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Business News/ Money / Personal Finance/  Utilities will be a better bet than consumption stocks post covid: Prashant Jain
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Utilities will be a better bet than consumption stocks post covid: Prashant Jain

For India, impact on the economic growth, incomes—especially for the lower income groups—and the fiscal deficit is likely to be significant, says the executive director and chief investment officer (CIO) of HDFC Mutual Fund.

One should not focus too much on near term negatives, but look beyond the current year, says Jain.Premium
One should not focus too much on near term negatives, but look beyond the current year, says Jain.

Key funds such as HDFC Equity and HDFC Top 100 have underperformed their category averages on a five-year basis (CAGR). Neil Borate spoke to Prashant Jain, executive director and chief investment officer (CIO) of HDFC Mutual Fund to understand the reasons for the underperformance and his overall outlook on the markets and the economy as a whole. Edited excerpts:

Global markets, including India, have seen a meaningful correction. What should investors do now?

The current situation is unprecedented, and the world is still in the process of figuring out the medium- and long-term impacts.

For India, impact on the economic growth, incomes—especially for the lower income groups—and the fiscal deficit is likely to be significant. However, on the external side due to a sharp fall in oil prices as well as likely sharp fall in gold and consumer durable imports, the current account deficit should improve despite a fall in remittances and exports.

From an investor’s perspective, it is best not to focus on the current year's profits for two reasons—first, FY21 is clearly an outlier year and current year’s profits are not representative of the future. Second, the impact on the intrinsic value of businesses due to lower current year’s profits will be marginal.

Post the sharp correction, market capitalisation to GDP (based on FY22 GDP estimates) is below 60%, a level seen last post correction during the global financial crisis in 2008-09. Historically, market returns from such levels were strong over the next three years. Also, it has been observed in the past that sharp corrections in Indian markets triggered by global events like the global financial crisis in 2008, attack on the World Trade Center in 2001 and Dotcom bubble burst in 2000 have been followed by strong returns.

It is interesting to note that Indian markets recover much faster than the global markets. This is because of strong domestic growth and low to moderate impact of global developments on India. The above suggests that markets hold good promise over the medium to long term.

Interestingly, this event also highlights the risks in equities and importance of right asset allocation (i.e. ability to hold in such situations is key) in investment decisions. In view of the attractive valuations and the inherent strengths of Indian economy, if risk appetite permits, investors should use this deep correction to their advantage by increasing exposure to equity funds in phases over the next few months.

Which are the sectors witnessing deep value post the recent market correction and what will be your investment strategy going forward?

These are sharply polarized markets. This is evident from the fact that around 80% of Nifty 50 returns in CY19 were contributed by five stocks only. In my judgement, currently, consumption—discretionary and non-discretionary (excluding tobacco) is at one extreme, while utilities, corporate banks, certain oil & gas companies are at the other. Sectors like information technology and pharma, among others fall in the middle.

The key overweights in the funds, which I manage are utilities, corporate banks, tobacco and EPC and the key underweights are in consumption discretionary & staples and retail banks. It is interesting to note that 10-12 years ago, market's perception of these sectors and our positioning of funds was exactly the opposite of today. Then utilities were one of the most favoured sectors and were trading at price to book value of 2-3 times. On the other hand, FMCG was trading at P/E multiple of 15-20 times! That was the time when real estate companies enjoyed market capitalisation more than large FMCG companies. Today, utilities are near or below book value, offer dividend yields of high single digits, going all the way up to double digits and FMCG trades between 40-80 P/E with dividend yields of 0.5-2%. This role reversal is not a first—there are several illustrations of how once fancied sectors fell out of favour over time and vice versa. Will this happen once again, time will only tell. In my experience while markets can misprice a business for a while, over time just like water finds its own level, so do valuations.

Select funds have underperformed their respective benchmarks. What has been the reason for this?

This is indeed true that performance has been weak for the funds managed by me. The primary reason for this is the overweight position in utilities, tobacco and select EPC companies along with an underweight position in consumption companies and retail banks vis-à-vis the benchmark. The impact of corporate banks has been to a certain extent offset by similar or higher fall in some NBFCs or small banks.

What makes me optimistic of the future are two things—first, the businesses that have caused the underperformance are some of the strongest companies, not just of their respective sectors, but of the country, and they continue to grow. Second, I have experienced similar situations of deeply polarized markets in 2001. IT was very expensive and old economy stocks were deep value. In 2008, utilities, NBFCs were very expensive, while FMCG and pharma were offering great value. Again in 2015, pharma was hugely popular and expensive and it lost 70% value over next few years and so on. On each occasion, while the markets have tested patience, but eventually the excesses reversed.

Looking forward, in my view, the post covid-19 environment is particularly supportive for the utility sector as the impact on earnings for this sector is likely to be minimal. With the recent initiatives pertaining to the power sector, the receivables position of these companies should also normalize. The impact on the incomes of a large section of population, on the other hand, should have an adverse impact on consumption for the foreseeable future.

You have large allocations to banking and finance in your portfolios. Some years ago, the sector struggled heavily with NPAs. After the covid-19 lockdown, around one third of the loan books of the major banks are under moratorium. What is your outlook for the sector?

The large weightage of banks in the funds should be viewed in the context of around 30% weights of financials in the benchmarks. However, we have been overweight on large corporate banks and underweight retail-focussed banks over the last few years. It is also true that these years have been challenging for the corporate banks due to delays in resolution of non-performing assets. Stepping into 2020, we believed that asset quality issues were largely behind us and were optimistic about FY21 earnings, as it would have been the first full year of normal profits post large resolutions in FY20 under the Insolvency and Banking Code (IBC). Unfortunately, covid-19 will push that expectation back by one year. In my judgement, challenges for smaller banks and select NBFCs are likely to be more than large banks. While large banks will face some provisioning or growth challenges in the current year, they are likely to emerge stronger as they gain market share from small banks, NBFCs and bond markets as well. Further, the asset quality issues are likely to be more concentrated in SMEs and unsecured retail loans portfolios that form a relatively small proportion of assets of most large banks, especially corporate banks. Finally, the large treasury gains due to lower yields should provide a cushion as well. It is interesting to note that the divide between retail and corporate banks is fast disappearing and in my judgement in future, the divide will be on the basis of liability franchise, the size, customer base and technology.

Post the sharp correction, the markets seem to have priced in the anticipated pain well. Some of the large banks are presently trading near or below book value, which is attractive. The key to successful investing at times like these is to focus on sustainability and valuations from a medium-term perspective and I think these pass both these tests.

Historically, the government has extracted value from PSUs by paying itself huge dividends or forcing mergers. With government finances under strain after covid-19, will such companies deliver value to investors?

In my opinion, not all PSU stocks are bad nor are all private sector stocks good. There are several cases in each decade of business failures or underperformance, wealth erosion from both the public and private sector. In certain sectors, PSUs are competitive, sustainable and growing—power generation, transmission, oil refining and marketing, among others. In certain sectors they have failed—telecom and aviation are good examples.

Interestingly, the BSE PSU index and BSE Sensex delivered nearly the same returns for 17 years between 2000 and 2017. However, it is true in the last 2 years, they have significantly underperformed. Since this underperformance has happened at the time when the financial performance of PSUs has been either stable or improving, this probably presents an opportunity for the long term investors.

With regard to dividend from PSUs, we believe that payment of dividend by PSUs is not an unfair practice as it is given proportionately to all shareholders. In fact, it is advisable for cash rich or low leveraged PSUs to pay higher dividends and fund their capital expenditure through debt considering the high cost of equity and low post tax cost of debt. It will optimize their capital structures and will improve return on equity.

With regard to mergers or inter PSU acquisitions, if such acquisitions are done in synergistic areas and at valuations that are earnings accretive for the acquiring company, it is a long term positive. However, if these conditions are not met, then it can be a drag.

Finally, there is no denying that there is room for improvement in some PSUs in areas like capital allocation, investor communication etc.

Conviction in stocks is important, but so is changing course when the data changes. Have you changed course in the past? What changes in sectors, themes or broad investment ideas do you intend to make going forward in the post-covid world?

This is a very pertinent question and all portfolio managers constantly grapple with this. I generally follow the following framework:

First question that needs to be answered is whether the business is not doing well or just the stock price? If business is doing fine and the outlook has not changed, but the stock is underperforming, it possibly implies that the stock is becoming more undervalued. In such a situation, generally, one should stay put or increase exposure within limits to control risk.

If business is underperforming then one needs to assess whether the reasons for underperformance are temporary or lasting? If temporary, then one needs to assess whether the expected returns justify holding the stock for longer. If the answer is yes, then one tends to wait, else take corrective action.

In the past, on some occasions, I have done course correction and am constantly reviewing current views or positions. While the above appears simple on paper, things are different in real life where one is constantly learning and refining one’s judgements. What makes investing both challenging and difficult is the constantly changing environment and the difficulty in figuring out how much of the pain is already priced in. There have been occasions where after holding an underperforming investment for several years, one saw it go up multifold after one sold as also cases where after a long wait, the returns in the next year or so made up for the entire holding period.

Much of the government’s 20 lakh crore package is about providing easier loans to businesses rather than large cash transfers or infrastructure spending. Will this be enough to revive the economy?

Over the past few years, the government has reduced the tax rates—reduction in GST rates (currently well below tax neutral rate) and cut in corporate tax rates, among others. This was done despite India’s tax-to-GDP ratio being relatively low. These changes along with expected loss in revenue due to covid-19 and the necessity of supporting the vulnerable sections of society has constrained the ability of the government to provide direct fiscal stimulus.

In any case, in my opinion, the ideal stimulus for reviving the economy is not by reducing taxes, but through increasing infrastructure spending. That need not be routed entirely through the government budget. It can be done through various arms of the government. The very low rates globally also support higher infra spends.

Equally, if not more important than stimulus, is to ensure that pending dues of enterprises especially SMEs or MSMEs should be cleared.

There is no denying the fact that the economic outlook for FY21 remains challenging. This is likely to be a temporary setback. However, long term structural growth factors of Indian economy such as favourable demographics, large infrastructure needs, competitive costs, reforms, likely shift of manufacturing from China, low oil prices and low export dependence, large foreign exchange reserves, low global rates and high global liquidity are positive and will revive growth strongly in FY22 and beyond.

As someone rightly said, “Sometimes you need a little crisis to get your adrenaline flowing and help you realize your potential". I feel that India will come out stronger from this crisis and one should not focus too much on near term negatives, but look beyond the current year.

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ABOUT THE AUTHOR
Neil Borate
Neil heads the personal finance team at Mint. A former colleague called them 'money nerds' and that's what they are. They cover topics like mutual funds, taxation and retirement, all to improve your chances of building wealth. Neil graduated with a degree in law and economics. He passed the CFA Level I exam and began his writing career at Value Research, a mutual fund research firm in 2016. He joined the personal finance team Mint in 2019. Everyday, the Mint Money Team tackles personal finance questions such as where to invest and where to borrow, through articles, charts and reader queries. They also have a daily podcast - 'Why Not Mint Money' and an annual ranking of mutual funds - the Mint 20.
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Published: 25 May 2020, 06:47 PM IST
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