Small and midcaps provide a margin of safety but they need a growth catalyst : Nilesh Shah

Nilesh Shah, MD, Kotak AMC Navneet Munot, SBI MF and Manish Gunwani, Reliance MF in conversation with Nikunj Dalmia and Abha Bakaya of ETNOW.

What should one do to make money in a volatile market?
Nilesh Shah: Last year, market delivered roughly 10% return on Sensex at 4% inflation, that is 6% real return. In the best of times also Sensex delivered 6-7% real return. We are not way off from the average despite all the twists and turns and a series of lower growth numbers.

Second, when the news flow is bad, sentiments are bad and valuation obviously is also bad. If you buy at cheap valuations, probability of making money increases immensely. It would not increase tomorrow but who knows what happens day after tomorrow? This is the time to put your head together, understand that valuations are cheap and if you buy quality companies run by good managers, there are better days ahead.

Are we in for a long winter? Will bad get worse before it gets better or has bad already got worse and now it will get better?
Manish Gunwani: Now with the caveat that policy matters, we have all seen globally that government policies, whether the US in 2009 or India in 2002 policy, has a lot to do with how bull markets shape up, but with that caveat to my mind, I am a bit more optimistic that in a very simple framework, typically historical data proves that the trend growth rate of an economy does not change very fast.

While we keep reading a lot of news, we think that the budget or something else has changed the trend growth of the economy. Large economies like US, India and China have a persistent trend growth rate. India has only four things -- monetary policy, fiscal policy, exchange rate and global growth rate. Now if you look at those four factors, last year was a bit of a perfect storm where everything was negative, but the direction of all four is marginally improving across the table. In two-three quarters, we should see a much better economy.

Long term investors should focus on two things -- margin of safety and risk. For a long term investor, three to five years define both these parameters -- margin of safety and risk. How are they right now for equity investors?
Nilesh Shah: From a margin of safety point of view, there are four compartments in the market. Super largecaps are pretty expensive, compared to their historical average. Now in a market, where things deteriorate, they will provide safety but from a valuation point of view, there is no margin for error.

On the other hand, there is extreme end smallcap which is way below its historical average. They need a catalyst to give returns but the margin of safety from a valuation point of view is the highest. In between, now largecap and midcaps are reasonably well below their historical average. They need a catalyst to give return but the margin of safety is pretty high compared to largecaps, but lower than smallcaps. They need a catalyst to deliver return. Growth could be one catalyst, precursor to growth, which could be additional credit flow in the form of FPI buying. There could be settlement in some of the NBFCs and banks which are in trouble and that could change the sentiment and the fundamental. From a valuation point of view, small and midcaps provide a margin of safety but they need a catalyst of growth or certain other things to lift.

Consumers are expensive. They were expensive three years ago. Quality stocks were expensive and they are expensive right now. But that is where all the returns are and where all the participation is. If that is where gains are, what is wrong in chasing them because the investor would say I do not care what you buy. I ultimately want returns?
Navneet Munot: Echoing the views that Nilesh has just mentioned, there are few stocks which have done exceptionally well. Most of them lie in the megacaps or largecaps, but there are a few mid and smallcaps which are in that consumer quality space where the return on equity is higher. You still see some growth in a low growth environment and of course where are the perceived governance is far better. They have substantially outperformed the rest of the market and there is a large part of the market. I measure one thing, where a number of companies which have underperformed in BSE 500 index the number of companies that have underperformed the index that number is now more than 70%. It has been increasing over the last few months because there is a small set of stocks which have been doing well.

As growth becomes more broad-based, if we are able to tackle the challenges that are there in the financial sector as flows improved last few days, at least there are indications that even from the global investors, the flows have started improving. People would start looking at a wider set of universe. Then may be the chase that you have for the perceived quality where you pay any price for growth or quality.

People would start paying attention to valuation as well and would look elsewhere for value. Maybe you just need a catalyst as Nilesh just mentioned. Once we see that catalyst, it has become a lot more broad-based than what we have seen in the last one year. This has been one of the very narrow rally the 10-11% that has come has come from a very narrow side of stocks which is not good over a long period.

And you own those narrow stocks?
Navneet Munot: Of course that is why the funds have done well. So, touch wood!

So then there is a problem…
Navneet Munot: No, but we have expanded over the last few months. The idea is to spend a lot more time on those stocks where the valuations have turned quite favourable. May be the near term outlook is not as good but we are waiting for that catalyst and of course, markets will bottom or the stocks will bottom much ahead of the bottoming of the economy and the profits.

This government seems to be open to incremental measures. Unless they have succeeded with their divestment agenda, everyone has been calling out for a massive fiscal stimulus. Are you looking at other things that could possibly help stimulate growth?
Manish Gunwani: There are big strategic divestments from the government. It will be a big trigger because it will do two things: a) both bond and equity markets are definitely worried about the fiscal situation in the second half of this year, especially on the state government side which do not have access to RBI reserves or other non-tax revenues. You could see a big squeeze on expenditure because once tax revenues are falling short and you have to meet a committed fiscal deficit number, then the only option is to squeeze the expenditure which pulls down the economy and you go into the vicious loop. A big strategic divestment would address that.

b)We all know that a big segment of the market which is the PSUs, are very value centric stocks. They have good dividend yield, price to book, price to earnings multiple is very attractive but they have been suffering from supply through ETFs. Also the fact that it provides a big catalyst for them. If there is a strategic divestment at 2x-3x of current market price for one of the PSU stocks, the whole universe would get rerated and that will kind pull up the index as well so on both sides from a macro economic perspective and from a market centric perspective I think that will be a big thing.

At the current price, given where the interest rate and oil is, how much more can we go? What happens in the short term could be a technical factor but fundamentally how much more do you think? What is the worst case scenario?
Nilesh Shah: A lot will depend upon how the situation evolves if oil prices go to three digits. Obviously our markets will suffer, if today there is geopolitical tension in our border or outside, obviously there will be impact on the market.

When you are investing in equity, you have to take the ups along with the downs and earlier today, from a valuation point of view, in small and midcap space, there is a limited downside. It does not mean that what is attractive cannot become cheap or what is cheap cannot become cheaper but then you will have to add more. That is how the disciplined asset allocation works. Overall, even last year, which was very tough, the largecaps delivered 6% real returns this year. it. looks like corrective actions have been taken.

Banking liquidity from May 19 is positive, interest rates have been cut, PSU banks have been capitalised. In NBFCs, some steps have been taken like securitisation with first loss. It has not yet become operational but hopefully once you have announced, you will make it operational. If you see the currency which was overvalued is now little overvalued around fair value, that will push exports. The strategic divestment is now right at the centrestage and hopefully it would not be like last time’s Air India.

More importantly, with China which resulted in higher trade deficit with India, there has been discussion about curtailing that. This Chinese trade deficit is converting our manufacturers to traders. Hopefully, if we can curtail that, it will be very positive. So there are lots of corrective actions which have been taken and coupled with valuations, I will say there is limited downside in small and midcaps.