"If there is no pain, why should valuations be attractive?"

Prashant Jain has to his credit the best 20-year performance track record among mutual funds not only in the country but also across the world. Yet, being in the money management business, with custody of Rs.30,000 crore of assets directly under his management, he can’t escape being judged on his every move. For the first time, his funds are struggling to keep pace with the benchmark over a five-year period. Over the past five years ending February 16, 2016, HDFC Equity Fund delivered a return of 6.43% versus 6.04% for benchmark CNX 500 and a category average of 8.87%, while HDFC Top 200 delivered 6.02% versus 5.67% for the BSE-200 and a category average of 6.47%. Of immediate concern though is Jain’s contrarian stance that is the root cause of this pain. Jain has foregone his winning bets in the consumption space in favour of financials and capital goods that are currently under stress. In this free-wheeling interview with Outlook Business, Jain explains his stance.

This is perhaps the first five-year period where your performance is barely matching the index performance. Does this worry you? Rather, should it worry your investors? 

Normally, 3-5 years is a reasonable time to measure performance. But when market cycles are changing this may not suffice. For example, in 1999, if one wanted to preserve near-term performance one should have held on to IT stocks and not bought old economy stocks that were remarkably cheap. Again in 2007, if one thought from the near-term perspective, it would be very difficult to sell power or infra stocks and buy consumer, pharma stocks. When one feels that the market is moving from one theme to the other, you have to let go of your winning bets and buy something that is promising for the future. Till the time this works out, performance suffers. And if your one-year performance is weak, it impacts the three- and five-year performance as well. Fortunately, this is not the first time I am facing weak performance. In 1999, we trailed competition by 60%. Why? Because after we sold Infosys, the stock doubled and so did the PE from 150 to 300. But when IT stocks fell, we more than made up.  

The NAV of HDFC Equity Fund, since its launch in 1994, has grown from Rs.10 to Rs.440 now. As you can see from the chart, there are periods of underperformance in this journey. But each time the fund has lagged behind, it has come back stronger and more than made up for the underperformance. For example, 2007 was a weak year for us as we stayed away from real estate, infra plays. Instead, we concentrated on FMCG, pharma and auto sectors. Today, the index is up some 20% and the fund’s NAV has nearly doubled. If to avoid underperformance in 2007, we had instead participated in infra, real estate sectors, today’s results would not have been possible. 

Why are you betting on banks and capex? 

In my opinion, the pain is maximum in capex and related businesses. Capex should grow faster than the overall economy. Consumption and export-oriented businesses represent high quality but, in my judgement, there are better opportunities elsewhere. Also, the risk-reward of large-caps appears to be better compared with small and mid-caps.

You are not just buying shares that are undervalued because the market is focusing elsewhere, but stocks that are actually under stress. Isn’t that risky?

Valuations are attractive only when there is pain. If there is no pain, why should valuations be attractive from a long-term perspective? The key is to figure out if the business can deal with the issues and come back to health over a period of time. 

When you look at financials, you have to first understand that there are two types of banks in India. The popular way of looking at banks as public vs private is not the most appropriate. In my opinion, corporate versus retail framework is more apt. SBI, ICICI, Axis Bank and several other public sector banks are corporate lenders, while HDFC Bank, Kotak Bank, IndusInd are predominantly retail banks. Both are good business models and if India were to grow, both should do well. But corporate lending is more cyclical; it goes through ups and downs with business cycles and in stressed times asset quality issues can rise. This is what is happening today. It’s not the first time this has happened nor will it be the last such cycle. Way back in 2001, the situation was similar. As the economy improved, the stock performance did too. In my opinion, the same should happen this time. 

As economic growth improves, interest rates move lower, some assets are sold and banks provide for impaired assets, things will improve. Also, there are chances that imposition of minimum import price (MIP) will work out favourably for the stressed steel sector. 

In any case, post asset quality review (AQR) by the RBI, banks have already recognised or will recognise stressed assets by FY16. Bank of Baroda's managing director expects steady improvement in profitability and has suggested that return on equity should reach 15% by FY18. 

As Buffett says, “The future is never clear. You pay a very high price in the stock market for a cheery consensus. Uncertainty is the friend of the buyer of long-term values.”

Governments usually take the path of least resistance and can do unpredictable things that may not please the market. Although some public sector banks may look relatively robust, there are others that are under more stress. Is there an outside chance that the government may saddle better banks with bad apples – that will only destroy value? 

In my assessment, while mergers can’t be ruled out completely they are unlikely. But as I said, with the impact of AQR behind us, likely improvement in cash flows in the steel sector post MIP, asset sales by some leveraged corporates, and capital infusion by government should lead to improvement FY17 onwards. That will pretty much take care of things.

When it comes to banks, is the fact that stress will subside soon from balance sheets enough to bet on them? Do you see them growing? What drivers are you counting on?

There is good value in corporate banks. Value is the biggest driver of stock price over time. 

If most industries are operating at less than 70% capacity, where is the question of expansion?

I expect recovery to be visible within 12 months. Capex recovery will be led by infra capex coming from sectors such as roads, railways, power transmission and distribution, mining and so on. Manufacturing capex will take time because of overcapacity. But over the next few years, capex should lead economic growth. 

What is the risk to your analysis?

Risk either comes from flawed analysis or from lack of patience to stay the course when the market is not supportive, not from a contrarian view. We have taken contrarian bets in the past and we have been proved right over time. Time will once again tell if our analysis is right… 

Is size becoming an impediment for HDFC Equity Fund? Do you have to time your entry much ahead or exit much before?  

In my opinion, this thought is an illusion that keeps on coming back for as long as I can remember. In a universe of, say, 100 funds, there will be large funds and there will be small funds. When a large fund underperforms, it is noticed a lot more and the easiest conclusion is that size is to blame; when a small fund underperforms, it is simply noticed less and size cannot be blamed.  

Reality, in my opinion, is that there is no correlation between size and performance; anyone who feels this way should arrange all funds either in order of size or performance and the picture will be clear. Actually there are no large funds in India; the largest fund is less than 0.2% of the market capitalisation!

How do you expect the economy to perform over the next five years?

The Indian economy has experienced steady growth for the last several decades irrespective of changing global and local conditions. Secular growth drivers like attractive demographics, rising purchasing power, low penetration of consumer durables, skilled and competitive manpower have fuelled this growth. While these long-term drivers continue to be in place, the outlook for the next few years is better due to a cyclical recovery that is firmly underway. 

Unlike most emerging markets, India is a large commodities importer. The sharp fall in oil prices has led to savings of 2.5% of GDP. This has lowered CAD from 4.3% of GDP in FY12 to 0.8% in FY16, as per Citi Research estimates; fiscal deficit in on a steady decline from ~5.8% of GDP in FY12 to 4.1% in FY15 (is projected at 3% in FY18). Inflation has fallen sharply from 10.2% in FY13 to 5.9% in FY15 (latest reading is 5.7% in January 2016). Interest rates are also steadily coming off.

Improving macro-economic indicators and a cyclical recovery that is underway in capital spending point to a faster economic growth in the future. The current year’s growth is projected at 7.5% compared with 5.1% in FY13 and this should go closer to 8-9% in two years. 

India will most likely be the 5th largest economy by 2020, behind US, China, Japan, and Germany. It is also likely to be fastest growing.

What is the outlook for Indian equities?

The correction in Indian equities at a time when the economy is improving on nearly all parameters offers good opportunities for the discerning investor. There is a clear evidence of falling commodity prices working to India’s advantage.

The policy direction is right and the economy is making good progress on most fronts. Both the economy and equity markets appear to be transitioning from consumption to capex. Improving margin outlook of corporates, likely lower interest rates, soft commodity prices and reasonable valuations point to a positive outlook.