Look out for pockets of value in public sector banks and commodity stocks.
Can you talk about two sectors which delivered very good returns for your funds in 2012?
Our financial sector picks have done very well for us. Another sector that is not a big weight across portfolios, but was unique to us was media. Here we took a call that media internationally is a pretty big sector, but in India occupies a fairly small segment of the market. Some consumer names contributed too. This has been a year for stock selection. Through the year, we ended up reducing very large sector over-weight and under-weight positions and instead focussed on selecting the right stocks. That was a trend across portfolios.
We looked at sectors and companies that would enjoy good pricing power over the next two years. That led us to media, for instance, where average revenue per user (ARPUs) were pretty low and there was scope for them to improve.
Stock markets have shot up in 2012 despite slowing GDP growth and a poor earnings picture. Do you think markets are too expensive to buy today?
The macros don’t appear good today, but this is a micro/stock driven market. On valuations, the assumption is that by FY 14, we will move out of this 8-10 per cent earnings growth that we have seen in the last 3-4 years and move up to 15 per cent. If that happens, that is, corporate earnings pick up and interest rates fall, that combination will be very strongly supportive for the markets. If you look at the markets based on FY14 earnings, valuations are at 13.7 times. This isn’t very expensive. Some pockets however are over-valued. As far as macros are concerned, the worse seems to be over too.
Where can investors look for pockets of value today?
There are many pockets of value, if you define ‘value’ as sectors that are trading far below their average, long-term valuations. To assess this, you need to look beyond short-term pressures on profitability. PSU banks would certainly fall in this class, with most of them quoting below book value now. Technically, there is also value in commodity stocks if you work to a half-the-book-value principle; they are at about 0.7 times their book. We see some energy and oil and gas stocks that offer value too. Basically, the market has over-punished and over-rewarded sectors in this rally.
We are under-weight on commodities today, but have them on our radar. Traditionally, when you get commodity stocks at a steep discount to book value, it pays to buy small positions and wait for them to deliver. When an economic upturn happens, they are likely to perform quite well.
There has been a steady decline in the shareholder returns on Indian stocks (return on equity) in the last three years. Does that not justify lower valuations?
Yes, incremental capital allocation by companies is today earning a lower return than before. Return on equity has declined from a peak of 22 per cent to about 15 per cent. But this now appear to be at its trough. I see a scenario where earnings growth rate will shift upwards.
A lot of money has got stuck in projects where the cash flows are not coming in, due to delays in clearances and approvals. We see this changing. We also see the public sector investing in capex over the next year or two. Thereafter the private sector may pick up. That should lead to better growth and return on equity by FY14 and FY15.
Then markets are also very sensitive to the spreads between interest rates and return on equity. If interest rates start to decline, the spread will start widening and equities will get re-rated. Once returns start picking up, valuations will expand very quickly.
What is the one investment people should avoid in 2013?
I would not recommend completely avoiding anything. I think investors have to careful of sectors where there is pricing pressure. Some segments of core infrastructure for instance, may take time to recover, pending moves to de-leverage and put through asset sales.