Unabashedly bullish and a passionate believer in the “growth” style of investing, Sandip Sabharwal, JM Mutual Fund’s new Chief Investment Officer (Equity), has made a big difference to fund performance s ince his joining the house, earlier this year. Several equity funds managed by JM Mutual Fund have floated to the top of the performance rankings, helped by a change in investment strategy and early moves into stocks from sectors such as power equipment, infrastructure and cement. In an interview to Business Line, Mr Sabharwal talks about how he interprets contrarian investing (JM is rolling out a Contra Fund) and shares his views on a diverse range of sectors.

Excerpts from the interview:

What is your sense of the FY08 earnings? Large Indian companies have consistently beaten earnings expectations over the past three years. But with IT companies missing their earnings estimates, will there be a repeat this year?

The markets usually look at earnings one year forward. In that context, we think 2008-09 will be a watershed year for the economy, with growth exceeding 10 per cent. That is why we feel that while valuations may look over-stretched on this year’s earnings, the next year’s estimates seem quite pessimistic. They could be over-achieved by a big margin. For example, at the beginning of the year, the earnings growth estimate for 2006-07 was only 20 per cent whereas the actual achievement was 36-37 per cent. Talking of technology, only mid-cap stocks have missed the estimates while some large companies have fared well. Overall, I think the expectations on growth across quite a few sectors, are quite pessimistic today, and that is captured in stock valuations.

On what are you basing your economic growth projection of 10 per cent?

There is a basing effect happening across sectors. First, in the infrastructure sector, there has been a marginal slowdown last year. As the orders begin to pick up again, growth will accelerate. Second, next year being just prior to the election year, government spending will accelerate, providing a fillip to the economy. Agriculture growth is a difficult call to take, but I think services, infrastructure and manufacturing will be the key drivers.

Apart from this, as gas production starts from the Reliance fields (the quantity they are speaking about is quite significant), it may contribute the core infrastructure growth. Power generation may also pick up as the implementation of power projects, which has been delayed over this Plan period, are implemented. With both manufacturing and services turning in higher growth, growth rates will pick up. Select sectors of the economy have been underperforming because of the sharp increase in interest rates compressed into a short span of time. If interest rates start to trend down, I see rate-sensitive sectors also performing better.

You have always been an investor who seeks out “growth” stocks. How does a contrarian strategy fit in with your investment style?

In India, a contrarian philosophy is often interpreted as one that relies on “value” investing, based on PE, Price to Book value or other valuation parameters. When we launched JM Contra Fund, we decided to follow the core philosophy of contra investing and not the one which is based on “value” alone. That means that you pick out companies and stocks that people are ignoring today, before their fundamentals turn positive. When the fundamentals turn positive, that is when the price move is the sharpest and we would like to capture that first wave of positive sentiment. As an example, about two months ago, we took exposures in cement stocks. Cement stocks had crashed after the Budget, due to the tax changes and the one-year price freeze.

The general impression on the sector was that the surprise factor was gone. However, we took a call that cement looks fundamentally sound — there was a severe demand-supply mismatch. Then sentiment turned, and there was news of price increases. When this happened, the appreciation was very rapid; leading cement stocks delivered 30-35 per cent over just 40 days. That is the kind of trend the Contra fund will seek to capture.

What are some of the contrarian investment opportunities you see today?

In today’s context, we believe sectors such as automobiles are attractive. The demand environment is strong but stock prices have fallen because of the interest rate environment; we believe the auto sector is under-owned. Similarly, construction is a huge growth sector but has undergone a severe de-rating over the past year, with the ownership of such stocks declining. We believe this sector has great potential.

We are also positive on airlines. Though consolidation has happened, the companies continue to be loss-making in the short term and investors are wary for that reason. We believe that companies will, however, start doing well.

Similarly, we see opportunities among realty stocks. The notion that real estate stocks follow property prices is not right, they actually follow interest rate cycles. If the interest rate environment turns benign, realty stocks will start performing. Basically, I want to make the point that there are several sectors today where people are ignoring positive trends in fundamentals.

If you see technology stocks today, the demand environment is extremely strong, but the rupee appreciation is affecting underlying profitability. Yes, companies have taken a one-time hit and margins will be impacted by the rupee factor; no company can adjust to a 8-9 per cent appreciation in a single quarter.

But, from a longer term perspective, we have to recognise that India is the key destination for outsourcing and there is no real alternative for people who want to outsource.

Therefore, over time, pricing will get adjusted to the rupee factor and companies will find new models to manage their profitability. When that happens, profitability in IT companies will bounce back. Therefore, some time from now, IT will be a good contrarian buy.

Doesn’t a further appreciation in the rupee appear likely?

That looks unlikely as interest rates are now peaking out. As interest rates stop rising, there will be less pressure on the currency to appreciate. One should also remember that India still has a trade gap and will remain a trade-gap country.

The trade gap is increasing steadily and this too should reduce the pressure on the rupee to appreciate. Our view is that, from this level, the rupee may not appreciate significantly this financial year.

The consensus is now building that the RBI may hold interest rates in its forthcoming policy review. Will rates actually begin to decline?

The RBI, in our view, does not have to take any measures. It is ultimately a free market. Most banks today have excess deposits and credit growth is not really strong. If you look at how the gilt yields have moved, the 10-year gilt is down by 50 basis points over the past few months.

In this environment, the challenge is how to take the bond yield up. One strategy that might be followed is a cut in the Statutory Liquidity Ratio (SLR) to temper deposit rates. A cut in SLR could trigger a 100-150 point drop in deposit rates. That will be good for banks because they are currently facing a squeeze on their net interest margins.

You mentioned that you would be focusing on under-owned stocks for this fund. How will you identify such stocks?

We will be tracking ownership patterns of companies on a regular basis. We will also constantly watch the market to see the sentiment towards different sectors. We will keep track of other portfolios (of funds and institutions), not to see what they own, but to see what they don’t own. That will be the core portion of our contra strategy. The second approach would be to move aggressively between mid-cap and large-cap stocks. This (Contra) fund will have no capitalisation restriction. This, we believe, will help the fund do well under any market conditions.

Third, about 10-15 per cent of the portfolio will be dedicated to stocks that are undiscovered — the smaller companies or sectors of today. We expect these stocks to provide significant alpha.

Despite the indices hitting new highs, PE multiples across the market seem to have declined over the past year. Are the lower PE multiples signalling the possibility of a slowdown in earnings growth?

I think that is where the skill lies. One has to identify the sectors where the PE de-rating is justified by an earnings slowdown and those sectors where there is excessive pessimism. In some sectors, we do believe the de-rating is because of slower growth. But in others, the market is taking an excessively pessimistic view.

Do you see the stock market rally continuing to be driven by a narrow set of stocks as has happened over the past two years?

No, I actually see the rally becoming more broadbased. I think the broader market may fare better than such indices as the Sensex or the Nifty over the next couple of years.

This trend is already underway with a broader set of stocks participating over the past few months.

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