Even as markets are hitting new highs, Prateek Agrawal, Business Head & Chief Investment Officer at ASK Investment Managers, which has total assets under management of over Rs 12,000 crore, tells Vishal Chhabria that valuations are still at fair levels, and there could be further gains aided by a revival in earnings growth. If done well, fresh equity issuances can help markets and investors, he says. Edited excerpts: Markets have been hitting new highs, but valuations are at record highs too. Does that worry you? No. I believe that in the context of declining interest rates, the valuations are fair given that markets discount future cash flows into the present. A close to a 2 per cent decline in interest rates over past 2 years and the expectation that interest rates would continue to remain low given the government focus on fiscal consolidation, has made 18-19x one year forward as the new normal vs 16.5X in the past. The fact that the long period growth outlook is strong given the reform momentum and strength in the global economy further aids present valuations. Also, one has to see the profit margins of the present which are now at less than half the peak margins of over 7 per cent in 2007-8. Margins touched 3 per cent in FY2017, while the average of last 10-15 years is about 5 per cent. We believe that as the capex cycle revives and investment into housing goes up over the next few years, we should expect an uptick in margins. It happened between 2002 and 2007, when margins moved from 2-3 per cent to 7 per cent led by buoyancy in the economy, favourable global economic trend and rising commodity prices. We had a backdrop of similar reform and macro economic template then as now. The macro environment was favourable in terms of low fiscal and current account deficit, strong INR and low-interest rates just like now. In the present like in 2002-3, the economy is coming out of a sluggish period and has the benefit of pent up demand. Government spending has been high and has the support of FDI which is now at record levels and one of the highest in the world. On top of it, government schemes like Pradhan Mantri Awas Yojana should help catalyse private household demand for medium to low-cost housing. So, chances of margin increase itself driving earnings over next 3-4 years are high. If we go back to average margins, profits will increase 50-60 per cent. Over next 3-4 years, if corporate tax rates decline as promised by government, profits could look up further. There is a very good chance of organised sector doubling profits over next 4-5 years (assume margins to improve from 3 to 5 per cent over this period and assume a 10 per cent nominal GDP growth). With luck it may happen slightly quicker and, markets should logically reflect the same. Earnings have disappointed every year for last 3-4 years. What gives you confidence? Last year itself earnings should have improved but got impacted by demonetisation. Festival season of last year was very good for India businesses. However, after digesting demonetisation and GST, growth is coming back. Festival season has gone reasonably well, monsoon was decent, minimum support prices for crops are up and PSU employees have started to get wage increases. Hence, we are hopeful. If this sustains and since second half has a benefit of an extremely low base of last year, earnings recovery could be really nice. The gains for the organised or compliant sector (includes listed companies) is another tailwind. In FY18, the 16-17 per cent earnings growth expectations should be achieved. Maybe, we could beat it unless there is again a big event which makes us go back. Quick numbers from sectors like Cars, Two wheelers, energy demand and cement sales all point to recovery. As a money manager, are you still finding good investment opportunities? Yes. We invest only companies where we see earnings sustain for a long period of time. As earnings compound, the value of the business increase and our investors make money in a sustained manner over a longer period in a relatively more predictable manner. In our portfolios, we have achieved compounded returns of 20-21 per cent post fees over 7 years, as portfolio earnings compounded at 25-26 per cent while over the same period the index compounded 8pct. Investment opportunities are being found across many sectors. We are focussed on the high quality and high growth part of the market and believe that this part is pricing in less growth than what is being delivered by these businesses. An uptick in the economy would provide tailwinds. We are exposed to private sector banking, autos and auto ancillaries and consumer businesses. Sectors like textiles, insurance, chemicals and tyres are of interest to us. Markets have seen a lot of equity issuances —— IPOs, divestments, QIPs, etc. Will this impact secondary markets? That thought keeps coming. But, in some ways, it is good for the market. Good businesses give new opportunity to invest money. If fundraising is done well and investors make money, it actually keeps the sentiment up and vice-a-versa. The past tells us that if there are a few large issuances clubbed together, as it happened in the recent past, in that brief period markets may take a step back because people are using the cash to put into a new offering. Importantly, the difference between now and last time (2007-08) is that very high-quality issuance have come to the market. In most cases, companies don’t need money. It is an exit by a PE. This money should be invested into another business. Earlier, companies had come rushing to raise money. So, it’s pretty healthy now. How do you see the government’s bank recapitalisation move? Are you turning positive public sector banks (PSBs)? In PSBs you would really value a bank on price per adjusted (for bad loans) book. Now, because the government is putting such a large sum, the price to book and price to adjusted book will converge. So, valuations should reflect the new reality. The big question is at what price PSBs will get the infusion. In the past, the government has put in money at the then prevalent price. All said and done, there is a new lease of life. So, there have to be higher valuations. We are more positive than we were on this pack. We have taken some exposure but are not going overboard. In terms of capabilities, we have not seen much change and that keeps us wary. Let’s see the progress.
Will there be a recurrence of the problems or not? If they do it well and we see the semblance of that we’ll get more positive.Post PSB recap, do you see private sector BFSI players concede some market share gains to PSBs? PSUs were not able to compete and that helped certain players. But most of the players who have done well in the stock markets have found their own new business niches. Nobody started 2 years back, but 10 years back. That time PSUs were very strong. And yet if they have done so well it is because they were doing something which was needed and was not addressed by anybody, both PSU or non-PSU. For example, microfinance, gold finance, small housing finance, two-wheeler/auto and consumer durable financing, kind of businesses really got built. Secondly, NBFCs got most of their money from the PSUs itself. So if PSUs could lend to them, why couldn’t they lend to the end consumer? Because they couldn’t reach them. So, one it is non-standard lending and two there is something that the NBFCs are bringing to the table which is why they are able to make that margin and sustain. The competition will come back in standard products like corporate lending and maybe there will be some margin squeeze. But for that to happen, PSBs will really need to get the act in order and start to move faster. Do you see potential for consolidation in the BFSI space? Yes of course. All the State Bank of India subsidiaries are now State Bank. The government is talking of merging many PSBs. Many private sector banks are saying they do not need any further branches to grow. The cost to income ratios of established players is dropping sharply while newer players would need to continue to invest which would make them less competitive. So, the pressure on cost itself will make banks merge. Consolidation would be intense. Scalability of many businesses is now being put into question. For instance, how scalable is MFI business? Hence, in several spaces, one should expect consolidation. Do you think the pain has bottomed out for IT, pharma and telecom? Do you see any revival in their prospects? In IT, the pain is related to the inability to get the rates (pricing) increased, and business volumes itself are expanding at a slow pace which reduces the ability of the business to maintain margins. This is causing downward pressure on valuations. It’s a difficult place to be in now even as the business continues to be cash rich. I am significantly hopeful for pharma given the ability of Indian companies to make things the world needs, at the cheapest price and given the significant size of the opportunity. Telecom is a very interesting place. Tata’s gave away their business to Bharti, Reliance Communications to banks. Just a few years back, none would have imagined their exits and BSNL becoming a non-entity. Let’s see how much money the remaining companies make in future. I believe that the market is pricing in a two player (relevant ) market. Maybe, Bharti has emerged as one of these two players while the other one is still being discovered. Where do you see markets in the next 3 years? Over the next 3 to 5 years, if earnings double markets should respond commensurately. In the near-term, there is evidence of economy reviving. If it sustains the positivity in the markets would continue. Presently, domestic investors are buying while FIIs are selling. As winners emerge under the new regime, we expect FIIs to also relook at India for allocations and that would help markets. With US economy picking up, dollar strengthening and US interest rate inching up, cheap money will reduce, and hurt markets like India? Cheap money has reduced, the dollar has strengthened and hence money has flown out from all emerging markets into the US; more from India, less from others. However, India is the only large country witnessing interest rate declines. Hence, Indians are finding domestic markets very attractive. That is a new story. For last several years, Indians were not buying and domestic markets were at the whims and fancies of foreign investors (FIIs). Now, Indians believe in their economy, making FIIs significantly less relevant than they were in the past in terms of ability to move markets. Today, India is a significantly larger pool of domestic long-term money which keeps coming in SIPs every month. A large institutional base gives foreigners much more confidence to invest larger sums when they choose so. We have interacted with several of the institutions abroad and their interest in India is extremely high. From a global level when they look at a GST happening in India, they are positive. Everybody said it will take time to adjust, and it has been done beautifully. Pre-GST there was a threat of inflationary pressure to build up. However, that has not happened. The industry is continuing to deliver good numbers in spite of whatever we have seen. PSU banks have been promised capital. The whole template, block by block, has been put into place creating a strong framework for a sustained 3-4 years kind of a good growth. At this juncture, the India story is one of the most promising stories globally. This time, next year onwards we will start getting into election mode. Will that impact investor sentiment and government behaviour? This government or whenever this (BJP-led) combination has come into power they have kept their eyes on the fiscal discipline. Despite talks that the government will slip of fiscal discipline to fund higher growth capex, they stuck to the path. Hence, I hope and believe that they will stick to this path going ahead too. After 90s, a lot of the reforms happened because we had very little choice. This time, reforms are happening by choice. You have to give the government credit for it. Investors are underinvested into the equity as an asset class. As the income levels increase, we expect risk-taking ability to increase and allocation to equities would move up in a structural manner. Also, we believe that vs in the past when investors came to equity markets in a tactical manner, this time around it is structural. An increasing percentage of money into MFs is coming from SIP where investors are investing over a length of time. An increased allocation to equities is needed and we believe that the trend would sustain. Our investing is long term and focuses on businesses that are of high quality and are relatively less influenced by the environment and we expect to meet our investor expectations.