Stick to valuation or go with the momentum is a million-dollar question: Nilesh Shah

When I met you on the Budget Day, the market had fallen and it was a different conversation we had. Today, it is a different market we are looking at. Was the Budget Day price action real or today’s price action real? Because somebody got it wrong, and somebody got it right?

On the Budget Day, we fell in line with the US and Chinese markets. On Saturday morning, we saw the US market correct 600 points, or 2 per cent and we were looking at Chinese market opening on Monday about 10% down. So the market reaction was more in sympathy with what had happened in the US and what was going to happen in China than the Budget. Today when we see a range-bound market, looking directionless in the near term, it is still trying to figure out the impact of coronavirus on the global economy. But by and large, coronavirus is benefiting India in terms of lower oil prices. It is benefitting India, as countries around the world lower their interest rates and pump in liquidity to support falling growth rates. The most important thing that can happen is an acceleration in disruption as the supply chain shifts. Many global companies would like to shift part of their supply chains away from China, and clearly apart from Southeast Asia and North America. India will also feature permanently over there. Last week I was reading a newspaper report that showed Samsung at about $62 billion turnover from Vietnam accounts for 28% of their GDP. Now such over-reliance has its own risk; it just shows the power of global conglomerates where they can go and account for a substantial portion of GDP of a small country.

We just need to get 10-12 such Samsungs into India, and they can make India part of their supply chains or global supply chains and that will boost growth significantly for years to come. By and large, the market is today keeping one eye on how coronavirus is spreading or getting controlled, and another eye on how India is going to reap these benefits.

Though we clearly seem to be aligning ourselves in the interim, as we did on the Budget Day, do you think the signs of fatigue will set in soon? Because if you were to map the earnings, we have not seen a major recovery come by in Q3?

Undoubtedly, the earnings that have been above expectations so far are more due to tax cuts than business improvements. But in the market today, we are seeing two kinds of divergence: one is due to passive money chasing fewer stocks where supply is limited or not there, leading to these stocks getting rerated again and again. Many of today’s Nifty leaders are trading at 100% premium to their 10-year historical averages. If this passive money keeps on coming without looking at prices or valuations, then probably earnings would not matter in those stocks. At the end of January, the midcap market-cap was about Rs 17 lakh crore, the same as what it was at the end of December 2014 and December 2015, give and take 2% here, 5% there. In those intervening five or six years, these companies have increased earnings, yet valuations or prices are not reflecting that.

So where there is passive money flows, earnings do not matter, at least till such time those flows are there and where flows are not emerging or not chasing earnings. So, valuations have kept on becoming cheaper and cheaper. As investors and as fund managers, we have to balance these two aspects on which part of portfolio we focus on – is it valuation, or will it be that part of portfolio which is catching up with the momentum right now due to passive money.

Let’s look at DMart as a case study. Here is one company which is expensive. It is a great business to be in. When it went public, it was expensive. Purists would say it is a good company but a bad stock to own. But it is up 10 times from IPO price and 5 times from listing price. So what are the lessons to be learnt when you see a classic great business run by a classic great entrepreneur like RK Damani? How should one value such a stock or such a business?

Undoubtedly, growth, governance, management and promoters are of exceptional quality in this company. That gives lot of confidence to investors to stay invested for a longer period. However, the price seems to have moved up ahead of fundamentals, driven partly by limited floating stock and partly by committed investors. I have done some back-of-the-envelop calculation before the recent QIP and OFS, where more than two-third of the stock was cornered by just one investor. In passive investment as well as active investment, as long as there is one investor willing to buy without looking at price or valuation, the price can go higher and higher. We saw that during the Harshad Mehta bull run, where a cement stock went into five digits. We saw that during the 2000 technology, media and telecom bubble, where few stocks went into stratospheric heights just by changing their names. So one needs to evaluate valuations and keep an eye on momentum. In this particular case, limited floating stock and committed buying have probably pushed the prices ahead of valuations, ahead of fair value.

What choice do you think investors have right now – stay with largecaps because that is where ETF flows are coming to? That is a small market, but those stocks will continue to go higher because we are in an environment of low growth and abundant liquidity. Or is it time now to think and say investing is about buying good companies at good price, investing is not about chasing momentum and liquidity, and one should now seriously shift some part of their portfolio from largecaps or Nifty 50 ETFs to smallcap and midcap portfolios or smallcap and midcap schemes.

This is a million-dollar question, for which there is no right or wrong answer. One can say bhav bhagwan che (price is God). As long as, passive money continues to flow in, these 15-20 stocks can still continue to go higher and higher. We know it is the beginning or middle of the bubble, but who knows where the end of the bubble be? Many of these multinational and Indian companies now contribute one-third to half of market-cap whereas their profitability contribution is 5-7% or even lower. At some point of time, these multinational companies will come to sell or reduce their holdings in Indian companies, saying I might as well utilise this money to do buyback in my original company. Unless and until that kind of supply emerges, which then brings down prices to fair value, I do not see how these stocks will correct, especially when there is relentless buying day after day, week after week, month after month by the passive monies.

As an investor, clearly we have to balance between momentum as well as valuation. It is a very-very delicate balance. Markets can remain irrational for longer than we can remain solvent. Each one will have to take a call as to how much of the portfolio one wants to allocate to momentum. Undoubtedly, these are quality business run by exceptional managers. We are only talking about valuation here versus the portfolio of smallcap and midcap companies, which have also done well over the past five-six years yet their aggregate market-cap has remained flat. So, it is a million-dollar question for which there is no right or wrong answer. Each one will have to find own balance.

Everyone always wants to know when we are going to see this recovery happen? We are already seeing price movements, but when are we actually going to start seeing a recovery? In recent times, we have been hearing different things from the automakers and NBFCs. Some are saying green shoots are already visible, some are pushing it back by another six months. A large part of the market is clearly betting on financials. How are you timing it? Are you adjusting your portfolio?

As of today, the data offers a mixed signal on the economy. GST collections have been above Rs 1 lakh crore for last three months, but the IIP numbers in three out of last four months have been negative. PMIs have started turning positive, and been above 50. But auto sales were down 13% for January. Real estate investment by households remains poor and is falling, down about 50% from their peak levels. However, both production and power sales have turned positive after five months. So, there are mixed signals emanating from the economy and that impact will be felt in financials as well. Hopefully, the recovery will be gradual from here on and calibrated as fiscal and monetary policies start working. In this Budget under the FRBM Act whatever was permissible at 0.5 per cent of GDP, that deviation has been taken. Against 3.3 per cent fiscal deficit this year, we are looking at 3.8 per cent, and against 3 per cent, we are looking at 3.5 per cent. So the government has pushed the accelerator fully in order to support growth recovery.

On the other hand, RBI has created surplus liquidity in the banking system; the current banking liquidity will be almost around Rs 4,00,000 crore. Now we need to figure out a way on how this liquidity moves from the banking system to borrowers. On an incremental basis year to date, incremental bank credit is down by about Rs 4,70,000 crore from last year. If this surplus liquidity in the banking system reaches out to borrowers, hopefully that gap will be covered and that will support growth.