Striking a cautious note about going overboard on cyclicals, Harsha Upadhyaya, Chief Investment Officer – Equity, Kotak Mutual Fund, says the segment needs to be played through select stocks. He feels that the auto sector has bottomed out and may be set for a revival. Excerpts from an interview to Business Line :

We are seeing a revival in interest in cyclicals the last couple of months. Is it the right time to be taking a call on cyclicals now?

We would look at the market in terms of cyclicals that do not have any balance sheet issues, such as high debt levels or high interest rate burden. We prefer to play any possible economic recovery through such cyclicals. For example, we would like to play it through auto and auto ancillaries rather than capital goods. The investment cycle is not picking up. If we see a pro-growth government, 6-12 months down the line, some of the projects may start coming on stream. So the real investment cycle could perhaps start 12-18 months from now. There is not enough reason right now to be too bullish on capital goods or power on a sectoral basis. But yes, you can always play those sectors through a few good companies, which we are trying to do.

Is there still room for IT, FMCG and Pharma to do well in 2014?

IT still has room to do well. Even where you have seen it outperform over the last two-three quarters, the valuations are not high compared with their historical valuations or relative to market. Most of the stocks, barring TCS, are quoting at 12-15 times one year forward P/E which is more or less similar to market multiples. In some cases, it is actually lower than market multiples. We are also seeing some amount of stability in global growth and the deal pipeline looks very strong. For the next few quarters, we will also have year-on-year benefits due to rupee depreciation. Given all this, IT will still continue to outperform the index. That’s our view. As far as FMCG is concerned, yes, it continues to be expensive. At some level, we are seeing a compression in terms of volume growth momentum and also some pressure on margins. That is a sector where we are underweight — not so much because of the earnings trajectory there but more because of higher valuations. In Pharma, we are neutral. Within the defensive basket, the order of preference would be IT, Pharma and then FMCG.

We still see a gulf between valuations of mid and small cap and large-caps, even as mid-caps have run up a bit in the last few months. Is it still a good idea to cherry-pick mid-caps?

Because of the outperformance of mid-caps over the last three-four months, that valuation gap has narrowed considerably. But still there is a gap and from now on, you need to be stock specific. We don’t think the entire segment is going to perform uniformly as the fundamentals are quite varied.

Companies that have issues in terms of growth and large amounts of debt on the books will take quite a bit of time to recover. In a scenario where growth is sluggish overall, the only way they can show higher earnings momentum is by cutting costs, which is difficult. And any growth in EBITDA margins has to come from lower interest costs. And that can happen only when interest costs go down significantly by 200-400 bps. In the wave we saw three-four months ago, there was a lot of compression in terms of valuations. That has got bridged to a large extent with the recent upside.

The trailing PE for the Sensex right now is at 18 times. Are we poised for a bull market or a correction right now, given that the macro-economic scenario is still not rosy?

We don’t look at trailing multiples. Stock markets look at future growth prospects. From this perspective, on a one-year forward basis, price to earnings multiple is around 14 times, which is at a clear discount to long-term averages. The long-term average is at about 15.2, if you take the last 10 years’ average. So while the markets are at 21,000 on Sensex, the valuations are quite reasonable.

We are expecting earnings to improve to low-double digits over the next 18 months. So given this scenario, we think the markets can track earnings growth, and if there is some amount of improvement in economic activity, they can probably move towards long-term averages in terms of valuations.

Should retail investors look to start rebuilding their equity portfolios now?

From a retail investor perspective, for the last four-five years, asset allocation has got completely skewed and moved away from equities. Either they have stopped investing in equities or redeemed most of their equity investments. Now the valuations seem quite reasonable and going forward, there seems to be room for gradual improvement as well.

Given this scenario, it is not advisable to be underweight on equities. But again, one should use caution and build it gradually.

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