India is going through samudra manthan: Nilesh Shah

On the auspicious day of Dhanteras, investors welcome goddess Lakshmi into their homes for blessings of wealth and prosperity in the new year. To mark the occasion, Nilesh Shah, managing director and chief executive officer of Kotak Mahindra Asset Management Company, shares investment ideas to help retail investors chart the choppy equity markets, and add sparkle to the Diwali celebrations as Dalal Street welcomes the new Samvat year 2076.

According to Shah, India is going through a “samudra manthan” [a churning of the ocean] but adds that the country is a “long-term structural growth story with ups and downs. It will always reward disciplined long investors.” The ace fund manager points out that small- and mid-cap companies are trading below the historical average. “For an investor who has risk appetite, current valuations of small- and mid-cap companies are attractive,” he says. Shah says he sees better growth opportunity in select companies across tech, pharma, cement, financial services, and FMCG sectors. “Avoid companies whose results are lower than market expectations,” he cautions.

Shah says that the Street has discounted subdued results for the September quarter. “The critical aspect is the management guidance for the next quarter and beyond,” he says. On an optimistic note, he says the economy is moving in the right direction, “but the speed can be enhanced”. Shah sees the cut in the corporate tax rate as a big-bang reform. “This step is like liberalisation of the 1990s. It has the potential to change the growth orbit,” he notes.

Shah tells Fortune India why India is going through “a phase of conundrum“ and why it is both “the worst of times as well as the best of times”. Edited excerpts:

We live in perplexing times. Soap and toothpaste sales have dropped, but Amazon and Flipkart sold goods worth Rs 19,000 crore over just six days. Auto sales have declined, but Lamborghini set a new sales record. What explains the dichotomy we are witnessing?

We are indeed passing through a phase which Alan Greenspan famously described as ‘conundrum’. In some sense, today’s phase is similar to early ’90s liberalisation. Companies protected... [behind a] high tariff wall and license permit raj crashed. Competitive entrepreneurs thrived in an open economy. Today, companies which are not innovative are on a slower growth path and companies that are disruptive are on a high growth path. It is, in Charles Dickens’ words in A Tale of Two Cities, the worst of times as well as the best of times.

We are in a low interest rate environment, the rupee has depreciated, and oil prices are low. But the liquidity crunch continues to hurt economic activity, and crucial sectors like real estate, auto and NBFCs remain vulnerable. In this scenario, how and when do you see the economy turn the corner?

We aren’t in a low interest rate environment. Interest rates are down in nominal terms but not in real terms. In fact, it is exactly the opposite. Real interest rate burden on the commercial sector is highest at more than 6%. More importantly, fund flows to the commercial sector are down 88% in April to mid-September 2019 over the last year. If your food intake is down 88% in the last six months, you can very well imagine what will happen to your well-being. The world has a standard template of recovery—from the U.S. in the 2008 subprime crisis, ECB in 2013 PIGS crisis, and China from a growth point of view. Both the U.S. and ECB rescued their sinking economy by increasing fiscal spending, pumping astronomical liquidity, bringing nominal interest rates to zero, bringing real interest rates to a negative level, taking out toxic assets from the financial system, recapitalising the financial system to ensure transmission of credit, deepening markets through reforms, improving regulations to ensure that earlier mistakes are not repeated, and punishing the guilty through swift action. In some sense, we have to copy and paste the same to accelerate growth. China’s growth acceleration came on the back of massive FDI, infrastructure development and export push. We are moving in the right direction but the speed can be enhanced.

The current spate of affairs in the economy strongly highlights fundamental cracks. Historically, one may say that the stock market tends to discount the future. Still, what explains the euphoria that is cheering not just the broader market, but also mid- and small-cap stocks?

The stock market always discounts the future. Today in the stock market there are four compartments. One, super large-caps whose valuations are above their historical averages. Two, large-caps’ valuations are near their historical averages. Three, mid-caps’ valuations are below their historical averages. Four, small-caps’

valuations are way below their historical averages. Broad market indices don’t reflect the crash in small and mid-cap stocks. The market is hopeful about the future as subdued oil prices and above-average monsoon has been favourable for the economy. Some steps that have been taken by the government and regulators over the years will benefit the economy. Today, after years of effort, inflation is in lower single digits, fiscal situation is in a better shape, NPAs in the banking system are transparently accounted for, tax collections have improved, subsidies are being distributed to the end recipients, and real estate sector is being cleaned through progressive customer protection regulations. All these steps have strengthened the economy.

So far the management commentary has been fairly muted. Do you expect this to be a dismal earnings quarter with no surprises? Which sectors look relatively attractive and where do you see white spaces where growth can sustain?

GDP growth has decelerated to 5% in the June 2019 quarter. The September 2019 quarter is likely to be adversely impacted by floods and rain over and above other factors. The Street has discounted subdued results for the September quarter. The critical aspect is the management guidance for the next quarter and beyond. We expect select companies across tech, pharma, cement, FMCG, and financial services to provide better profit growth. However, to make money, one has to invest in companies whose results are better than market expectations and avoid companies whose results are lower than market expectations.

Returns in small- and mid-cap funds have been negative, there’s been significant wealth erosion. Is this a safe category for small investors? In such uncertain times what must a retail investor do over the next 6-12 months? What would be the best asset allocation bet?

Investors in small- and mid-cap funds have to be prepared for volatility. In CY2017, many small- and mid-cap funds delivered returns between 30% and 100%. Those returns were like five years returns’ in one year. Obviously those aren’t sustainable returns. As mentioned earlier, small- and mid-caps’ valuations are

below historical averages. For an investor who has risk appetite, current valuations in small- and mid-caps are attractive to invest.

Would you say the current valuation is reasonable? Do you expect prices to correct further? Which sectors would you say seem to be overvalued at this juncture?

It is difficult to predict short-term market movements. In our opinion, super large-caps’ valuations are above historical average. Large-caps’ valuations are around historical average valuation. Mid-caps’ valuations are below historical average valuation. Small-caps’ valuations are way below historical average valuation. We recommend investors to be regular investors through systematic investment plan, disciplined investors through asset allocation, and long-term investors for the business cycle to play out.

What is your view on ETFs? Given what has happened globally, do you sense a threat? What must investors bear in mind?

ETFs are part of a passive investment strategy. In the current Indian environment, active fund managers are adding alpha. The investor has to take a call based on value-add to their portfolio. If actively managed funds are adding value to clients, they should invest. If ETFs are adding value to investors then they should invest in ETFs. We should make decisions based on our situation rather than blindly copying global practices.

We are going through a challenging phase coupled with high outflow of savings. To what extent can this dent inflows into the equity market if left unchecked?

India is like a patient who has been admitted in the hospital for recovery of health. However, it is insisting on blood donation. A patient can’t expect recovery in health if it insists on donating blood. The Indian economy is bleeding about $ 22 billion in coal imports despite having large reserves, $15-20 billion in travel abroad, $30-35 billion in gold imports, $10-15 billion in educating our students abroad, and $55 billion in trade deficit with China. All these outflows have shifted our savings to the outside world. This has reduced our investments and consequently growth.

Would you say the mutual fund industry has grown too fast and too quickly? What are some of the risks to be wary of at this stage?

The mutual fund industry has grown rapidly in the last few decades. However, when we look at its potential, we have barely scratched the surface. The mutual fund industry, when evaluated against peer group on performance, transparency, services, customer complaints, cost, etc., comes out with flying

colours. The credit for this should go to SEBI for creating the right regulatory environment for facilitating the growth. The mutual fund industry is poised for higher growth in the days to come based on the solid foundation laid in the past.

Lastly, is it all gloom and doom? Or, have we hit rock bottom? How is India placed relative to global peers?

Presently, India is going through samudra manthan. Poison of slow growth has come as India became fiscally prudent, provided for NPAs, brought down inflation, cleaned up the real estate sector, improved tax compliance, and plugged leakages in subsidies. The nectar of higher growth will come over a period of time as oil prices are subdued and monsoon has been above average. Corrective steps are being taken by way of improvement in banking liquidity, reduction in interest rates, and capitalisation of PSU banks to improve transmission of credit. The government has done a big-bang reform on corporate tax rate cut. This step is like liberalisation of the 1990s. It has potential to change the growth orbit. To summarise, India is a long-term structural growth story with ups and downs. It will always reward the disciplined long-term investor.