Buckle up for more volatility: UTI's Vetri Subramaniam

What do you make of the regulatory action on unsecured lending and more recently on NBFCs?

I would interpret this as each regulator doing what they are doing in terms of good housekeeping and making sure that rules are followed. Making sure that disclosures are adequate, and processes are in place. I don't know if there is a master plan which is suddenly combining everything together, but I would say each of the regulators in their domain is doing things. Like Insurance Regulatory and Development Authority (IRDAI) is having ongoing discussion with companies about surrender value of policies.

This is part of regulatory review of things which are happening in the marketplace and then seeing how it can be made more foolproof. So, it will always be a combination of disclosure, new regulations, and processes and eventually perhaps an action against some people which we have seen in the case of the Reserve Bank of India (RBI) where there has been action against certain entities.

Are you worried that some of the sharp practices cited are more widespread?

No. There are systemic issues, like the RBI raising risk weights on unsecured lending, which is part of typical prudence that you would expect from a central bank and many people have looked at this data of unsecured lending and said it was warranted. I think RBI has done the right thing in terms of acting on it. That to my mind is a systemic issue that one would worry about as it could have an impact on the financial system. Other issues may not be systemic in nature, being restricted to a few individual entities.

Is there irrational exuberance in small- and mid-cap stocks?

We always look at things from the prism of valuation. From that prism, mid- and small-caps have been looking richly valued for some time, though I could also argue that they've been looking richly valued for six months and they actually did very well over the last six months. So, it's very hard to figure out because valuations are not like a school bell. The school bell rings in the morning, you assemble; it rings in the evening, you disperse.

We have to be conscious of the fact that valuations were rich over there and in my experience of three decades, as far as market falls and rallies are concerned you should expect one fall of 10% for Nifty every 12-18 months and one fall of 20% in 2-3 years. This is the historical pattern. Once every 8-10 years it falls 30-50%.

Markets, by definition, are volatile. You should plan for volatility in your investment journey to achieve your goal. If you plan for zero volatility, you are asking for trouble. I don't have any specific view on the recent volatility, on whether it will persist or not, except to say volatility has historically been there. We have actually seen low volatility in some of these asset classes in the last year or two. You should certainly buckle up for more volatility, particularly when valuations are giving you that message. When I talked about the fact that volatility is part and parcel of the market, that's a statement I can make without reference to valuation. But when you have an orange light coming on in terms of valuation and you have a lack of volatility then you should worry.

Do you think there are pockets of value in small- and mid-caps even as we speak?

When you put an aggregate together and the aggregate gives you a particular signal, it tells you that people have either discounted the future potential quite significantly in the price and the margin for error is greatly reduced. So, when you look at it from that point of view, let's say index behaviour over the last one year, how much of the gain came from earnings and how much came from PE multiple expansion?

As you go down the market cap curve, what you will see is that more and more of the gains have actually come from a multiple expansion rather than from earnings growth. Another point is when I stand back and look at metrics like a price-to-book, which has nothing to do with earnings growth; you’re just looking at a multiple of book, it can be interpreted as the future earnings potential of the companies, right? And I'm using the word companies, not company, because this is one of those unusual times in my career where I'm actually seeing the Nifty Small Cap 250index on a price-to-book trade at premium to even the Nifty 50.

Do impossible things happen in the stock market?

Of course they do at various points of time, but if you were to ask me can 250 small-cap companies as a basket over the next 10 years outperform the top 50 in terms of earnings growth given all the challenges that smaller companies face—access to capital, susceptibility to economic cycles, interest rate cycles, susceptibility to changes in regulations, management depth and breadth to manage the enterprise over such a long period—I would submit that historically they have been more vulnerable to those sort of cycles. When I look out 10 years if I'm going to pay premium to large caps then it gives us some bit of discomfort. Too much of future potential is already discounted into the price and margin for error is greatly reduced.

There is also a lot of excitement around PSUs, but here the argument is that there are paradigm shifts in management, tech efficiencies, etc. Your comment.

There's a cyclical element to everything in life. It could well be the case that the public sector undertakings (PSUs) had de-rated very significantly as a basket, but you know my preferred approach to this is not to look at PSUs as PSUs. It has to be based on the industry and company and the credentials of the company in the industry in which it competes. You and I will never have a discussion about Tata group, Birla group.... that's not the way it works, right? I mean, we may think one company in that group is outstanding because it's best in class. Another company may be best in class, it's just not the best in the industry. So, I would submit the same should be done even for PSUs.

Now, for a variety of reasons—weak governance, and so on—they were trading cheap. Maybe there has been a significant catch-up trade in terms of some of these things going away. But I would say on an ongoing basis you need to benchmark and see in every industry where is a company functioning relative to its peers, how well does it score in terms of its fundamentals—return on capital, return on assets (RoA), ability to redeploy capital at higher rates of return. That is what eventually creates value for those companies. There could be some areas in which the PSUs are not only dominant, they may be the only game in town, because if you take something like defence, it’s dominated by PSUs.

But I would submit in many other sectors where there is both PSU and private sector company, in many cases we do find the private company's metrics and fundamentals are better than those of PSUs. Secondly, there is better alignment of eventual incentives between shareholders and management and that is what eventually creates value for us. So, I don't think the issue is so much of just who owns the companies, it is how well they stack up relative to their sector. But, there could have been a time when the basket had de-rated, irrespective of the fundamentals of the companies and maybe there's just been a cyclical move which has now caused some of that undervaluation to go away. But, I would submit that from here onwards you need to treat each company on merit rather than look at who's the owner because the fundamentals matter.

Just to add perspective, the top five private sector banks would have an RoA which is somewhere between 1.7% and 2% or higher. The best public central bank is barely at 100 bps of RoA.

That certainly has an impact on your ability to absorb credit cost…that has an impact on your ability to generate enough profits to be able to drive your own growth. The minute you take that (RoA) into account, then you will understand why companies are valued differently from each other.

And I would submit that this is not just a question of private versus public. I can even show you within private banks why some bank is getting a much better valuation multiple. Almost 99% of the time you will find significant correlation between its ability to generate a higher RoA and reinvest capital at that higher rate of return. That makes all the difference. Even within private sector you will find wide variations and that is a function of different fundamental outcomes.

Coming back to large caps, what’s the view?

Relative comfort is more with large caps at this time. But if you look at it from a sector level, we do have a range of sector funds we run. If I look at that bunch and say where is the opportunity today, we actually think the opportunity is in the core banking and financial services space, because over there in general, all the banks have reasonably healthy balance sheets. So, you know that's a great starting point. Valuations for many of them are actually at very attractive levels relative to their potential growth prospects. There could be concerns about earnings over the next 12 months because of tight liquidity in the marketplace, potential drop in the repo rate, which would cause some net interest margin (NIM) compression, but those are one-year issues. But this starting point of valuations and ability to grow over the next three to five years, that's something which makes the banking sector attractive from our point of view. So, investors will be looking for a beta opportunity to invest in the banking and financial services fund as one opportunity. 

The other sector where we are still positive, though valuations are not as attractive as they were a year ago, is the whole pharmaceutical and healthcare space—among the top two-three sectors over the last one year in terms of performance. Valuations are no longer so cheap, but we still think over there, you know, those companies are now putting behind almost a decade of capital allocation misadventures and other problems that they have in the pharma space and at the same time, growth is now looking to be reasonably well established in some of the areas like hospitals, etc. In terms of performance, in absolute terms, the sector is banking and finance. In relative terms, but still reasonably positive, it's healthcare.

What’s your view on the IT sector?

It is very rare to find any sector in which you have so many world class companies as you find in IT for obvious reasons that India has been globally very competitive in IT services.They are going through a tough time in terms of what the current demand environment looks like. Valuations are not as expensive as they were in 2021, but I would say they're not particularly mouthwatering either. So, our view on IT would be more, you know, if it were to really sort of decline, we would incrementally turn more positive. It is still not fully clear to anybody including to us as to what extent and when artificial intelligence (AI) may start to, you know, potentially create some disruptions in the pattern of IT services that we have seen. Our own sense is that much like we have seen past disruptions in IT, one area of a company’s business portfolio may get affected, but work gets created upstream of the disruption, right? But during that transition period, what will be very critical is how well our company is able to manage this. A) Have you reskilled your people? Are you able to redeploy your people; B) when you start losing some of the business that you might be doing today, due to AI are you able to fully and more than sufficiently replace it with that upstream work which could happen upstream of AI, so it may again over there be more company-specific outcomes that we'll have to be careful about, but as I said, this is certainly one risk that we are also dealing with in IT.

Are you more tilted to private sector banks in the BFSI pack?

I can't comment on individual stocks, but our portfolio is dominated by private sector lenders who have demonstrated the ability to manage credit cycles over time without requiring significant equity support. If you look at the history of the PSU banks and the extent of equity support that they have required from government then it's a risk that I have to worry about—have they actually learnt from the past and how well will they manage their cycle? But, you will find two to three public sector banks in the portfolio.

There is this worry that deposit growth lags credit growth but then RBI could cut the repo rate in H2? Does that offset the challenge faced by banks in general. There is the case of the largest private sector bank after merger...

Yeah, except remember that the fall in the rates will actually have a short term hit on NIMs, because the lending rates will come down faster than the deposit rates. Rates coming down actually has a negative impact on bank spreads in the short term, so that's slightly more a concern than a positive. I would say as far as the deposit thing is concerned, we are not particularly worried about it simply because eventually you know this tightness of deposits are more to do firstly with the fact that RBI is running liquidity tight, which we think will anyway start to change in due course. And, secondly, there's also been some unexpected seasonal tightness in liquidity because the government has been running a positive cash balance. These are more cyclical factors. The argument that money is going to mutual funds, therefore, there is less banking liquidity is completely misplaced. When people invest in debt mutual funds, that money goes right into a bank.

Mutual fund operates with the banking system. The nature of the deposit might change for the bank. It could go from being a time deposit or savings bank deposit to suddenly becoming high frequency current account money. Current account money is also zero-cost money, so there's also benefit. At the same time, we have to worry that because it is high-frequency money, I need to have a buffer in terms of liquidity against that. So, there is a trade-off between these two. We don't think there is a tightness in the banking system just because people came to MFs. That money sits in the banking system. 

I think once some of these, what we think are more, short-term factors go away, then you should start to see the liquidity situation get better. Certainly, there is one bank which due to its own reasons, merger related, which has to raise its share of deposits, but I think they have a reasonably aggressive rollout plan of branches to take care of that.

Given the fact that inflation and crude oil prices have largely been under control do you think a repo rate cut could precede an FFR (Fed funds rate) cut?

I think the key thing to remember is "where is the pressure on rates?" Your economy is growing at 7.6% (second advance estimate), RBI governor is hinting that he thinks it could be closer to 8%, inflation is 5%. You now have an RBI who says my target is 4%, no longer interpreting it as 4 with a range of 2% on either side. Now, if I'm at 5%, my target is 4% and growth is anyway coming at 8%. Where is the pressure to cut rates. The governor himself was saying this is the opportunity to actually get to 4%. So, first of all, I don't think there is any reason for RBI to be in a hurry to cut rates. The government appears to be fully on board with this, that, you know, low, stable inflation is preferable to volatile and high inflation. And, therefore, I think they will take their time and, in any case, why second-guess the Fed.

Keep your cards as close as you can and play them at the last minute rather than pre-empt the Fed and start to play your cards, I think they will take it slow both for the reasons of what is appropriate for India—growth is holding up so well. And secondly, you know, they don't want to get on the wrong foot.

There is also growing interest among foreign portfolio investors (FPIs) for government paper especially since the bond inclusion. What’s your view on fixed income?

I think the money is already starting to come. Data shows that from September to date, there has been almost $10 billion-plus of FPI inflow into fixed income. And if you look at the back of the envelope math, the bond inclusion over the period of a year should create about $25 billion of inflows. So, I would say some level of pre-buying has already started and I'll be surprised if we don't get another $10 billion by the end of this year. 

But I don't see this as fundamentally altering rates in India, because what you have to remember is that in the bond market RBI is a participant and RBI, as a participant, bought a lot of bonds in 2021, when the pandemic hit...government tax revenue collapsed, government had to borrow and RBI bought the bonds to fund them. So, this will give RBI an opportunity to sort of reverse their trades and start to shrink their own balance sheet. So there is certainly some downward pressure on yields, from 7.2%, we’ve moved closer to 7%. I would suspect that’s also a function of the government saying “look, my fiscal deficit target is 5.1% (FY25), more than this FPI inflow". FPI inflow certainly lends the support. 

But I think it's actually the government thing of saying 5.1% in FY25 and then 4.5% in FY26, which is giving the market more confidence. Because, when you talk about 4.5% by FY26, you're actually saying that for five years, your nominal borrowing number will be flat or negative, right? So, there's a significant restriction which is happening and discipline that the government is demonstrating. Money will come from foreigners, but from our point of view when we look at the bond index and where the money comes, a little bit will come at the long end, but actually most of it will come at the middle (3–5-year tenor). So, which is why we've been recommending products like the short duration fund, the Banking and PSU Debt Fund, because those funds operate in that two to three-year three maturity window where we think the impact of these flows will eventually be.

What’s your take on private capex...so far it’s the government that’s doing the heavy lifting...

If you get the data over 10 or 20 years, the importance of government capex in the total capex of the country is a falling number. The bulk of capex is done by the private corporate sector and by what we call households. But just remember households in India, not just you and me and our households, but it also includes the unincorporated businesses, right. So, an idli vendor is also typically a household but he is an unincorporated business.

The business, so this is really the bulk of capex, which happens in the economy. There are two reasons why the capex cycle in India has been soft. Most people talk about the private corporate sector, but actually the other reason why capex in India has been soft is that real estate capex has been very soft. The biggest drop in capex, if you look at the historical cycle in India, let's say 2008-11 compared to today, the biggest delta happened because of the collapse in real estate. I think the good thing is that we are starting to see some pickup in real estate. I still won't call it very widespread because it appears to be driven more by organized high-end market and there's a large part of the market sitting in unorganized and small ticket, but it is certainly good news that real estate investments are picking up, that will help the capex cycle. 

As far as the private corporate sector is concerned, I think the enabling conditions are there, meaning their balance sheets are healthy and the bank balance sheets are healthy. Between the corporate tax cut of 2019 and the post-pandemic boom in profits, which could not have been anybody's base case in March 2020 when we got locked up at home. If somebody back then said corporate India profits will go up 70% in the next three years. You would have said I don't know where my food will come from tomorrow. And your forecast is 70% growth in profits but actually that is what happened. Right? So that has significantly recapitalized corporate balance sheets.