The issue with unwinding of low interest rates is well understood but the outcome is not

Market watchers are debating overheating, heatedly. While the market cap to GDP ratio, or what is known as the Buffett indicator, and the forward P/E are on the higher side, Prashant Jain feels valuations overall are reasonable. The executive director and chief investment officer at HDFC AMC manages some of the largest funds in the industry, which underperformed for a few years but now things have started to look up. While he may not be wildly optimistic about sectors across the board, he retains rock-solid faith in PSUs, which he believes have got a bad rap without reason. When everyone seems to be watching new economy rising stars, he is betting his money on old economy strong businesses. In this interview with editor N Mahalakshmi, he shares the reasons for his contrarian bets.  

What is your market prognosis right now?

I think they are reasonably valued — over the past 15 years, Nifty CAGR has been 11.4% versus nominal GDP CAGR of 11.8%; market cap to FY22 GDP is 101% versus past 15-year average of 80%; and FY23E P/E of 19.3x versus 15-year average of 17.3x, which is the one-year forward consensus P/E. These numbers are according to CMIE, Kotak Institutional Equities (for GDP and FY23E P/E data) and Bloomberg (for Nifty/market cap and average P/E).

While P/E and market cap/GDP are moderately higher than long-term average, given the low cost of capital, this is reasonable. The valuation of the consumption sector is particularly high and should be taken into account while assessing the aggregate valuation. Further, earnings growth outlook is strong, especially for FY22, post which aggregate earnings growth should track long-term growth of the economy.

In conclusion, while short term is always hard to take a view on, over the medium- to long-term, the market could deliver return in line with nominal GDP growth of the economy.

Is the rally in industrials and commodities sustainable?

Prospects of capex – infra and industrial – have improved. As a response to the pandemic, interest rates have dipped sharply and the government is focused on infra spend. The prevailing low interest rates outside India along with favourable government policy have also increased the flow of capital to infrastructure sector.

Further, last year witnessed a broad-based revival in profitability in manufacturing sectors – metals, chemicals, textiles, paper, sugar and so on – and companies did well. This along with low leverage on corporate balance sheets, growing prospects of exports given the improved competitiveness of India and customers looking to diversify sources of supply, and focus of government to support manufacturing through schemes such as production-lined incentive scheme (PLIS), encouraging domestic production over imports in defence and many other areas, are all supportive of improved capex. These support industrial growth. However, a caveat here that stock return also depends on valuation apart from growth prospects, thus the outlook varies across stocks and sectors.

Commodities are hard to take a view on, especially a long-term view, at this point. The underinvestment in this space over the last decade, strong demand due to focus on infra in many parts of the world, opening up of the economies, weak outlook of capacity growth in China, increasing focus on reducing pollution in China and so on are arguments in favour of optimism in this sector. History, however, suggests that excessive profit is not sustainable. Improvement in balance sheets due to large cash flows is a positive for equity value of companies, but the cash flows are unlikely to come to shareholders meaningfully and will be used mainly to fund expansion and so on.

Though this sector has strong near-term prospects, stocks are discounting that to a large extent and given the inherent volatility of this sector, risk reward is not too appealing.

PSUs have run-up significantly. Is there more room for growth in stock price?

Some common notions on PSUs are not supported by facts. PSUs have not always underperformed. Underperformance of PSUs has been sharp over last few years. This was, to my mind, a result of selling PSU shares through ETFs on one hand and the underperformance of sectors in which PSUs operate, such as corporate banks, metals and mining, utilities, power and so on. PSUs have no presence in FMCG, Pharma, IT and such. Interestingly profit growth of PSUs (ex-banks) during FY15-20 was ahead of the broad market! With PSU ETFs less likely now, focus on strategic sales and economy sensitive sectors doing well, I feel there are reasons to be optimistic.

It is not logical to paint all PSUs or private companies with the same brush. There are good and not so good companies in both. The main casualties in metal, power, infra and NBFC sectors were private players; the entire banking NPA cycle was a result of that. We are, however, careful to invest only in those PSUs that generally have sustainable competitive advantage and avoid the rest.

Barring oil marketing, there is private competition in every sector in which PSUs operate. If the government continues to drag its feet on strategic sales, would you agree value destruction is imminent?

As I said earlier, I prefer to invest only in those PSUs that are competitive. Even in oil marketing – and this sector has been open to competition for nearly two decades – the low market share of private sector, even after such a long time, is due to the strong infrastructure, economies of scale and improvements over time that OMCs have carried out. Sectors such as banking, power utilities, mining, oil marketing, defence and so on offer significant advantage to incumbents. For example, existing large power utilities should emerge as significant players in solar as well – the lower cost of borrowing is a key competitive advantage and solar power is for all practical purpose like a bond.

The large PSU banks have not lost their market share, have highly successful technology platforms and have created value in non-banking subsidiaries, such as in life insurance and credit cards, and asset management companies (AMCs). This is a testimony to their competitiveness. In defence sector, incumbents have had at least a ten-year advantage, given the nature of the business. Finally, loss of market share of incumbents when new players come is likely, but this should not be the sole measure of a successful enterprise.

There are PSUs that are well managed and competitive and there are PSUs that are not. When investors do broad generalisations, it is often a sign of excess or mispricing and this creates opportunities for the long term. Strategic sales are an important trigger for value discovery in this space. The current year should hopefully witness the closure of some!

Do you think your key bets have paid off? Are value trades at start, mid or end of cycle?

In corporate banks and OMCs, I think we are mid-cycle; in utilities, closer to the start than end; and in capital goods, at start of business cycle but mid-cycle in valuation.

What is your view on interest rates and global risk? How do you guard yourself against any catastrophic fall?

An important transition has taken place in recent times. Central banks have become more tolerant to inflation and growth considerations have become more of a priority. The rapid rise in debt, especially in the West, and extremely low interest rates have no precedent. The unwinding of this and/or the consequences of this are a key source of uncertainty and are a risk. Unfortunately, the issue is well understood but the outcome is not. The best way to guard against a sharp fall is appropriate asset allocation in the near term and focus on sustainability and value in the long term. If one invests only as much as one can hold in bad times, it will help not just to survive a difficult time but also to come out stronger and not overpay for the same. Thus, we can not only avoid permanent damage to wealth but increase our chance of a good return too.

What is your view on the valuation of Zomato and PayTM? The latter is estimated to list at a valuation of Rs. 2 trillion whereas SBI is being valued at Rs. 3.8 trillion.

Some of these businesses will be successful beyond what we can imagine today, but some may disappoint. The range of outcomes of these businesses is so wide that it is not easy to get such predictions even roughly right. In any case, even for successful businesses, valuation at the time of investment is an important determinant of long-term return. While some will make return, it is hard to accept that the vast pools of capital that are being raised or are likely to be raised will generate return commensurate with the expectation. The good news is that, irrespective of who makes money and who does not, this is a great situation for the country.   

What have been your biggest learning over the past six years? Has this period prompted you to change any aspect of your investment approach?

I continue to learn every single day. Learning intensifies in difficult periods. That’s why the last few years have been a period of intense learning.  Not all learnings are new, some are just reinforcement of an earlier lesson. Let me share some of them.

One, our ability to forecast is limited. The environment may remain challenging for longer than anticipated. When one issue is resolved, another may crop up. One should therefore either be prepared for a longer period of pain or take shelter in places where there is less uncertainty.

Two, in the end, if one’s understanding of value and businesses is correct, the market rewards you for the entire holding period. Three, human nature is to seek quick gratification and pain avoidance, therefore the majority finds comfort in consensus. The market will therefore continue to remain imperfect in the near to medium term and continue to throw opportunities every now and then.

Four, and on a lighter note, periodic periods of underperformance if followed by recovery are not bad at all! I can say this with confidence having underperformed and recovered three times over the last three decades.