SBI Mutual Fund hopeful of better earnings trajectory

India’s top asset management company, SBI Mutual Fund (MF), says India Inc. has seen earnings dwindle in the past decade and corporate profits as a proportion of GDP have declined to 2% from 7% in FY08. However, the fund house is hopeful of an improvement in the earnings trajectory.

In an interview with Fortune India, Navneet Munot, CIO, SBI MF, says, “Given the trough profitability levels currently and our expectations of a cyclical uptick in the economy, we see a case for stronger earnings over the next three years. Signs of improvement in the big loss leaders such as corporate banks and telecom, should also aide corporate earnings.”

Munot explains a new earnings cycle will lead to a broad basing of profit growth that will support the overall breadth of market performance. “Our expectation over the coming year is for the breadth in equity markets to improve with mid and small caps outperforming along with a revival in interest in ‘value’ stocks and cyclical sectors,” adds Munot.

After a dismal year, SBI MF expects credit funds to make a comeback. “Going forward as confidence in economic recovery improves, we expect credit spreads to continue to shrink. Therefore, credit funds should perform well over the next year,” says Munot.

Apart from equity and debt investments, the yellow metal continues to glitter as an asset class. “Investors need to have some allocation to gold as a hedge to geopolitical risks and a still fragile global economy,” advises Munot. Edited excerpts:

The economic slump has deepened, and the outlook for consumption and investment is weak. Has the economy bottomed out or is there more pain? When do you expect the growth cycle to meaningfully pick up?

There is a confluence of factors that has led us to the current situation. The near term disruption caused by some of the government’s structural reforms, a challenged financial sector, high real interest rates and then the liquidity crisis caused partly by local factors and partly by global central banks resorting to quantitative tightening all came together to lead to a slowdown. A lot however has changed for the better of late. The RBI has cut rates by 135 bps, banking system is awash with liquidity and global liquidity has meaningfully improved as most central banks have turned accommodative. In addition to easy money, corporate banks’ balance sheets are in a much better shape now, the recent moves have strengthened the bankruptcy law thus paving the way for easier stress resolution and credit spreads have started easing too especially for the better rated borrowers, all of which should improve transmission going ahead. This we believe will lead to an improvement in credit offtake and the economy. In addition, various policy initiatives by the government, with corporate tax cuts being the most big-bang one, should also aid recovery. On a structural basis, however, we need to do a lot more ranging from reforms on labour and continued thrust on lowering cost of capital to judicial and administrative reforms that ensure that sanctity of the contract is upheld, and allow for speedy dispute resolution if needed.

Record low nominal growth at 6.1% is worrisome, and while headline earnings show promise due to corporate tax cuts, the underlying earnings for the broader market remains under pressure. What’s your outlook for corporate earnings—do you expect an earnings cut in FY21?

Corporate India has been facing an earnings slump for over a decade now with most profitability measures such as profit margins and return on equity at trough levels, last seen only at the beginning of this century. Corporate profits as a proportion of GDP has dipped closer to 2% from a peak of over 7% in FY08 based on a sample of 20,000 listed and unlisted companies. In addition, the nominal GDP growth itself is running in single digits now versus mid-teens in the FY06-FY08 period. Incrementally tax cuts should help margins as should lower real interest rates. In addition, our expectation that the economy should witness at least a cyclical pickup, will lead to better toplines as well as aid margins through operating leverage.

What’s the potential upside for S&P BSE Sensex and Nifty 50 from current levels in the next one year?

I don’t want to hazard a guess on the index level—we are largely a bottom-up driven house and for an equity investor three years is anyways the minimum duration over which to evaluate an investment. That said, our analysis of earnings yields versus bond yields suggests that we are fairly valued at the headline index level currently. Given returns are a function of two variables, change in price to earnings and earnings growth, we believe earnings growth will determine returns trajectory hereon. Given the trough profitability levels currently and our expectations of a cyclical uptick in the economy, we see a case for stronger earnings over the next three years. With signs of improvement in the big loss leaders such as corporate banks and telecom, that should also aide corporate earnings.

What’s the strategy to manage the periods of downside to generate returns to investors?

Investors should follow an asset allocation based approach to investing, stick to their investing discipline without getting swayed by emotions, and rather than let volatility deter them, should use volatility judiciously to their advantage by keeping a long-term investment horizon.

It’s only a few stocks that is fuelling the market to conquer new highs, but the economy may have to grow at 7% to 8% to support a broader rally. In this backdrop, which sectors look attractive in terms of price and value in the next one year?

A new earnings cycle should lead to broad basing of profit growth which in turn should improve the breadth of market performance, in our view. This is especially relevant as stocks perceived as safe havens trade at hefty premiums to the rest of the market today. Early signs point to a change in market undercurrent—‘value’ stocks have significantly outperformed over the past two months. Similarly, along the capitalisation curve, small caps should start to perform as markets get more confident of a recovery. While our investing style is bottom-up driven, a look at our funds reveals that we are overweight on financials, industrials, and telecom. Within consumption we prefer discretionary to staples given the stretched valuations in the latter.

Stress in the banking system is far from over, the NBFC crisis is still unfolding, and liquidity crunch is a big concern. Where do you see growth potential in the banking, financial services and insurance segment in the next one year given the underlying economic challenges?

The current crisis has separated men from boys. Given the broader under-penetration of the sector in India, we believe the winners will continue to deliver strong shareholder returns. We continue to look for banks and non-banks that are strong on liability franchises, digital capabilities, risk forecast and assessment, and better asset-liability profiles.

At low valuations, medium and small caps are throwing up attractive opportunities for investors with risk appetite. Where do you see pockets of value in this space in relation to good governance, RoE, and cash flow?

Today, we find that the market cap polarisation in favour of large caps is at historical extremes. Overall, an improving economy and broad-basing of profit growth should lead to a revival in the fortune of mid and small caps. Moreover, given the large universe, especially in small caps, we believe alpha generation opportunities for active managers are significant.

What’s the potential for alpha in active large cap funds, medium and small cap funds?

In India, active fund managers have historically delivered alpha, barring the last few quarters which have been characterised by a very narrow market. We believe there are two dimensions to alpha generation—first is time arbitrage wherein keeping a long-term investment horizon and avoiding short term noise provides edge, and the second is research arbitrage wherein the ability to analyse relevant information forms the basis of edge. Finally, behavioural edge is an important supplement to these two sources of alpha. The ability for these factors to generate alpha also depends on the size of and the disparity within the underlying universe. So naturally, alpha generation potential in small caps should be more than in large caps.

In the backdrop of recent downgrades and defaults, what's the outlook for returns from debt funds in the next one year?

Duration funds have done well over the past year while credit side had challenges. However, the various policy initiatives to revive the economy along with ample local and global liquidity have led to some compression in credit spreads for the best-rated borrowers. Going forward as confidence in the economic recovery improves, we expect credit spreads to continue to shrink. Therefore, credit funds should perform well over the next year.

Passively managed assets comprise less than 4% of the industry’s total AUM, currently. But, are you seeing a marked shift in investors moving from active large cap funds towards ETF/index funds?

Globally, passive investing has taken off in a big way. However, the industry penetration is quite high globally unlike in India where penetration and awareness are still low. In India, a large part of passive investments today are by institutional investors mainly provident funds. Further, given that alpha generation opportunities continue to exist in India owing to the large and disparate investable universe, we believe there is a case for both active and passive to coexist.

Do you concur that ETF/index funds can consistently outperform the majority of actively managed funds given the low expense ratio of index funds vs active large cap funds? Why?

TERs [total expense ratios] for actively managed funds have also come down. In addition we continue to believe that managers who focus on time arbitrage and research arbitrage, and supplement these with behavioural edge, will continue to generate alpha. In fact as passive funds become larger, their compulsion to mimic their benchmarks should also open up interesting opportunities for active fund managers to exploit.

What’s SBI MF’s asset allocation outlook and key milestone targets in the coming year?

Given the severe challenges facing the economy, policy makers have taken and in our view will continue to take initiatives to revive it. We expect the economy to pick up going forward. Therefore our expectation over the coming year is for the breadth in equity markets to improve with mid and small caps outperforming along with a revival in interest in ‘value’ stocks and cyclical sectors. Within fixed income, we expect term credit spreads to narrow and therefore credit funds to do well. Investors need to have some allocation to gold as a hedge to geopolitical risks and a still fragile global economy.

On milestones, just as our parent SBI takes pride in being the ‘banker to every Indian’, we aspire to be the ‘wealth creator for every Indian’. We aspire to do this while staying extremely focussed on “sustainable investing”, by incorporating environmental, social and governance factors into investing process.