It's time to go cherry picking in mid, smallcaps: Navneet Munot

Navneet Munot, CIO, SBI Mutual Fund, says there are opportunities for stock picking in the mid and smallcap space after the value erosion in the pack. In an interview with ETMarkets.com, Munot, who manages the country’s largest equity fund, says he would look at four factors - macro, corporate profitability, valuation and liquidity to form a view on the market. Edited excerpts:


We know that you do not give a near term view but how does one form a medium term view? Also, what is your medium term view on the market?
Normally, I look at four things -- macro, corporate profitability, valuation and liquidity view. Just to give you a perspective, macro view is about the monetary and fiscal policy, the growth and inflation dynamics, what is happening in the external side, global economy, global markets and global liquidity. Then comes corporate profitability because at the end of the day, the most important thing for equity prices over a long period is the corporate profit trajectory. Equity price is nothing but the slave of the earning power of the underlying corporate and that is where it may be at an aggregate level, a trajectory of the direction in corporate profits.

In the last few years, in the top 500 companies -- ex-financials and ex-oil and gas -- the overall profit margins which used to average around 12.5% PAT (profit after tax), has come down to around 7.5%. This year, it is less than 7%. That is a very significant decline in the PAT margins. It is largely due to the negative operating leverage which means capacities are not getting fully utilised. Corporates have invested but the growth has surprised on the downside. We believe that over the next few years, both in terms of revenue as well as the profit growth, this should be higher than the nominal GDP growth.

The third part is valuations. On a year-on-year basis, markets may not replicate the growth and profitability or GDP growth, while over a longer period, there is a correlation because at the starting point valuations are very critical in the equity market.

Valuations at an aggregate level, particularly for the largecaps, look slightly higher than the long-term average. But the mid and smallcap indices are slightly lower than the long term average. Again, sometimes the law of averages becomes a bit of a misnomer simply because there is a part of the market which is trading at excessively higher valuation, related to their long-term average, while valuations have come off in a large part of the market.

The fourth thing is the liquidity flow in India. From India’s perspective, FII as well as domestic flow have continued this year despite the challenges in the economy, corporate profits and challenging environment. We have seen foreigners investing $13 billion while the domestic flows have slowed down a bit in the last few months. The SIP flows continue to remain robust.

How important is ESG in your investment strategy?
We have been one of the early proponents of the environment-social-governance (ESG) framework in India. ESG is integrating the environmental, social and governance factors into the investment process. While looking at all our investee companies, the environmental impact, the social impact, environmental footprints, social impacts, governance factors and engagement form a very critical part of our overall ESG frameworks.

It is not only about voting at their AGM or EGM, but a continuous constructive and proactive engagement with the companies is also a critical component of our ESG framework. We believe that ESG is going to be very critical for sustainable growth of our industry as well as for the economy.

You said corporate profitability ex-financials was sub 7%. Does it indicate that the worst is over? Would we see earnings recovery from here on?
Had you asked me this question a year or six months back, I would have said that yes, we have bottomed and from here on, there is going to be a strong recovery. But we have not seen that. Growth has surprised on the downside. The hope is that at some point in time, earnings are likely to mean revert. Corporate profits at an aggregate level as a percentage of GDP are less than 2%. This number used to be 7% in 2008.

There are a few structural as well as cyclical factors behind this substantial fall in corporate profit to GDP. The losses in the telecom sector as well as the NPA provisioning by the banking sector have also led to that fall in the aggregate profits and a couple of other reasons at the margin level. Over a period of time with the fall in real rates, the recovery in the overall economy and the investment cycle, hopefully we should see a recovery in the corporate profits as well.

You said the valuations for mid and smallcaps stocks were lower than their long-term averages. Is it time to go cherry-picking there or is it still too early to do that?
In the mid and smallcap space, there was froth in valuation at the beginning of 2018 with the correction over the last two years or so that froth has come off significantly. There are opportunities for the stock picking.

The government has taken various measures to prop up the economy. What else can the government do to revive animal spirits?
While a lot has been done, there is a lot that they will have to do. We will have to do a lot more at an aggregate level as the demand is still muted. We need to revive the demand. For example, on the rural side, with a lower MSP growth over the last few years, it is difficult to really improve the farmers’ income without pulling a large number of farmers out of agriculture and putting them in other productive businesses. For that, a lot more has to be done to revive the rural economies.

Let me put it differently. I think a lot has been done in the last few years in terms of reforms, including the IBC, RERA, GST implementation, the liberalisation of FDI, direct benefit transfer etc, but a lot more has to be done, particularly in the factor markets like land, labour in the area of power, agriculture. We have to do a lot more on the healthcare and education to reap the full benefit of our demographics. We need to do significant reforms in agriculture where there is huge over-employment and significant lack of productivity.

Also, the policy predictability has to improve over a period of time. The recent corporate tax cut has been very encouraging. A similar thing needs to be done on the direct taxes front. We need to come with a direct tax code which makes taxes lower as well as more simplified. We have a huge shortage of risk capital in India and for that, taxation and regulation policies have to become more conducive to attract a lot more risk capital into the economy, to get a larger part of savings into the financial markets.

We also need to do a lot more to improve the innovation in the economy. As a country, we spend very little on R&D, both at the government as well as in the private sector level. In order to compete in a globalised world, we need to do that a lot more and that is the only way we can increase our exports and move towards import substitution. There is a long list. I must mention that a lot more needs to be done on the administrative and judicial reforms in India.

A lot of this would be in your wish list for the budget?
Of course, and I do not think that we need to wait for a particular day to do a lot of these things. Some of these things should be on the table throughout the year.

Your fund house has been best performing over the last 10 years. What is the secret of this outperformance?
A consistent focus on process, a focus on risk-adjusted performance, a focus on having a good stable team with a clear cut philosophy, continued investment and robust research and portfolio construction are key. All of these things have really helped us.

Markets have cycles, there are ups and downs in the economy as well as the financial markets and corporate sector. We have always focussed on the long term and all of these things have helped. We take huge pride in having an outstanding team which has stayed with us with a clear cut philosophy and process.

When I look at the November buy and sell data of fund houses, it looks like your fund has topped up PSU stocks a lot. Is that a part of the index fund buying or have you found value in that pack?
It is a combination of various factors but with a strategic divestment on the table, there is a possibility of rerating of some of the PSUs. The valuation gap between PSUs and the rest of the market has gone up substantially in the last few years. That can be bridged if the government remains on the path of strategic divestment and improvement in functioning of the PSUs. We believe that the economy has bottomed out and there is going to be a cyclical recovery and some of these PSUs may be a beneficiary of that.

On top of that, you have the valuation gap, the dividend yield of most of the PSU stocks have gone up substantially, given the rerating in valuation and high payout by several of these PSUs. Also,the basket is very limited.

The entire PSU pack is seeing a rerating of sorts. Is it worth looking at it from value buying perspective deeply?
As I mentioned earlier, most of these stocks have a good dividend yield. They are in cyclical sectors which are likely to revive and there is a valuation gap with the rest of the market. Now with strategic divestment being the biggest catalyst for rerating of these stocks, one or two success on that count, can lead to a rerating of several of the other PSUs.

What is your take on the telecom sector which currently is going through a lot of woes? How could one save the sector?
If we look at the average revenue per user, in India it is a fraction of any other market in the world, even markets with a similar kind of income levels. Significant consolidation has already happened in the sector. There is a possibility that the profitability improves over a period of time and the government has clearly indicated that they want to support the industry. The industry has seen a challenging period in the last few quarters or years. Going forward with the policy makers’ support, the sector can come out of the current rough patch. Structurally, India is the largest data market in the world.