Let us identify the method to the market madness. Is it only about liquidity which is making the markets look good and is liquidity the only reason why markets are trading where they are?
For any market, liquidity is very important, there is no doubt about that. My view is liquidity cannot be the only reason. The markets are also responding to the fact that there is a gradual recovery and opening up of the economy. India is not the only country where the markets have gone up. So in many senses, it is a global phenomena and we must not forget that Indian markets were recovering even while FIIs were selling in this market. So the phase one of the markets was where we corrected because of the lockdowns and the fear of uncertainty and thereafter global stimulus and opening up of the economy was put in play, the markets responded in their own wisdom. We just cannot hang the hat of liquidity. The markets’ wisdom is far beyond just liquidity. So liquidity is important but my sense is markets are looking ahead, rather than behind.
Why are markets convinced that the future is bright because there is enough empirical data which says that private sector capex will not pick up, NPA is a huge concern for banks when moratorium will get lifted. With an exception of a few digital companies here or there, every sector is going to slow down. So if the future is uncertain, what is making markets excited?
We should understand that what we call the markets is basically the index, the narrow index and probably even the broader index. The markets have the ability to filter out companies which will not grow or survive because of the current challenges and we have seen that there are several companies and sectors which even today are trading at pre-Covid prices. So capex was not happening even pre-Covid. There is nothing new about the fact.
In fact, as an economy, we were slowing down even before Covid happened. We have retraced 70-80% of pre-Covid levels and the challenge for growth remains going forward from here. But what the markets are also representing is the consolidation that is happening across sectors where there are companies. All over the world, the indexes are being driven by large mega caps which have a larger representation in the index and who are seen as survivors, somebody who will thrive in the post-Covis era. We need to differentiate the market and the fact that a continuous consolidation is happening in the markets and there are fewer companies which continue to drive the so called index.
Stock price is a function of EPS into PE. Let us talk about both these aspects and let us split it into two. Where do you think EPS, which is earnings, will grow and where will it contract?
At an aggregate level, you would not get the right picture of earnings because clearly there are some sectors where earnings will contract. The consumer discretionary will contract. Financials this year have taken extra provisions fearing an NPL loss in the second and third quarter. These earnings may contract as opposed to our expectation of earnings rising. So FY21 clearly will be an earnings contraction year at an aggregate level.
While some companies will grow earnings, many of them will see contraction of earnings and I do not think that current market prices are only going by FY21 earnings numbers because clearly the value of business is the present value of the longer term cash flows and profitability of a business. Therefore, the markets are willing to overlook the current contraction in earnings in FY21. On an aggregate level, there will be a contraction but the markets are saying that this is a one-time phenomena and we are willing to move on.
PE is a function of liquidity and perception. There are some parts of the market where PE multiples are at levels at which they are not going to sustain whether it is a Nestle or a D-Mart or even an HUL. There are some ends of the market where PE multiples are so smashed down in some of the steel stocks, cement stocks, PSUs that they cannot contract a bit more. Where in the market could there be a change of perception because PE is nothing else but perception at the end of the day?
I would say that there are two parts when you look at PE; at a very aggregate level, PEs are also a function of interest rates in the economy. This argument was something that was discussed over the last three, four years. Even though we had very anaemic earnings growth, we still saw the markets going up, we still saw the PEs going up in response to falling cost of capital. In India, now for the first time, the cost of capital is continuing to fall and we have seen that the 10-year has come down post Covid. Therefore, there is a case in general for PEs to sustain because the cost of capital continues to come down.
Secondly, as you rightly said, it is also about where the market sees incremental growth and visibility. Given that there is an x amount of liquidity which is going into this asset class, it is quite likely that the PEs in sectors will continue to be high where the volatility in earnings and certainty of earnings at least in the near term is higher and therefore one might argue that some of these franchises are very expensive, but unless there is complete clarity and visibility as to how the broader economy is recovering, PEs of companies where the earnings visibility is generally high and the volatility in earnings is low, will continue to remain high for some time at least.
Have your top three holdings changed because of the Covid era?
They have changed because some of them obviously have corrected substantially and there are sectors which have not corrected. So clearly, if you have exposure to pharma or consumer or telecom, then the valuations have gone up rather than down even as the markets corrected and moved back up.
Clearly there are some sectors which have benefitted and we are trading at prices which are higher than pre Covid levels and that is what the reflection is as far as portfolios are concerned as well.
Where do you think franchises like Bajaj Finance are headed? In the long term, they would be a big beneficiary of what is happening to NBFCs, market share gain, data advantage but in the short term they will have to slow down the growth. Do you think a franchise like HDFC Bank, Bajaj Finance, AU Financials will feel the heat of rich valuations?
When we talk about some of these leading financials, one must understand that the valuations that they had were a combination of growth and the ROE and the opportunity that was there ahead of them. That opportunity continues to exist. Some of these businesses will continue to benefit disproportionately because market share gains also exist.
I think what has changed in the near term at least is that most people argue that the liability side of the balance sheet of these businesses will be good and I agree that they have managed the liability side extremely well. The challenge is on the asset side in the current cycle and the challenges on the asset side are very significant.
First of all, we do not know what is the exact level of NPLs that will hit these balance sheets. All of them have proactively gone and raised capital in order to fortify their balance sheets. And yes, in the near term I do believe that growth is also likely to be impacted. So in the near term, there would be a challenge in terms of valuations but longer term if these businesses are able to maintain their ROEs and the opportunity exists, then I do not see why these valuations will not come back. Rather, they may come back with a lag.
Once the markets are convinced that this is the extent of loss that the business would have to take and they have provided for that and then if once growth comes back, then these franchises will start to trade at multiples that we had earlier but yes, at least in the medium term, we cannot expect them to go back to the earlier multiples that they were at because those were times of hyper growth and I do not think those hyper growth years are coming back in a hurry, at least not in the short to medium term.