly well.

We saw the pharma sector underperform last year after a really long time. The sector has seen quite a secular run in the last four or five years. Last year, because the issues related to the U.S. Food and Drug Administration, with the warning letters that some companies have received we have seen some setback and that has led to some de-rating because people started to perceive the risk of U.S. FDA warnings which were not there earlier. There was also a delay in introduction of new products because the approvals got delayed for introduction of new products in the regulated markets like the U.S. So we have seen underperformance. The good thing is that we have been in touch with some of these companies, we have met a few consultants and the sense we get is that some of the larger companies are taking corrective action. They are employing consultants, investing more in their facilities, trying to really work around and ensure that the plants meet standards which the U.S. FDA requires. The U.S. FDA also realises that the Indian pharma is a big player in the generics space and they cannot really be as harsh as they have been. So recently they have been giving approvals. We think this process should catch momentum and it's a learning curve for the Indian pharma space is going through. They should be able to come out of these issues in six months to a year. They have invested in good research and development; they have a good product pipeline based on which they will be able to do well over the next two to three years and post the correction it should be a good time to look at the pharm sector. The pharma sector has always been stock specific and that is what we are looking at as the product pipeline is strong over the next three years where they have done the necessary ground work on the facilities to ensure that the facilities get approved in the near term. We remain constructive on the sector.

All your observations are perfectly right. In the U.S. there is some pricing pressure in the generics space. That is why we have some companies which are launching better products and moving up the value chain where price erosion is much lower. It important to look at which companies have been able to invest in research and development and really get products where there aren't too many players in that space and they would not see much of price erosion. There has been pressure in the domestic market though volume growth has been pretty good. The NLEM list has a short term impact but after that there is steady increase because there is an inflation linked price hikes that you can carry out and a lot of companies keep on working to bring their costs down. So the domestic market remains pretty good and steady. There could be one year impact on some of these stocks but we think domestic market can grow at 14-15 percent and it is a good growth to look at especially compared to broader markets.

So on consumption, you are right that we have seen weak kind of volumes growth because I think we are still reeling in the last two years of impact on consumption. Initially it was urban consumption which got impacted which is now showing signs of improvement. Rural started to get impacted a few quarters back on back of second year of poor monsoons and soft commodity prices also hurt the cash crops income for the farming community. We have seen a revival over there. The soft commodity prices have moved up like sugar, wheat, cotton, rubber so that should bode well for a lot of the farmers and also monsoons this year should be well above normal and the sowing has also been good until now which is up about 4-5 percent. So I think that should bring back some of the momentum on the rural side. It may not happen immediately but if this continues you should see the rural economy start to kick in and especially consumer staples should see a pick up. On the discretionary side, lower interest rates will help. Further rate cuts will drive demand. A lot of consumer durables are now also being financed. Also pay commission pay-outs will start to kick in and though they not be as big as what they were last time, it will still be more money on the hands of the public sector employees. We remain fairly positive on the consumption story. Consumption has been the mainstay of the Indian economy. And that still remains the long term secular growth not just driven by demographics but also some of these near term factors. So given these things one would still look at better outlook for consumer names and valuations are on the higher side but again where there is more visibility and a lot of these companies have strong brands, pricing power, high return on capital employed, free cash flows, so there we have seen re-rating. Of course high quality has been re-rated. So despite the higher valuations, I would say it is a good sector where growth outlook despite the numbers we have seen in the last few quarters, should do better.

It's very difficult to say what one should avoid but we are underweight on the IT sector because the growth expectations are much lower and we think there could be some further downgrades to earnings if Brexit and its implications get fully factored in. And also telecom. That's a sector where we have been cautious mainly because of the capital intensity because of spectrum auctions and there is a lot of money that is getting invested in technology or towards spectrum. The competitive intensity, especially with a new player coming in, we might see pressure on the data side. So one will have to wait and see how that pans out before one starts becoming bullish on the sector.

Brexit is something that surprised everybody. Pre-Brexit a lot of people were saying that if that happens, we would see big ramifications of that on global liquidity, the banking sector will get impacted in Europe but up till now we haven't seen any of those things and the liquidity issue has been addressed by the ECB cutting rates, the Bank of England coming with a bond buyback programme and also with reactions from other central banks. So that has taken care of the liquidity issue for the time being but I wouldn't rule out any second derivative impact because of Brexit. We have seen some pressure in growth in the U.K. which has slowed down, the property market has been impacted and there has been a correction. On the banking sector, one has to wait and see how it impacts European banks which are already very highly levered and there is a lot of collateral against real estate and if there is a correction there, what impact it will have. All these things are very difficult to predict and if one thing goes bad, you will see a cascading impact. So we remain cautious and haven't really brushed aside the Brexit impact. So one would remain cautious.

A stock would go up to that extent for two reasons. One, there could be re-rating in the stock or there could be better earnings growth. So only a combination of these two factors will give you that kind of huge alpha. And there are very few stocks that will measure up to those kind of reasons – unless it's a totally undiscovered stock, and it sees a huge re-rating, and it's a high growth sector where the earnings growth can grow at a compounded rate at a much higher pace. So one has to look at if there is any significant change in the underlying market outlook or the opportunity which is there which was not factored in earlier. One needs to watch whether there is any significant change. It could also be due to some kind of management change where new management comes in and talks about a big amount of restructuring. There will a lot of low-hanging fruits that you can benefit from initially. So such factors need to looked out for. But you should be alert and look for the negatives as well. Also look if the stock is driven by institutional ownership or whether it is driven by speculative activity. We see a lot of penny stocks rising because of liquidity or some other reason, so one needs to be warned and cautioned about that.

It's a complex sector. The government is trying to focus on coastal shipping and inland shipping as a cheaper mode of transport. But that would require a lot of infrastructure development at various ports which will take time. On the global front, with the global growth slowing down, with overcapacity in oil, it does not look exciting. So it might look good from a longer-term perspective but one has to see real progress in terms of infrastructure development on the domestic side for us to be really bullish on that space.

Our debt view is that we are sanguine about inflation remaining low from a structural perspective. Short term we have seen it touching 6 percent or so but looking at the way monsoon is and even pulses where we saw sharp inflation last year, cultivation of pulses is up 30 percent, so we should see prices correcting. So given all these factors and where global commodity prices are likely to be, we think inflation should remain pretty low. Also given where global interest rates are at this point in time, there is scope for bond prices to go down further, even from these levels. And so there is some juice left on the bond side rally to play out over the next one year or so, though the bulk of the rally has happened. In the short term, one might see some pullback, but over a one year period, looking at domestic inflation, global macros, and global interest rates, and the interest rate differential of India vis-à-vis the world, there is still some more juice on the bond side.

The influence has been over a period of years. I had started this investment journey about 23 years back so in the initial years, was brought up on books on Warren Buffett, Philip Fisher's “Common Stocks, Uncommon Profits” – in terms of what to look at companies, trying to identify potential winners. It's not the number of stocks, but the outperformance of a few big stocks that can make a big difference to your portfolio. That's what really influenced in the early stage. But after that, it's purely your own experience and learning in the market which is important. Every mistake you make in the markets, I think it's the tuition fee you pay for learning, and that helps you to really define your own philosophy. I think you need to have your own philosophy. You might borrow initially from great masters, but you have to really bring in your own philosophy which will help you stand during difficult times. Also, as a firm, over the last few years, we been influenced to some extent by our parent Sun Life. Sun Life owned MFS in U.S. which is one of the oldest funds in the industry and their philosophy of looking at stocks from a longer-term perspective, evaluating stocks or even fund performance from a three-year perspective is something we have also tried to adopt. Earlier we used to look from a one-year basis – that used to be the horizon to value a stock. Now we increasingly looking at a three-year view. That helps us to identify companies from different dimensions. You are asked about stocks which are overvalued, so even if a company is expensive in the near term, but if you are able to visualize over a three-year or longer period, what kind of a compounding it can do, then your comfort level goes up and you are able to buy into companies even at higher valuations, good companies which are long-term great compounding stories. So these are factors which have influenced our philosophy and my philosophy personally as a fund house also.