‘Focus on cash flows, not just earnings'

Steering some of India's largest equity funds through three boom-bust phases in the stock market and delivering double-digit returns couldn't have been an easy task. However, Mr K.N. Sivasubramanian, Chief Investment Officer (Franklin Equity India), Franklin Templeton Investments, wears the mantle lightly. Stating that fund managers are as susceptible to emotions as lay investors, he makes a strong case for buy and hold investing, taking equity exposure in measured doses and focusing on traditional metrics such as cash flows while selecting stocks.

Excerpts from the interview:

With stock market cycles becoming shorter and sharper, investors are questioning if buy-and-hold investing really works. After the recent correction, the five-year return from the diversified equity fund category is at just 5 per cent per annum. What is your view on this?

Volatility has become a way of life and unfortunately stock market investing has become a kind of 100-metre dash.

However, if you go back and really look at stocks and companies that have done well, focussing on fundamentals works. The only investors who make money are those who buy stocks based on fundamentals, track their investments regularly but are not unduly worried about day-to-day fluctuations.

Having said that, any asset class that has done well over a five-year period is bound to see some reversion to mean. Equities as an asset class should track earnings growth. If earnings growth averages 15 per cent, stocks should deliver roughly that. However, in 2003-2007, stock market returns were upwards of 25 per cent plus. Therefore, at some point, the law of averages kicks in.

We've seen similar cycles in the past. Before the 2003-07 rally, we saw a four-year period from 2000 to 2004, when markets were consolidating after the 2000 crash. However, the returns after that period were quite spectacular.

The other aspect to this is that returns from the stock market are always depressed when companies are in an investment phase, as that depresses Return on Equity (ROE).

Indian companies have seen a decline in return on equity in the past three years or so. What does that imply?

Recent research shows that Indian companies have invested unusually high amounts in capex in the last four-five years, much higher than companies in other emerging markets. This has weighed on return on equity. Eventually, money will start gravitating away from companies where ROEs are falling to stocks of those companies whose ROEs are improving.

The other aspect to this is that some companies today have large hoards of cash. That depresses their ROE as treasury operations can seldom match returns from the core business. Indian companies have been holding back on dividend distributions and waiting for opportunities.

Increasingly, as companies grow larger and the cash pile grows, they may need to adjust to the idea of higher distributions. Some companies have been heavily punished in the market on cash flow and leverage worries. Post-Satyam there is a lot of scepticism in the market about the cash on books that some companies hold. Dividend payouts will help companies alleviate such concerns.

With higher volatility in the markets, should fund managers protect the value of the portfolio to investors? Possibly through cash calls or hedging using derivatives?

When the investor takes an exposure in an equity mutual fund, he takes a decision to invest in equities. Therefore, typically mutual funds worldwide don't take cash calls. We ask the investor not to time the markets and we need to follow that too.

One fund that does tactical allocation extremely well is our Dynamic PE ratio fund which increases the equity allocation when valuations are low and reduces it when they are higher.

Fund managers can reduce volatility through stock selection — going for companies with better fundamentals and cash flows. It has been proved time and again that people go for the hedges at the wrong time. In 2007-08, many companies took wrong decisions to hedge their currency exposure using complex derivatives without fully understanding the risks.

Many people make the case that valuations today, at a PE of 16 times for the Sensex, are attractive. However, the worry is about whether the denominator – the earnings will hold up. Will it?

The market mood is obviously pessimistic. I think valuations have to be seen in relation to long-term interest rates. As long as the earnings yield is close to the yield on 10-year government securities yield or higher, valuations are attractive. After the recent correction, valuations are down to 13 times current year earnings. Earnings for FY12 have also been cut to the bone with people expecting a 10-12 per cent growth. That is a substantial fall in expectations from 15-20 per cent at the beginning of this year.

In India, there is a good correlation between GDP growth and earnings growth. If GDP growth holds at 7 per cent or so, a 15 per cent earnings growth is not unrealistic over the long term. If we manage that growth next year, the PE will move down to 11 times or so. That is an attractive valuation. Historically in India, whenever valuations have moved down to 10 times or so, your chances of making money tended to be very high. Closer to 20 times, your return potential declines.

Have earnings downgrades captured the recent depreciation of the Rupee?

No, that is something that is yet to be assessed. However, the hope is that with the global slowdown, oil prices will correct. There are many factors impacting the Rupee. I think policy issues and concerns about the twin deficits are impacting it. Then there is the rush to the Dollar, given the cyclical upturn in the US economy and its current safe haven status. At this stage, we don't foresee any issue for Indian companies in terms of their external exposure.

Many of the established firms are known to hedge their foreign exchange exposure and have been consciously trying to diversify their export mix, away from developed economies to Asia and emerging markets. If the rupee depreciation continues, some of these companies might see their earnings getting impacted due to increased provisions.

Every bull market has a different set of sectors leading it. It was telecom, software in 1999-2000, power and infrastructure in 2006-07. Do you think consumer stocks represent a similar situation now?

I don't agree with that. Good companies tend to perform well across market cycles. Yes, there will be fads that die out quickly. However, if one focuses on cash flow generation and not just earnings, then one can easily stay away from momentum stocks. Consumer stocks from that point of view have done well, though valuations in that space are not in our favour right now. However, there is so much risk aversion in the market today that investors want to buy something they know well.

Given that power or infrastructure companies in India are in a nascent stage, should investors wait for positive cash flows before they invest in them?

Infrastructure and power in India are growth sectors and not defensive plays as they are in developed markets.

However, the way you fund these businesses and mitigate risks is important. In India, given that fuel is a big problem, power projects should not have come up with tentative fuel linkages. Plus, projects have been promoted with very low equity stakes, with telescoping structures and high leverage. We have seen similar instances in the past when the development financial institutions funded steel and power projects, which took on too much debt and had to be restructured. On those occasions shareholders did not make money, while promoters benefited.

In construction again, there are issues with the way the sector has emerged in India. The basic business model is to put up structures for a third party at a margin. It is very difficult to lose money with that model. However, what has happened in the past is that the market was rewarding order books, so companies took up contracts with very low margins.

In the California Gold rush, suppliers of goods to the miners did better than the prospectors themselves. It may be similar with the infrastructure boom. Suppliers of equipment to infrastructure companies — the capital goods companies — may do well. There are some very good companies in that space.

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