“Full impact of lower rates will be visible over the next two years” | Outlook Business
Home  /  Specials  /  India's Best Fund Managers 2017  / "Full impact of lower rates will be visible over the next two years" | MAR 17 , 2017

Soumik Kar

India's Best Fund Managers 2017

"Full impact of lower rates will be visible over the next two years"
Sunil Singhania believes the worst is over and that the stage is set for equities to thrive on a strong macro

Jitendra Kumar Gupta

Looking for high growth companies is obvious for a mid and small-cap fund manager, but what separates Sunil Singhania from the rest is the way he scouts for outsized opportunities which are yet to be identified by the market. The chief investment officer of the country’s third-largest fund house, who also manages over 5,000 crore across two mid and small-cap funds, is also influenced by the well-known book A Zebra in Lion Country. Written by famous small-cap fund manager Ralph Wanger, the book mentions that moving out of one’s comfort zone to look for opportunities, where the rest of market fears to tread fetches higher payoffs. Not surprising that the Reliance Small Cap Fund has generated a 34% annualised return over the past three years, better than the 21% clocked by the Nifty Free Float Mid Cap 100 Index. In an interaction with Outlook Business, Singhania elucidates on how he zeroes in on potential multi-baggers and the big investing themes in store. 

You have been in the market for the past two decades. What, according to you, has changed in all these years and how have your thoughts as an investor shaped up?
Evolution is an on-going process and it’s no different for the stock market. After five years, if I get the opportunity to be interviewed again, I would say a lot has changed. But the one big development that has transpired over the past two decades is the closer integration of India with the global economy. Currencies, trade, valuations... everything is interlinked. The world is as flat as it can get. Today, whatever happens globally, be it a new trend or technology, comes to India at a much faster pace. This is precisely the reason why the big picture [macro] is increasingly becoming an important cog in the scheme of investing. Today, merely looking at a stock from a price to earnings ratio (PE) perspective has become irrelevant. 

Can you elaborate on the PE multiple losing its relevance?
When I joined Reliance MF in 2003 and, even before, balance sheet was very important and still continues to be so. The only difference at that point of time was that very few understood and tracked a balance sheet. But, today, it’s the norm. In that sense, investing has become much more competitive. Since 2003, as the economy grew, it threw up a lot of new sectors such as infrastructure, power and a new set of businesses such as financial services, insurance and the likes. Some of these sectors cannot be merely assessed based on the traditional metric of price to book value or price to earnings. You will have to look at the big picture in terms of possible opportunities. There are some sectors and companies where PE is important, but it has to be looked at from a future perspective and not from a trailing one. Let’s say, if company A is trading at 10x PE and company B is trading at 20x. If the growth in earnings for A is 5% and it is 30% for B, then B, despite a higher multiple, will still be relatively cheaper to A.

How has your stock selection criteria evolved?
We follow the criteria of “MEET” — which stands for management, events, earnings and time. There are lot of events that cause a stock to go up and down. Like in pharma you can have a FDA ruling or a favourable or unfavourable launch of a product. Recently, in the case of a media company, just a court decision caused the stock to double. Timing is equally important and it’s not from a daily perspective. If you are buying a stock at a PE multiple of 50 and the growth is 10%, you better wait for good times to come. If the growth collapses, the company will not be able to sustain its higher valuation. Take the case of IT, the sector was growing at 25-30% and the PE was a similar 25-30x. But now since the growth has collapsed to 10-12%, so has the PE. 

What if a story isn't enticing but has compelling valuation?
If a stock is trading at a significant discount to its intrinsic value, it’s a no-brainer that you have to buy it. Even if you do not grow, the discount to intrinsic value is so high that it will generate a good return in the future. Price is a function of earnings and perception. When both price and perception, I mean PE, improves, you will end up with multi-baggers. However, when a stock trades cheap like they did in the periods of 2003 and 2009, you need to ask the question: if the company is going to survive, is its intrinsic value significantly higher than the quoted price? But such situations are few and far between. In the end, construction of a portfolio is what matters. Owning everything cheap or bulking up only on growth stocks can be equally disastrous. For example, in 2008, a portfolio skewed towards growth stocks would have been the worst hit.

How do you assess the valuation-growth tradeoff?
You cannot ignore growth as humongous value is being created by some of the fastest growing companies. PSU banks have been cheap for a while, but its private banks such as HDFC and IndusInd which have generated the biggest wealth. But you have to balance your portfolio to give it stability. While we have few value stocks, there are some high growth names in our portfolio as well.

What’s the big takeaway from Ralph Wanger’s book?
When I was in Chicago, I had the privilege to interact with Wanger. I was very impressed by his insights in the book which points out that zebras move in a herd because every one of them fears the lion. As a result, most of them want to be in the centre of the herd as they believe that it will save them in the event of an attack. But that is only perception. Because there is so much rush at the centre, these zebras get to eat the worst grass, while those on the side actually get the best grass. In fact, even when a lion attacks, it is the strong zebras on the side which are able to run faster and escape. So, the ‘defensive stocks’ are the zebras in the centre, while the mid-caps are the ones on the side. You end up buying large cap stocks in the hope of stability but when the market rises it’s the mid-cap and small-caps that run the fastest.

But then how do you deal with volatility and the risk of permanent loss of capital?
When you invest in under-the-radar stocks, it should be backed by strong conviction and rigid internal research. A lot of these smaller companies are promoter driven. So, you have to be really sure about the promoter’s ability, dedication, passion and fairness to minority shareholders. You need to have the conviction that the promoter has the passion and desire to grow and that the sector, in which the company operates, has good growth potential. The beauty lies in the fact that some of these companies might be operating in a really niche space where large companies may not have a presence. For instance, information technology started as niche but has now become a segment in itself. Infosys was a small-cap company when it started. Telecom was small-cap space. Organised retail and hospitals are still a small-cap play. They will eventually grow bigger. Even if it is not unique, let’s say you are investing in a traditional old economy sector; the growth has to be faster than the large-cap, only then can returns be made. For example, in the banking space, smaller banks have delivered huge returns.

But, of late, you haven’t bought banks and financials?
Private sector banks are in a good position compared with public sector banks, which face a challenge in their business model because their main franchise is deposit-based. Except for a couple of large PSU banks, all others are using CASA for growth. Instead, we are very positive on the quasi financial sector plays such as insurance, exchanges and non-bank finance companies. They are really good structural stories. 

Chemicals and agri input stocks such as UPL have worked wonderfully for you? What made you buy them?
Our view was that some of the good Indian chemical companies were growing in size and capability. They showed characteristics similar to that of pharmaceutical companies — low cost, highly skilled manufacturing and a global market. The chemicals opportunity has been doing well since the past four years and has played out well, both in terms of expanding PE and growing earnings. This, in turn, led to higher returns.

Do you think there is more steam left in this space?
We are still confident about this space as there are a lot of opportunities coming in because of environmental issues in China. We already have stricter environment and pollution norms. It’s only now that China is tightening the lax norms which had allowed them to sell at a cheaper rate in the past. As a result, China is now no longer cheaper than India. Second, global companies want to have a second source which is where India has an opportunity. Third, we are very strong in knowledge-based R&D capabilities, thus enabling companies to develop their own products. It may not be as sophisticated as pharma but it’s a similar kind of opportunity. It’s no longer at a nascent stage but it is a sector where decent growth can be expected — earnings can compound at 15-18% over the next five to seven years.

How do you manage your exits? You exited stocks such as Bajaj Finance very early and possibly missed out the rally. What is the learning in such situations?
We were not able to foresee that companies can grow at such a high rate for so long. That was a mistake. When you are assuming, say 20% growth, and the company actually delivers 40% growth, even your discounted cash flow will not work. But that’s something you have to live with and use it as an opportunity to learn. So, the learning for me here is: you cannot sell a stock just because it has gone up. Valuation is no longer a sufficient condition to sell a stock. One needs to look at it from the perspective of growth rate and the opportunity in store. Even if valuations are a little stretched and if I see the potential for further growth, I will not sell the stock. In the interim, valuations can be expensive, but growth rates can always spring a surprise.

What is your view on mid and small-caps? Have valuations run ahead of fundamentals?
The number of companies that are really good is limited. But when you say that the 16x PE is expensive because historically it has been 14x, is not the right way of looking at it. For some companies, the immediate results do not reflect their true earning capabilities. They might look expensive optically but over two to three years, their profits will rise faster. Therefore, the valuations may not be that high. Now, look at our interest rates. They used to be at 10-11%, which has now come to less than 7%. Logically that itself should mean our markets should be commanding a higher PE. One needs to be careful but not pessimistic about small and mid-cap stocks.

Are there enough triggers in place for the broader market?
If you look at India’s macro, they have never been so good. Interest rate is at a low, monsoon has been good, foreign currency reserves are robust, and the rupee is stable. There have been so many reforms being undertaken by the present government such as GST, among others. All this will gradually start to reflect in the core sector’s growth numbers or the headline numbers, which are currently not in good shape.

From an earnings perspective, there are couple of key things to look at. One, the full impact of lower interest rates will be felt over the next two years. It will help in two ways. One, the cost of borrowing will go down and, second, consumers will spend more as a result of lower EMIs. That will give a fillip to companies which are facing lower capacity utilisation but were waiting for demand to kick in. As demand improves, operating leverage will come into play. A combination of operating leverage and financial leverage will ensure that impact will be much stronger than what the people expected.

Also remember, there were lot many sectors that have caused this earnings stress. Banks had to provide higher provisions, contributing negatively to the earnings momentum. Banks have started to see the benefit of a lower base rate, metals have started to do well. Engineering and power are expected to do well. Effectively, many sectors have started to turn around or are expected to turn around, giving a fillip to earnings. It is quite possible we will see 17-18% earnings growth over the next two years. 

Which are the big themes that you see playing out over the next couple of years?
Revival of capex cycle will be first theme to play out. It will be first driven by public expenditure followed by private capital expenditure. But you have to back companies which have decent balance sheets. For example, we are focusing on cement as a sector and companies with good technologies and clean balance sheets. Construction, engineering, capacity building are the other businesses within this theme. The second theme continues to be consumption. Branded crockery, branded shoes, branded apparels…the list is endless. Even in categories such as tiles, plywood, veneer and sanitaryware, brands will play a big role. Look at a branded apparel company Zara. It comes from a country like Spain whose population is about the size of Mumbai or may be little more than that. Today, the company enjoys a market cap of about $70 billion. In India, the highest selling branded apparel may not be even 1,000 crore. Third, we also like stocks that will benefit because of the shift from physical savings to financial savings. Private sector banks, life insurance, asset management, and wealth management are all part of this theme. Today, India’s asset management industry is only about $250 billion and this is nothing compared with India’s annual savings of close to $600 billion. So, all these opportunities will become really big themes in the near future.

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