Why are FIIs aggressive sellers now in a market like India where the performance and earnings are showing signs of genuine outperformance?
The first point to note is that FIIs have been sellers across Asia. This is not just an India centric phenomenon. There have been sellers in China. There have been sellers in Korea, Taiwan and even in South-East Asia. So it has to be looked at in that perspective and partly the reason is the concerns about the consequences of renewed Covid wave in this part of the world, where the momentum of vaccination is significantly lower than in the developed markets.
Secondly, we are noticing some concerns about the regulatory changes in China. It is the China centric issue which is leading some degree of enthusiasm about the non-China markets. We have seen that of late in Korea, Taiwan, and India as well. On a relative basis, the FIIs view towards India should possibly improve slightly from here. They would also take into account the fact that the recovery from the second Covid wave, both in terms of infection rates and economic parameters have actually been quite strong. These two were the reasons why we upgraded India back to overweight just around the middle of last week.
The Indian market is trading above its historical PE multiple and it is the best performing emerging market. The only other market which has done better than India this year is Saudi Arabia because of oil. How would you defend your overweight stance? Aren’t you too late because valuations have already run up?
Valuations no doubt appear expensive compared to the Asian peers but I would also point out that there are only three markets which are driving the earnings estimates upwards and these are Korea, Taiwan and India. It is not surprising that foreign institutions’ interest on a relative basis is actually focussed on these three markets.
Secondly, one also has to note that these sectors are driving up the earnings estimates in these three markets and are actually quite broad based. We have seen four or five different sectors in India, maybe six or seven different sectors in Korea driving up these earnings estimates. What appears to be a relatively expensive valuation in an environment of rising earnings estimate, might appear cheap tomorrow. It is basically a dynamic decision making framework that we have to appreciate.
What is happening to banks per se in India? Erstwhile favourite private banks are taking a bit of a step back and some of the large PSU banks are coming up along with some of the private corporate banks?
In the financial space, there is a clear degree of differentiation when it comes to this question of retail delinquencies. We think that despite the recent news flow, it is the top quality, top run private sector banks which would be relatively immune from this partly because of the diversity in their loan portfolios and partly because of the systems and presses that they follow which are superior compared to their peers.
Within the non-banking financial space, the second and third tier retail lenders could be at risk, That is the space where investors need to be cautious. This problem could arise even in the public sector banking space but I would make the point that the front line or the top quality or the top rung leading banks could possibly be relatively immune from this. We have increased our weight on India recently by adding to the financials and in particular through the public sector banking universe. We still remain positive on a relative basis on private sector banks. We still have a large allocation to that. But the incremental addition has come in through the public sector bank universe.
How long is the super cycle in metals going to last? The big rally in metals has lasted almost over a year already?
In the near term, metals could take a breather. There is a lot of government pressure in some pockets on the metals and mining companies and on other commodity companies to curtail the steep movement of prices that are affecting some markets. But at the same time, we must also remember that there are two sides to this demand supply equation. Number one, demand has skyrocketed as a consequence of consumption demand and investment demand in the developed markets. The supply side has been curtailed for over the last several years. The capex to sales of metal companies in Asian economies — when they are primary investors — has declined from about 15-20% to low single digits over the past six to seven years.
So these sectors are also largely underinvested. Only over the last couple of years, some sectors like building materials have seen a small uptick in some of the Asian markets in terms of capex to sales. So not only has demand moved up, supply has also been at a very low ebb over the past several years which is accentuating this demand supply gap. Additional supply cannot be created overnight. So we think that buoyant commodity prices, buoyant metal and mining prices would be here to stay for some time. Stock prices may take a breather because a lot of expectations have got factored in but the basic story will stay for now.
What are the sectors whose profits will be most vulnerable to inflation?
For some sectors and for some companies within those sectors, it is definitely a threat. I would particularly focus on those companies which are unable to pass on these cost hikes to their customers, companies which lack pricing power in the present market.
The top rung leaders in both consumer discretionaries and consumer staples seem to have some degree of pricing power and as a consequence, would be relatively immune from this margin pressure. But if one follows the commentary of the companies, both in staples and in consumer discretionaries, there is a degree of margin pressure that most companies have talked about and it is something that investors should take note of.
Somewhat fortunately, these two sectors along with some of the other engineering or capital goods companies contribute close to 20-25% of India’s earnings. Commodities, metals contribute about 10-12% and in general, commodity prices cannot really go up and sustain themselves at a high level without global and local economic upturn taking place. The sectors that have positively correlated to these local and global economies like financials or IT, also have a significant contribution to the overall earnings pool. On a net basis, the consequences of this commodity price going up are positive for India. It is something that we are already beginning to see. Sectors that are driving up their earnings estimates are IT services, financials, metals and mining and energy, some of the top rung companies in the consumer discretionaries and staples even though the earnings estimate in those two sectors are not uniform.
IT companies have seen a massive run up. We are assured of top line growth at least if we go by the guidance given by these companies. Do you see more fire power in these stocks or do you think all positives have been discounted at these multiples?
We do see more fire power. We are quite positive on the IT space and we have a significant allocation to the India side in our Asian model portfolio to IT. We are seeing new orders coming in. In fact, most of the top front large cap IT companies are reporting a significant momentum as far as new order book growth is concerned. We would potentially see some margin improvement as a consequence of the remote working practices that many of these companies have started adopting. It has been an ongoing phenomenon for the past one and a half years and it could actually become an entrenched practice for some of the companies. This is a space we are positive on over the past few months. Even the currency has provided a tailwind and all these factors combined to make IT a sector of choice for our Asian model portfolio.
How does one go about getting rich and creating wealth in this market?
I am not an expert on bitcoin and I would stay away from it for now. But if you look at global equities, the earnings yield versus bond yield, that question becomes relatively easy to answer. Earnings yields — and this would apply more in the emerging markets — are somewhere in the 6-8% range. Bond yields are significantly lower despite the recent increase in bond yields in much of the emerging markets. So that equation, which over the past 20 years has usually remained loaded in favour of bond yields, has actually reversed.
I would also point out that in the context of the recent decline in the developed market bond yields like in the United States, the 10-year bond yield has declined about 50 to 60 bps some of the some categories of equities in Asia which are high dividend yield. Companies are becoming relatively more attractive. There are real estate investment trusts in Singapore, in Hong Kong which are positively correlated to declining bond yield. So new avenues of investment are opening up
The whole low yield environment that we have seen has created a phenomenon of equities becoming the only inflation edge that investors could rely on on a sustainable basis and therefore that driver of attractiveness of equities would possibly last longer.
The Covid case load in India — and especially in states like Maharashtra and Kerala — have once again seen a bit of a spike. What happens to the reopen trade of multiplexes, aviation companies, QSR and hospitality because the market definitely is giving them some premium right now as things tend to get better?
As we vaccinate more and gradually engage in unlocking in different parts of the country, these sectors which have been beaten down the most, have the potential of maximum recovery going forward. Now that said, there is always a risk of the Third Wave. I think governments and local authorities would always have to be on their guard to prevent that kind of a situation. So companies which pertain to hospitality, QSR are something that we have to be slightly cautious about and it is only when we have a significant degree of full vaccination not just in India, but in the region as a whole, we would turn sustainably positive on these companies. That is why while we have some of these exposures in Hong Kong, China we have not really dipped our fingers in these companies or these sectors in the Indian context.
