‘The demand impact of the second wave is likely to be temporary’

The disconnect between stock markets and the real economy has never been starker. Even as the economy continues in the grip of the second wave, stock prices are running up, making valuations pricey. Swati Kulkarni, EVP & Fund Manager, UTI AMC, shares her view on the stock market and sectors in this interaction with Business Line .

Price earning ratio of the Sensex and the Nifty 50 are at record high both on trailing and forward basis. The RBI warned of a bubble in equity valuations. Will there be a mean reversion any time soon?

I don’t like to look at just price earning multiple because earnings tend to be much more volatile than balance sheet-led valuation multiples. Also market is an aggregation of businesses and the market valuations may not reflect opportunities in certain segments. Nonetheless, PE valuations are definitely higher, around 15 per cent, compared to long-term average. But these multiples have been higher than the average since 2017, except for the Covid-related correction last year. In terms of Price to Book-value multiple also valuation is around 10 per cent above the long-term average.

The measures taken by the government along with the liquidity provided by global central banks have been supportive for stocks globally, and in India, so far. There are expectations that growth will be sharper with normalisation of economic activities aided by the fiscal and monetary measures. From a long-term perspective, the reforms undertaken by the government., pick up in global growth, low interest rates are likely to be catalysts for growth.

It’s difficult to say when mean reversion will happen. As I said valuations in PE terms have been expensive for a while now. If there is any disappointment on earnings growth or if the talks of monetary tightening increase (if central banks perceive structural issues in the inflation rather than the current consensus of ‘transient’), equity markets can correct. We do not, however, know, when it will happen.

The second wave of Covid-19 has dealt a blow to consumption and demand at least in the first quarter. Savings in the hands of investors is down due to medical spends. What’s your view on consumer demand for the rest of this fiscal?

Yes, there are some people in the lower strata, whose income has been affected, who may not have adequate health insurance. But there are others who are not as badly impacted by the second wave since they have income certainty. These people account for a large part of discretionary spending. So while there may be postponement the demand is not lost forever. The demand impact is likely to be temporary; that may be the reason why stock prices began moving up again as the second wave started abating.

If you compare the first and the second wave, though the second wave is more aggressive on the health side, it appears less disruptive economically, people seem to have learnt to live with this. The macro indicators like the PMI, rail freight, e-way bills etc. in wave 2 are far superior than in wave 1. So, there will be a short-term impact on consumption, but it will normalise as situation improves.

Do you expect margins of companies to come under pressure in FY22 due to rising commodity prices and lower pricing power?

Given the lockdowns and lower demands in various parts of the country, companies may be currently absorbing the input cost increases. It will gradually be passed on, but not immediately, due to which sectors such as auto, consumer durables etc. may feel the adverse impact of commodity prices, although companies holding raw material inventory can partially mitigate the adverse impact in the near term.

For the market, the impact could be offset by sectors such as oil and gas, metals, petrochemicals etc. which will witness margin expansion due to commodity price increase.

Also, you need to note that pricing power and margin impact will vary depending on the industry. For instance, in the paint industry, where 80 per cent of market share is controlled by just four players, passing on the input cost increase will not be difficult. But they may not hike selling price immediately, when demand is weak.

The portfolio of UTI Mastershare fund is overweight in IT stocks, especially the bellwethers. Do you think this sector will deliver in FY22 as well?

The pandemic has accelerated the cloud migration as companies realised the need to stay connected from anywhere to remain competitive. IT Spend on this part is more of a necessity rather than a discretion. The hesitancy to move data to cloud has been overcome. Most IT companies see near term growth as they build solutions to migrate clients from legacy systems to digital platforms which enable data analytics, superior customer experiences thus helping clients to stay ahead of competition.

Mastershare took the overweight position on IT around three years back. Growth for the sector wasn’t that good then, but we liked the strong cash-rich balance sheets, sustainable cash flow generation and high ROCE. Valuation was also comfortable then. Now, growth has come back and that’s why we stay overweight despite valuations running up.

Financial stocks still form a major part of most portfolios. Credit growth is still very weak and the pandemic is causing more stress among small borrowers. How is the way forward for these stocks?

There is no doubt that for financials, near-term credit risk perception has gone up. Typically, retail loans which are not secured could pose risk for many banks and NBFCs, we have already seen auto-finance related stress in NBFCs. Also, the AAA spreads over G-Sec are very low compared to the last year. In the near term, there really isn’t any incentive for lending to good corporates and retail credit is also very competitive leading to weak credit growth.

However, many banks have provided 1-1.6 per cent of loan book as extra provisions. Banks with lower exposure to unsecured retail loans, high capital adequacy ratio and with access to low cost CASA funds will be better placed and will gain market share in the current challenging times. We expect credit costs to normalise leading to improving return on assets and ROE for banks.

India has been among the better growing economies and the reforms have also been supportive to long term growth. With cleaner balance-sheets, banks are better proxy to ride on the economic growth and valuation are not very expensive relative to historic trends. Also, in financials there are non-lending businesses that have long growth path given the current low penetration levels like Insurance, Asset Management, Broking etc.

What’s your view on the outperformance of mid and small-cap stocks in 2021? Is there a need to exercise caution in the smaller stocks?

These movements reflect the higher risk appetite in the market. Prices of mid and small cap stocks peaked in 2017 and fell sharply since then, taking valuations lower. But with the rally over the past year, valuation of mid and small-cap indices is at a premium to Nifty50. There is no point in looking at earnings multiple because there is too much volatility in earnings. Nifty50 trailing Price to Book is 3.4 times while midcap index trades at 3.7 times, small-cap index is trading at 3.5 times. On Price to Book ratio itself they are more expensive.

Investors should approach investment in mid and small caps as part of their asset allocation and do the investing through mutual funds. The allocation can be according to the investor’s risk taking ability.

Taking the mutual fund route can help contain the risk since fund managers use more rigorous filters. For instance, in our mid cap and small cap funds, we choose stocks based on high ROCE, consistent cash-flow generation, scalability of business, with a small allocation to the turnaround opportunities and manage position size to avoid concentration risk.

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