The Hindu Business Line : ‘We have been undervaluing businesses in India’

People do not seem to understand what a 9 per cent GDP growth rate will do over 10 years. If you are convinced of that growth rate, then the current valuations are a logical outcome.

Mr Tushar Pradhan, Chief Investment Officer-Equities, AIG India Asset Management.

Shanthi Venkataraman

The heady activity in the markets these days may lead wary investors to consider booking profits. But investors have consistently undervalued businesses in India, says Mr Tushar Pradhan, Chief Investment Officer-Equities, AIG India Asset Management, in an interview with Business Line. Indian investors need to change their perception of valuations, he says, as some large-cap companies today may well deserve global valuations.

Excerpts from the interview:

Should investors be wary of the unprecedented rally that we have had in the markets in the last couple of weeks?

My experience has been that people have gone consistently wrong when it comes to the markets. The Indian mindset about a boom-bust has not changed. So every time we see gains substantially higher than what we think should have happened in that period of time, we think it’s over.

People say markets are expensive on 2009 earnings. But does that mean that earnings in 2010 or 2011 are going to be any lower? People do not seem to understand what a 9 per cent GDP growth rate will do over 10 years. If you are convinced of that growth rate, then these valuations are a logical outcome. We are so rooted in the fact that over the last seven-eight years we have had market valuations of 13 at the lower end and 15 at the higher end that when it reaches 18, we see it as expensive. But compared to what? Compared to a time when there was no economic growth. When there were severe restrictions on foreign exchange in this country, when conditions for economic activity were extremely difficult. Now we have a very interesting situation where the Indian economy is going through phenomenal growth. So two or three things that we have continued to ignore are now getting borne out in the market.

Traditionally, we have been undervaluing businesses in India. This undervaluation has been particularly high in sectors such as banking. Most of the bad books have vaporised. Look at the non-performing asset levels. They are at historic lows. If you look at the lending situation today, it has slackened in the first half; it should pick up in the second. But at the end of the day, if we have to build infrastructure, if banks have to fund growth, the growth for banks has to kick in. Markets are about equity ownership. Valuation is a matter that the market differs on, on a second-to-second basis. No one is an authority. Nor do markets let anyone become authorities. But it is the best way to generate wealth. It is the only available alternative to starting a business of your own.

Is this narrow rally likely to continue as foreign investors keep pumping money into India and index stocks?

I would agree with that to some extent, but the new investors are savvier. Earlier, foreign investors, I suspect, typically did not have the ability to spend resources in analysing companies in detail, especially in a relatively new market such as India. They would prefer to buy the index. But more and more foreign investors are setting up offices in India and are getting more aware of the breadth of the opportunity. There are private equity investors, early stage company investors, all sorts of investors. This will broaden the market.

Even if more allocations come into India, it will spread out. Take, for instance, all the money that is now flowing into IPOs, which are not part of the index. My thinking is that the percentage rise in allocation to India in recent times has been the sharpest. That should start to taper off from here on.

Why do mid-caps continue to lag large-caps?

Earlier, mid-caps used to perform well because their rate of growth was significantly higher than large companies, as they were smaller and could grow faster than the larger companies in the industry. But the larger companies today are talking of growth rates that are higher than these small companies.

That is because of the opportunity that has been created by regulatory changes. Take power, for example. The fact is they are only now really getting serious about building seriously large capacities. Earlier, there was a problem with power regulations and clearances used to take long periods of time. At that time the growth rates of those companies were significantly at their lows. Now the scenario has changed significantly. So it is about growth.

If the opportunity is higher in a large company than a small company, the market cap impact is huge. The wealth that is created by growth in a large company versus growth in a small company is much higher. That is what I think most people missed out when they said “how fast can a mature company grow”? Yes, some mature companies may not grow fast. But we forgot that there are other large-caps in the market that are growing phenomenally, at rates higher than the average mid-cap.

We are also getting to see the benefits of size. Because a company is big, it gets bigger projects. Because it gets bigger projects, its ability to raise capital is much better. Because of this ability, it cannot be seen as a small company anymore. So then it is time to compare this company with global companies. And as said earlier, Indian companies are at significantly de-rated valuations compared to regional and global players. So that slack has been taken up. It is not an “Indian” company anymore. If it can be any company, why am I not giving it that value?

That beats the mid-cap stocks hollow. This doesn’t mean that the mid-caps cannot beat large-caps, because the latter cannot sustain such growth rates over long periods of time. Mid-caps can. Because they are small, their rates of growth over longer periods of time can be substantially higher than the one-time pop we have had with large-caps now.

Your fund house holds the view that that neither growth nor value can outperform over a long period of time. But growth has outperformed in this four-year bull rally. There is also the thinking that value investing won’t work in an economy that is growing at this rate. Your take.

Growth has beaten value hollow in India in recent times. But as seen in the past, concepts such as growth and value change. We are agnostic. We understand growth is working. But we won’t be rigid about it, and not look at value at all.

For instance, there was value in IFCI. The stock has delivered significantly higher than growth stocks during that period. So value companies do not necessarily translate into growth performance. Value is undiscovered potential. Growth is understood potential, but is priced high; it is then a matter of this understood growth delivering much higher than expected growth for people to make money in growth stocks.

In the former, all that is required is recognition. But you could spend a long time before people recognise it. So that’s the opportunity risk attached to value investing.

We are purely bottom up.

Most mutual funds in India have, in the past, succeeded in beating the index. This has changed over the last year or two. Is this something that investors in funds should worry about?

Earlier, funds used to outperform the index because the index used to be very static. It always comprised companies that were mature, where growth was not happening. Growth was happening in stocks outside this mature group of companies. So a company that is growing faster would see its stock moving faster and beat the indices.

Now what has happened is that these indices have become dynamic. Now when a big company that is more flexible and growth-oriented enters the market, it is automatically included in the index. So this dynamic portfolio is harder to beat.

The second thing is that the big weights in the index have performed phenomenally. It has been a narrow rally. And there are regulatory restrictions that forbid mutual funds from holding more than 10 per cent in a single stock. This is besides fund house restrictions, which might prevent you from concentrating your exposure within one stock or one particular house.

But these heavyweights might not now perform as well as other pockets could tomorrow. So it is not a static situation. Index stocks are growing phenomenally. So the other opportunities outside the index are not getting enough recognition. It is not our (mutual funds) inefficiency; markets have ignored fundamental performance in companies for long in the past. It is just something that has happened.

Most fund houses say they follow the bottom-up approach. But increasingly, don’t macro factors play a more important role in stock market performance, be it the interest-rate scenario for auto stocks or US slowdown for IT?

Let me give you an example. We all know that aviation is growing. But has anyone been buying aviation stocks? So growth per se does not guarantee anything. There is growth, so what?

You can talk about the pipes business where there has been talk of growth but the big orders have not yet come. But people have been able to make money because demand has risen. So you can make money in a slow growth environment also.

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