“Valuation for the larger part of the market is still reasonable” | Outlook Business
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Soumik Kar

India's Best Fund Managers 2018

“Valuation for the larger part of the market is still reasonable”
Neelesh Surana believes some pockets in the market are still cheap and one can expect an overall return of 13-15%

Khushboo Balani

2017 has been an important milestone for Neelesh Surana, CIO (equities) of Mirae Asset Mutual Fund,  and the ten-year best performer in the Outlook Business-Value Research Annual Ranking of Fund Managers. His average annual return during the past decade has been 17.18% against the benchmark Nifty's average annual return of 5.54%. The assets under management for his India Opportunities Fund increased from 103 crore in 2008, when he joined, to 5,357 crore by the end of 2017. Surana is unassuming about his success and believes that the remarkable feat is a team effort. While his perennial aim is to deliver the magical alpha, Surana isn’t afraid to venture against the tide and take contrarian bets. He dwells on what 2018 has in store, where he is placing his bets and investment principles that will continue to guide his decisions going forward.

You are betting on consumption as one of the themes that will play out in the next couple of years? What are the factors driving the bet?
The consumer discretionary theme is an interesting space. In the near term, pay commission hikes, and good monsoons should help revive demand.  In the long-term, structural drivers are related to favourable demographics, rising per capita income, and increase in urbanisation will help sustain demand.

So, if you look at our portfolio we continue to have a large bias towards consumer discretionary including auto, media, retailers, banking and financial services.

The problem with some of the consumer stocks from an investment perspective is that you don’t always get them very cheap. But for any company which has a moat in terms of barriers to entry, distribution or a good franchise in terms of market share, there is a strong tailwind both in the near-term and longer term. In the near-term, there could be a significant tailwind due to the shift from the unorganised to organised sector which hasn’t fully played out yet. The caveat, however, is that you don’t overpay for a good business. 

What are the key risks to that assumption?
From a macroeconomic perspective, factors such as increasing crude oil prices and interest rates could play spoil sport. Secondly, there is a requirement to provide 11 million jobs each year. The services sector has been doing well but cannot provide all the jobs required. So we need a well-developed manufacturing ecosystem that generates jobs as well. From an investment perspective, there are certain segments in that sector that are already expensive. While the theme may play out according to plan, buying something that is already over-priced is a risk. So, one has to be careful in the process of selecting stocks. For instance auto stocks are not expensive but some of the consumer goods companies are.

Most of these categories are under-penetrated. Take the case of air conditioners. China is 17x the size of the Indian market. We expect to see a double-digit industry growth over the next couple of years driven by shortening replacement cycles and changing consumer traits. It’s no longer a luxury. Consumers are now going in for more than one air conditioner and will replace it after seven to eight years. So, there is a decent growth opportunity there.

In the case of financials, the penetration of household credit is still very low. Increasing urbanisation, aspiration and income levels means relatively small businesses can become large businesses given the size of the economy and given the extent of penetration. For example, in the internet space, we do not have listed companies at the moment, but that will change soon. 

Your portfolio continues to see additions from pharma and healthcare space, despite their muted performance in the past one year, what drives your conviction there?
Our bet on pharma hasn’t exactly played out the way I had predicted two years ago; but that is always the learning in the business. Often assumptions change and even the promoters fail to see possible disruptions to their business model. Pharma is not a homogenous sector, so having proactive management at the helm becomes important. Generic players, in particular, have been going through a bad patch over the past two years due to vendor consolidation, pricing pressure and regulatory hurdles in the US.

Pharma is one of the sectors where you need to have a basket approach and hold four to five stocks since the risk-return profile varies a great deal from one company to another. We have been patient all throughout and have not made any major changes. Only where there have been serious concerns regarding margins and earnings recovery, we have taken some action. We remain positive from a longer-term perspective, as the underlying growth prospects in the domestic market is good, and worst of pricing pressure in the US is behind them. Most Indian companies have proved that they have the capability to address current challenges. For example, they have been moving up the value chain by developing speciality products. In the current scenario where valuation in certain sectors are starting to look a little stretched, these companies are reasonably cheap.  

Over the past year, you have bought banks and financial services. What is your investment rationale?
We continue to remain positive on banking and financial services which have been core across our portfolios over the past seven to nine years. We think the sector will undergo a material transformation in the coming years. Banks focused on corporate lending will gradually recover from their NPA issues. In our view, the need of the hour is to ensure a speedy resolution to the NPA problem, which has been lingering on for a long time. On the retail side, the growth will be primarily driven by the long-term shift to financial assets. So, retail-focused banks have enough opportunities to increase their market share. 

What kind of economic growth do you expect in the next two to three years?
While GST, RERA and demonetisation have impacted the economic growth trajectory, there is a possibility of mean reversion on growth. At the same time, we have seen global growth improve significantly at a much quicker pace, so the synchronised recovery is like a Goldilocks scenario, where all the large economies are doing well, driven by an uptick in the investment cycle. From the peak to trough, a sharp fall in commodity prices can have an impact of up to 200 basis points on GDP growth over a period of time. Of course, that recovered in 2017. While the impact of new investments on growth may happen with a lag, we should go back to 7% plus economic growth over a period of time. Of course, the caveat is oil prices. A lot of structural factors like IBC, RERA, GST have to play out. These are structural reforms, causing short term pain, but will benefit the economy over the longer term.

What is your outlook for equities over the next two to three years? What will drive earnings growth?
Over the past three years, earnings growth has been impacted by various reasons. You had insolvency issues, GST, demonetisation before that, so only certain segments of the market were witnessing growth. The much anticipated corporate recovery didn’t happen. We expect 12% earnings growth this year on better economic growth and increasing consumption; next year, we expect earnings growth of over 20%. I think that’s possible because we have seen mean reversion in many of the businesses, mainly in commodities and corporate banking. If they revert to their 10-year or 15-year average, then you will have earnings growth coming in.  

Based on these estimates, some of the pockets in the market are still cheap and I think it should do well. It will be reasonable to expect an overall return of 13-15%. The valuation for the larger part of the market is still reasonable. It is frothy only in selective pockets, which is a good sign. IT, pharma, infra, corporate banks are all reasonably priced at the moment. The market has done well in the past couple of years, so one has to look at it from a three-year horizon. One must not just look at FY19 earnings, but at FY20-21 earnings. 

Has valuation run ahead of fundamentals in the mid-cap space or do you still see value there?
It has. Wherever earnings growth was visible, they were lapped up, also because money was available. While based on March 2017 earnings, mid-caps are more expensive, trading at 29x compared with large-caps that trade at 25x. But if you look at FY19, where earnings growth in mid-caps is 30-35%, the P/E multiple is at a reasonable 19x (Nifty Free Float Midcap 100) while the large-caps P/E multiple is at 18.5x.  Having said that, one has to be careful not to extrapolate past return, the divergence between mid-cap and large cap return in the past was high. So that kind of delta will not be there. That is not to say that one should avoid investing in mid-caps.  Follow the 70:30 rule and invest about 70% in large caps and 30% in mid-caps.

Right now, it better to avoid mid-cap companies trading at high P/E multiples because if you are getting a better franchise and a more stable business, for a slightly higher valuation, it is obviously makes more sense to invest in a large cap stock.

You mentioned stock selection as a crucial factor to generate the much sought after alpha. What parameters are important when it comes to your stock selection criteria?
The business, management and valuation are the three main buckets we look at before investing in a stock. With the economy growing; we look for companies that are generating a minimum double-digit earnings growth. For instance in mid-caps, we expect an earnings growth of at least 15-17%. Capital efficiency is equally important. We look for a minimum RoCE of 15% and about 17% for a mid-cap where we look for a higher margin of safety. If something goes wrong, there is also a liquidity risk involved, you can’t sell it so easily. So first we look at size of the company. It should come with decent cash flow. We avoid micro-caps. If the business becomes bigger you can buy it at a later date. You need to have strict filters since they are relatively newer companies, unlike the more established companies which come with high franchise value.

We also look at management, their track record in capital allocation decisions. The important softer aspect of the management is how proactive they are and how quickly they are to capitalise on emerging opportunities. In the same sector, two businesses run by different individuals can take very different growth trajectories. Even in some businesses as commoditised as cement, you can see a clear divergence with some of them have done extremely well and others doing not so well, even with the best of governance. The divergence is even more stark in healthcare, IT and among large private sector banks. The last piece is we look to buy at reasonable valuation. At the same time, we ensure that it does not take too long to generate the desired return. Our hits have largely been a combination of these factors working well.

Are there any sectors that you would avoid in 2018?
It’s not that we are negative on infrastructure, but the sector presents lesser opportunities on a bottom-up basis. You don’t get too many high-quality names in infrastructure, maybe one or two in large-cap. So the choice is slightly limited. In the mid-cap space there is definitely a dearth of ideas. Since many capital goods companies are expensive as consumer companies, you might as well own the latter.

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