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'Investors positive on India despite expensive valuations'

By Vishal Chhabria
March 13, 2015 12:35 IST
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Sanjeev Prasad, senior executive director & co-head, Kotak Institutional Equities, tells Vishal Chhabria why he believes the steps government is taking to revive growth will start showing results and why the markets will not correct significantly even as valuations are expensive. 

Edited excerpts: 

Post the Budget, the markets went up. But, even as the Reserve Bank (RBI) surprised again by cutting rates, the markets are off almost five per cent from the peak levels. Is there a reason to worry? 

I don’t think so. The current correction is a small pullback, after a strong performance by the market in the past few months and small concerns emerging regarding an earlier-than-expected increase in US interest rates and slower-than-expected legislative reforms.

Valuations have become expensive in certain sectors and stocks, with several already discounting the FY17 earnings.

Investors would naturally want to trim positions at high valuations. There is no change in the overall story of economic recovery and lower interest rates.

The government is keen to implement economic reforms but it is constrained by its minority position in the upper house of parliament.

Investors may be questioning the ability of the government to implement legislative reforms but not the willingness. 

What is your view on India's rate cycle? 

I would expect RBI to take a pause for the next two to three months and respond based on the emerging trends in inflation and growth.

Also, it might not want to act before there is some visibility on the monsoons. With the government sacrificing fiscal consolidation somewhat for growth in the recent Budget, RBI will look at data more carefully.

My best sense would be an additional 25-50 basis points cut in the policy rate by the end of the current calendar year but inflation data would be key. 

The two most significant Budget proposals? 

The most significant is simplification of the taxation system, including the proposed reduction in corporate tax rates, removal of exemptions over the next four-five years and implementation of a (national) goods and services tax (GST) from April 2016.

Likewise, there are several small positive developments for foreign investors, including reduction in technical fees and royalty tax, addressing certain concerns about foreign institutional investors managing money from India, and certain tax simplifications for real estate investment trusts.

The second big takeaway is with respect to the government’s efforts to kickstart the investment cycle.

Capital expenditure has been increased by 26 per cent to Rs 241,400 crore. The private sector is currently somewhat reluctant or unable to invest, so the government is leading the way.

Hopefully, private sector investment will come in later as the related challenges start getting resolved -- land acquisition, labour laws, allocation of resources, etc. 

Given the challenges you mentioned, when do you see this growth happening? 

The government will start investing soon and there are two big areas where it wants to immediately do so. One is railways, where there is a 50 per cent projected increase in capital spending outlay in 2015-16.

The second is the roads sector, where the government has budgeted a big increase. Projects are being awarded here and implementation will pick up in the next one or two quarters.
Beyond that, the larger investment has to come from the private sector, which has challenges such as stretched balance sheets. 

Also, the public sector banks that finance many of these infrastructure companies are themselves facing challenges in capital adequacy ratios and sitting on very high levels of non-performing loans.

So, it would be probably three or four quarters before we see big private sector investment hitting the ground. 

So are you now betting on Infrastructure stocks? 

There are two ways in which one can play the investment cycle. One is through the banking stocks and second is directly through industrials and infrastructure companies. We have preferred to play the expected improvement in the cycle through the banking stocks.

There are enough number of decent, high quality banks and as the investment cycle picks up, credit growth will pick up.

Also, NPL problems will also start getting sorted out for banks once the challenges that are plaguing the infrastructure companies start getting addressed.

In the industrial stocks, the problem is that valuations are quite stretched and are already factoring in a big improvement in revenues and earnings over the next 2-3 years. 

Any particular names you think would outperform? 

We like most of the private banks such as HDFC Bank, ICICI, Axis and Federal Bank. While valuations are no longer cheap, those banks will grow for the next several years, especially given the constraints being faced by public sector banks.

On the industrials and infrastructure side, Larsen & Toubro becomes the most obvious choice, as it is a play on all parts of the sector.

Adani Ports and IRB look fully valued but the valuations of Crompton, Gujarat Pipavav and Petronet LNG are reasonable. In general, it is a struggle of find inexpensive names in these sectors.

Are you comfortable with PSU Banks? 

With PSU banks, the big issue is the quality of the book to start with. The restructured loan book is very high, at 6.5 per cent of loans on an average for the PSU banks under our coverage.

We see a big risk of a reasonably large portion of restructured loans moving into the NPL category later. Unless the underlying factors in some of the sectors start improving, in particular, the power and steel sectors, I find it very hard to get excited about PSU banks.

Also, many of them will have to raise capital and unfortunately most of them will raise capital at below book value at current prices, which will dilute existing shareholders quite significantly. SBI is one name you can look at positively among PSU banks. 

But, the government is talking of strengthening the PSUs, giving them flexibility, or even merge with other banks, isn't there potential? 

The issue is more in terms of how it is going about to achieve this objective. The objective to improve the efficiency of the PSU banks is laudable.

But in the short term, the strategy is debatable. The government has decided to give capital only to the larger banks or banks that meet certain criteria on financial returns.

This is a questionable strategy since the larger banks can raise capital through the equity markets, whereas the smaller banks may not have access to the market and their financial position is far worse than the larger PSU banks.

So is this a strategy to eventually fold the smaller banks into larger banks? If so, why not do it now?

Why do we want to create a potential ‘stress’ in the banking system and then ask the larger banks to take over smaller banks? In that case, investors of the larger banks will question, ‘Why are you bailing out these smaller banks?’. 

So the better strategy, and this will require political courage, is to start reducing the government ownership to below 51 per cent and let the companies manage their own destiny.

The management of the banks are quite capable. Selling government stakes to financial investors will not meet with political opposition and will help in the government ownership falling below 50 per cent such that they are no longer government-owned companies.

This will give the banks operational freedom, professional management etc. and make them truly competitive. And by the way, this is true for all PSUs. 

The other big advantage is that the government can raise a huge amount of money from the sale of stakes in those companies. The math is mind-blowing. The current value of government stake in the 250-odd central PSUs is $200 billion.

The government can keep a golden share or additional voting rights if it is worried about losing control over the banks. Privatisation in Europe took place through the government selling stakes in the government companies to financial investors and this is a route worth exploring. 

With the Budget over, how are your clients, especially the foreign ones, looking at India? 

They continue to be positive. The Budget has reinforced the view that India is a good long-term story, given its demographics, size, etc. Also, India has a government committed to doing the right things.

To some extent, the long-term story also got strengthened by two short-term factors. First, a collapse in oil prices and, second, huge global liquidity. Finally, India is one of the few large markets which offers growth and quality companies. Investors are still positive, despite the fact that valuations are quite expensive. 

Do you believe it’s time that rating agencies upgrade India? 

It’s a tricky one. If you look at the consolidated fiscal deficit as a proportion of GDP, including the states, it’s still quite high, at about 6.5 per cent. So unless that figure comes down to say below 5 per cent, the rating agencies may not take a positive view on India’s sovereign rating.

The ideal number is 3 per cent, in my view, and we are a long way off from that. However, India’s public debt-to-GDP ratio is very comfortable at about 65 per cent and far better than most of the industrialised countries.

Most rating agencies will probably just keep our rating stable for now. Also, keep in mind that the government has postponed the fiscal target by a year for the central deficit of three per cent to fiscal 2018 from fiscal 2017 earlier, which may not be well received by the rating agencies. 

With markets up 43 per cent in one year, do you see any kind of risk? What is the probability of correction? 

Valuations are expensive, no doubt. But, I don’t see a sharp correction as long as the global macro environment remains supportive.

Global liquidity is very strong, due to the unconventional monetary policies by certain central banks. Also, India’s macro economic position looks quite good with low crude oil prices and is in far better shape than other large emerging markets.

So, I would rule out any large correction in the market. If there is a small correction, foreign investors will probably come in and buy. The US Fed will increase rates over the next few months but that is manageable.

What could go wrong is that earning numbers continue to disappoint for another 2-3 quarters, which is when investors will question the high valuations. The real risk would be a combination of India’s macro position starting to weaken through higher oil prices, US raising interest rates and earnings in India getting cut. 

Next year corporate tax will be higher and growth is still weak, so do you expect earnings to grow in double digits, which consensus is pegging at 15-17%? 

As of now we are forecasting 18 per cent earnings growth for the Sensex companies. But, my sense is that earnings estimates will get cut during the course of the year, unless and until, the investment cycle surprises positively and the RBI cuts policy rates more than expected. Let’s see how it plays out. A lot depends on the level of oil prices and consequent subsidy numbers, pick-up in industrial demand, the NPL situation for banks, etc. 

What’s your target for the Sensex 2015 December? 

One and a half years down the line, the market could be at about 17 times March’17 earnings, so about 34,000 in the middle of next year, say, around July 2016. So, around 32,000 for December 2015. 

What amount of foreign flows you are expecting in 2015? 

Probably, about $15-20 billion of FII equity flows. Forecasting debt flows is slightly tricky. As of now, we are seeing a lot of debt flows but the real challenge would be in the second half, when the US starts raising rates.

Then, we could have some slowdown in inflows as more money will go to the US. Also, the US currency is appreciating, which could attract more flows out of other countries. So, debt flows into India could be lower than last year's $26 billion. 

When do you deal with government and corporates, what is the sense that you are getting? Are they confident? 

Corporates are talking bullish but not acting so. They are still not seeing much of a recovery at the ground level and the data is there for all of us to see.

In the case of the government, it is working on addressing several challenges that affect India’s investment climate - whether it is reducing bureaucracy, making the approval processes or interactions more transparent, resolving labour and taxation issues among others. 

There are some things, however, which I think this government can accelerate. For example, if we look at the whole subsidy issue, it is a real drag on India and the government’s finances.

The government is trying to address the issue by implementing direct cash transfer schemes, which will take 1-3 years to implement fully for various items.

However, it seems reluctant to increase the price of subsidised goods by even small amounts, whether it is of food, which is at very low levels compared to the procurement cost of food grains or of fertilisers, where urea price has not been changed for the last five years barring a token Rs 50 per tonne in November 2012 or of LPG and kerosene. 

Also, I can understand that it wants to retain majority ownership in certain PSUs for strategic reasons, but beyond those few companies there is hardly any logic for keeping airline companies, banks, power utilities, telecom companies, etc in the public sector.

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Vishal Chhabria in Mumbai
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