Markets
‘We’ve borrowed returns from the future and are currently ahead of fundamentals’
Summary
- There is a lot of euphoria in some pockets of the market. It is mostly concentrated in low-quality and low-growth segments of the market.
Markets are often at their riskiest when they seem the easiest to profit from, said Vinay Paharia, CIO, PGIM India Mutual Fund who manages assets worth ₹24,883 crore as of 8 August. He believes that valuations are high, and caution is needed. In the near to medium term, equities might produce slightly lower returns than their underlying fair values. “We’ve essentially borrowed returns from the future and are currently ahead of fundamentals," he said.
Edited excerpts:
Have you noticed anything interesting in the market lately?
Over the past 15 to 20 years, we've observed a significant market trend: investing in companies with superior business quality and strong growth characteristics dramatically increases your chances of outperforming the market. These companies offer a 2 in 3 chance of beating the market, compared to just 1 in 3 for companies lacking these attributes.
Our analysis of NSE 500 companies revealed that low-growth, low-ROE (return on equity) companies (8-10%) have outperformed, while high-growth, high-ROE companies (18-20%) have underperformed. This suggests micro bubbles in low-quality segments, posing a risk of permanent capital loss as stock prices have surged 70-80%, outpacing intrinsic value growth. Conversely, high-growth companies (15-20% intrinsic value growth) are better investments, as they eventually become fairly valued and then undervalued, offering superior returns when the market recognizes their true worth.
Given this thesis, what investment opportunities do you find most appealing right now?
We believe the best investment opportunities lie in companies with higher-than-average returns on equity, indicating good business quality, and the ability to grow faster than average. Specifically, these are companies with expected sales growth rates exceeding 20% per annum and returns on equity over 15%.
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So, if you, as an investor, intend to deploy capital in this expensive market, the best opportunities lie in high-quality and high-growth segments.
Could you tell us about your concept of a ‘micro bubble’ mentioned in your newsletter? Why have you coined it so, and which market segments are affected?
In our research, we find that stock prices strongly correlate with intrinsic value growth over three to five years. While short-term trends may seem random, long-term patterns emerge: for example, a 10% intrinsic value growth usually results in a 9-11% stock price increase. "Micro bubbles" refers to those set of companies with very low intrinsic value growth and below-average returns on equity, which ideally should trade at low P/E multiples, but are currently trading at extremely rich valuations despite their weaker long term growth prospects.
Basically, you are calling these companies overvalued?
Yes. That is why we use the term bubble. Generally, you call an asset or security as overvalued when there is a major mismatch between price and value. But an asset is in a bubble when it is significantly overvalued, and when there is a chance of permanent loss of capital.
Sectors like capital goods have run up quite a bit and are probably entering the overvalued territory. Do you think there is growth potential there?
Yes, there are companies with growth potential, but we need to assess both: what we are paying for that growth and its durability.
In the capital goods sector, growth can be uneven, with large orders followed by periods of low demand. In the capital goods sector, orders come in bursts—big orders are followed by long periods with fewer orders. This cyclical pattern is normal, but the market might not be prepared for it, unlike the steadier trends in consumer businesses.
Are you suggesting that we are currently experiencing large order wins, but this could moderate in the future, and the market has not yet factored this in?
Yes, absolutely.
What is your approach at this point in time?
Our approach is straightforward: as mutual fund managers, we adhere strictly to our mandate. We deploy investor capital without holding cash reserves.
Additionally, we are overweight on large-caps as compared with small- and mid-caps relative to benchmarks.
Why are you overweight on large-caps?
We assess fair value based on four factors: durable earnings growth, forward returns on equity, business risk, and the risk-free rate (which we set at 7.5% for India). Using our proprietary models, we continually evaluate each stock's fair worth compared to its market price. Our model indicates that many large caps, despite their recent underperformance, are trading at more attractive valuations compared to similar mid-cap companies.
Do you believe current valuations are high compared to historical averages?
Yes, valuations are high, and caution is needed. In the near to medium term, equities might produce slightly lower returns than their underlying fair values. We’ve essentially borrowed returns from the future and are currently ahead of fundamentals.
So, there’s a sense of euphoria in the market, correct?
There is a lot of euphoria in some pockets of the market. It is mostly concentrated in low-quality and low-growth segments of the market. Therefore, if you invest in high-growth and high-quality companies today, you should still be able to achieve reasonable returns over a three to five-year period, unlike in the other segments.
Investors worry about missing out on more gains if they cash out too soon. How big is this concern about timing your exit?
Markets are often at their riskiest when they seem the easiest to profit from.
So, my advice to investors is to religiously stick to their financial plan and avoid emotions like greed (fear of missing out) and jealousy (my friend made more money than me) which are enemies of sensible financial behaviour and well-being.
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I believe the Securities and Exchange Board of India is doing a good job of protecting investors' financial health, which is crucial.
Based on your interactions with institutional clients, are they cautious about investing, or are they comfortable investing at these levels?
Generally, when we speak with foreign institutional investors (FIIs)—not retail investors—they are cautious primarily due to valuation concerns.
We're seeing significant inflows from domestic investors. Do you think domestic investor flows will continue while foreign institutional flows might remain unstable?
It is difficult to predict. That said, there is no doubt about India's growth potential or the quality of its companies. Two key aspects set India apart globally: first, its rapidly expanding domestic market, and second, the presence of high-quality companies. Many of these companies achieve returns on equity exceeding 15%.
There aren't many global markets where you can find such a diverse range of companies across different sectors delivering these kinds of returns.
Diversity is actually growing in India, evident from the new IPOs.
Absolutely. The quality of assets is not in question; the challenge lies in the price you're paying for them.
How will the turmoil in Bangladesh impact India and its equity markets?
The current political turmoil in Bangladesh may not have a significant impact on overall equity markets. Two types of companies may be affected: those sourcing a lot of finished products from Bangladesh, such as garment producers or luggage companies and those that receive significant portion of revenues from that country. Bangladesh is known for its high-quality, low-cost labour, so companies reliant on goods from there might experience supply chain disruptions for the next one to two quarters.
