WF: What do you make of this pre-election rally? How sustainable is it?

Mahesh: I wouldn’t call this a pre-election rally – rather, we are now catching up with the emerging markets rally that’s been in play since Jan 19. Over Jan and Feb, there has been a decent global rally and in particular, a healthy EM rally on the back of a belief that the US dollar’s strength is now behind us and that US interest rate hikes are going to pause for a bit – which gives room for an 8 year underperformance of EMs vs developed markets to now finally correct. India did not participate in this Jan-Feb rally due to concerns on how the election results will play out and whether we will get a stable Government post election. In the aftermath of the events in J&K, there is a belief that the ruling dispensation can come back – which gives the market comfort due to a perception of continuity. The other big drag on Indian markets was the NBFC issues – which now also seem to be behind us. Earnings for the December quarter were a bit disappointing – which also kept markets in check in Jan and Feb.

So there were many reasons why money was on the sidelines and now, the perception of potential continuity in governance post elections has caused that money to come into markets. What we are also seeing in the last few days is that its not just ETF money from abroad that’s coming in – some of the active funds which were so far staying away, have also started investing.

WF: Do fundamentals justify this market rally? Are earnings growing well enough to support a continued upward momentum?

Mahesh: I don’t think there is a material change in fundamentals – and that will perhaps keep this rally in check to some extent. I don’t expect a huge rally – we are seeing a catch up trade and going forward, markets will track earnings growth. If markets run far ahead of fundamentals, we are setting ourselves up for some disappointment down the road.

While we expect a decent earnings growth in FY20 – mid-teens if you exclude corporate banks where we expect a sharp jump up, we have to bear in mind that global growth has slowed down, we are not yet seeing a broad-based cyclical economic recovery in India and our fiscal position is a little stretched, though not worrisome. So, room for sizeable growth is limited. We therefore believe that post this catch up trade, markets will go back to tracking earnings growth.

For investors, it is all the more important to take a longer term view and invest in equity. The fear of a sharp correction due to political instability is receding and the longer term growth potential of the Indian economy is clearly there for all to see. The need to sit on the sidelines is receding, the need to stay adequately invested in equity is paramount. While nobody can accurately predict election outcomes, one can reasonably predict that earnings growth in FY 20 should be decent and that can support markets.

WF: In recent days, we have seen sharp rallies in the small and midcaps spaces and the belief is that smart money is moving in here now, post the huge corrections over the last 15 months. Is this a good time for distributors to advocate mid and small cap funds?

Mahesh: We have been recommending investing into small and mid cap funds in recent weeks and continue to do so. Post correction, valuations in this space have moderated considerably which fundamentals haven’t really deteriorated – thus making them a lot more attractive now. There has also been a huge aversion to this space especially from the second half of last year when the NBFC issue was at its peak.

In the universe of stocks we track, midcaps are growing earnings faster than the largecaps. Mid and small caps that focus more on the domestic economy should see healthy earnings growth which should sustain a rally in their stock prices in the medium term.

Take a 3 year view and invest in small and mid cap funds – however, as always, don’t go overboard – stick to 25% to 30% weight towards mid and small caps funds within your equity basket.

WF: “Quality” stocks – stocks with high earnings visibility – have been bid up to historically high PEs, perhaps due to too much money chasing too few quality stocks. What happens to these PEs when the market finally sees a broadbased earnings momentum, thereby providing more investment alternatives? Are quality stocks at a risk of de-rating?

Mahesh: Unfortunately, we can’t say with any degree of confidence that a strong cyclical recovery is underway. We’ve already talked about the US situation, then the ECB is now talking about more QE rather than cutting back on QE which was the plan, China’s growth is slowing – so the global picture is not really comforting. Domestically, private sector capex is yet to show material momentum and the Government’s fiscal situation will prevent it from investing too much – so investment led growth in India is still a little elusive.

In this scenario, quality stocks may continue to be in demand – though the point is well taken that from hereon, they may only track earnings growth or maybe a little lower, allowing for some PE compression – but I can’t see a case for significant de-rating of these stocks in the absence of either a broad-based global or domestic cyclical growth phase kicking in.

WF: What is your reaction to the chorus building up around vanishing alpha in large caps? Are investors better advised to consider index funds instead of actively managed large cap funds if they want large cap exposure?

Mahesh: I agree with the observation that data over the last 1 year does point to the fact that most large cap funds have underperformed the Nifty – the large cap index. We saw a very narrow rally in 2018 in large caps with just a handful of companies contributing to bulk of the index gains. Such extremes are the exception rather than the norm.

Going forward, while it will be a lot more challenging for active fund managers to beat the large cap index, I believe there is still scope to do so – albeit with lower levels of outperformance. Growth in ETF money coming into the market is also contributing to this challenging situation – as money gets allocated in proportion of index weights rather than relative fundamentals. Despite these headwinds, I remain confident that over a 3 year timeframe, active fund managers should be able to outperform large cap benchmarks. India is still a growth economy and there are businesses that grow significantly higher and eventually find their way into benchmarks. Then there are established businesses that are getting listed for the first time. So, opportunities to look for large cap names outside the benchmark continue to be strong – which therefore allows active managers an opportunity to create alpha.

WF: How are you guiding your equity team in terms of overall portfolio strategy now? What themes and sectors are you overweight on? Are you incrementally considering quality or cyclicals? Midcaps or large caps?

Mahesh: There are no overarching sectoral trends playing out right now. Where there is high earnings visibility, we have to contend with stiff valuations. Where valuations appear cheap, doubts linger on some fundamental aspects. In such an environment, being very bottom-up focused is the only solution.

That said, our bias today is more towards domestic cyclicals and domestic consumer discretionary spaces. As per capita income rises above US$ 2,000, demand for consumer discretionary products increases very substantially. We are coming to that inflexion point in India. This is also a space where we are seeing a shift from unorganized to organized sector, which will benefit listed companies in this space.

We are also overweight corporate banks – the NPA stress is largely behind them and credit growth should improve going forward, which augurs well for healthy earnings growth.

On market caps, we are agnostic towards large, mid or small caps. We are very bottom-up, stock specific in our views. Its all about where we see strong earnings visibility at reasonable valuations.

Share this article