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WF: Many advisors are worried about midcap valuations (BSE Midcap index now trades at above 30x 12 month trailing earnings) and are advising a switch to large caps. Have midcaps indeed run ahead of themselves?
KrishnaKumar: There may be pockets of stretched valuations. However mid caps in many sectors are at an inflection point and thus optically valuations may look distorted. We need to look holistically at their growth cycle and cannot be generic about this. In certain cases, valuations are also justified given the quality of the business and visible growth. Several midcap indices may be misleading if you cursorily look at them from a headline valuation perspective.
While midcaps and markets could go through several phases of correction and/or time consolidation, long term prospects do look appealing. History has time and again delivered the verdict in favor of midcaps (from risk adjusted growth perspective) as these represents tomorrows large caps.
Of course, a right balance of exposure to large and midcaps is always preferred.
WF: Some observers say that midcaps usually trade at a premium to large caps only at the late stages of a bull market. Does this mean that our market is in the late stages of its bull phase now?
KrishnaKumar: We don't think that our markets are at a late stage of a bull phase. Certain macro parameters have played out as panned like decent monsoon, GST Bill being passed, rate cuts as per schedule. All these factors now are starting to percolate towards corporate earnings and this is probably the beginning of long term secular growth. As a market, the earnings are bottoming out and still not into an year of strong growth. Every bull market starts with valuations normalising as expectations improve and then consolidate before the earnings growth takes over the drivers' seat.
WF: How have earnings grown in the mid and small cap spaces? Does growth justify valuations on a PEG basis?
KrishnaKumar: Corporate India has put up a reasonably decent show in Q2FY17 results season so far. While the aggregate earnings of over 500 companies have been broadly up 13%, the EBITDA growth has been healthy at 14.2% on a revenue growth of 6.4%. Excluding financials in this set, we have seen the rest showing a much better performance, a growth of 15.8% EBIDTA and 19.7% PAT, in aggregate terms.
Broadly, Automobiles, Cement, NBFCs, Retail banks, energy, textiles and Consumer Goods, has delivered good growth numbers both in sales and net profits with an average earnings growth of over 25% while corporate lenders and telecom tended to disappoint.
We have seen reasonable volume growth with benefits of gross margin expansion still visible. Leverage reduction seems to be happening slowly with benefits of falling interest rates visible. Our belief is that consumption will continue to lead the recovery.
The growth recovery is becoming more broad-based, driven by consumption, public capex and FDI. The much improved macro-stability here will minimize the impact from external uncertainties in the coming quarters. The farm sector will contribute to growth recovery too over the next 12 months, given the good monsoon and Govt. focus on the rural economy.
We expect the consumer, cement, retail finance, auto and lifestyle sectors to show strong earnings growth for the rest of the fiscal.
With particular emphasis on mid caps - earnings have been decent. Given growth is at an inflection point for many companies, on a PEG basis, valuations can be justified if one is prepared to take a long term view.
WF: What are the pockets within the mid and small caps spaces where you see value at these levels?
KrishnaKumar: There are enough bottom-up opportunities in many mid and small cap stocks. We still believe there is value in consumer, cement, retail finance and certain lifestyle segments, not to mention resurgence in sectors like Specialty Chemicals & Agro Inputs.
WF: If you were to pick one theme within the mid and small caps spaces which you believe offers very strong wealth creation potential over the next 5 years, which one would it be and why?
KrishnaKumar: We are quite excited about the consumer discretionary space - Auto, Durables, Entertainment, branded garments, lifestyle products, consumer finance and financial services. The rural thematic is also coming back strongly and looks interesting in the light of reforms driven the Govt. therein.
WF: What is your overall call on equity markets from a 12-18 month perspective and what do you see as drivers in the medium term?
KrishnaKumar: Globally, the sea of low cost liquidity is moving towards EMs in the search of better yields. With developed economies struggling at sub 2% growth, central banks have resorted to fighting deflation & slipping growth with easy monetary policies. Given this back drop, India is an attractive candidate for flows given the promise of broad based growth. Overall, the earnings growth cycle is picking up and growth is likely to accelerate in the coming months. Our valuation multiples may be rich relative to other EMs, but are justified given the macro stability, strong political leadership which is driving reforms and the impending improvement in the corporate earnings.
On the domestic front, rising disposable income levels is helping more savings and move towards equities given the poor real returns in other asset classes. This continues to be a big driver for the Indian stock markets in the long run, not to mention other sources of funds like EPFO investments in the stock market.
While Sensex consensus EPS growth for FY17 is currently at 12%, one expects a 18-20% growth for FY18 at about 1,800/-. This being the first year of improved growth, valuations on FY17E may look expensive but we would tend to look beyond into FY18E PER which is quite reasonable at about 15-15.5X. While short term volatility will continue, we believe these are buying opportunities.
WF: What is the overall guidance you are giving your equity team now in terms of portfolio strategy?
KrishnaKumar: We continue to be driven by our investment philosophy, as under, which is well supported by an intensive research process driven by a strong in-house Research team.
Objective is to invest in good businesses run by good management and staying invested through the growth phase of these businesses, using a mix of
Top down approach to sector selection
Focus on identifying ongoing structural changes in the economy Results in insight into the different sectors that could benefit from such changes
& a Bottom up, active approach to stock picking
with a 5S framework - Simple Business, Scalable Opportunity, Sound management, Sustainable competitive advantage and Steadily improving cash-flows and an overlay of GARP.
Portfolio Focus on:
Owning stocks that offer a high degree of comfort on quantitative and qualitative parameters Creating a well-diversified portfolio of high quality stocks Maintaining a fully invested status unless warranted by exceptional circumstances
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