As a Diwali bonanza, the Indian government came out with varuious foreign direct investments (FDI) reforms in 15 sectors, including agriculture, mining plantation, defence, broadcasting, aviation, construction, manufacturing and the private banking space.
With these reforms, there will be increased capital inflow in India, says Dhiren Shah, Portfolio Manager, BlackRock. Speaking to CNBC-TV18, Shah says: “As foreign capital comes in, it will increase the efficiency of life and business environment in India.”
While he is underweight on the IT sector in saying its growth story is only a thing of the past, he sees opportunity in other spaces. He is constructive on the auto industry, including two wheelers and says: “With the interest rates starting to fall, the cost of auto loans is also coming down; so we see this as a long term (growth) opportunity.”
In addition, he picks private banks over public ones in the banking sector.
“The private banks offer compelling enough growth, strong enough franchises that you don’t need to own a public sector bank as they (private banks) continue to deliver 15-20 percent growth per year,” he adds.
Below is the verbatim transcript of Dhiren Shah’s interview with CNBC-TV18’s Shereen Bhan.
Q: It has not been a particularly great year as far as the Indian equity are concerned. There has been disappointment, but what is your own take of the road ahead?
A: India is a story of a journey and when we look back to last year, there was obviously considerable hope built in by the market of the long term story for India which the new government was about to open up. What we have seen over the last 12-18 months is relevant progress in small micro reforms and these reforms are tremendously important and will help India in a four to five year horizon. These are small reforms, the ease of doing business has got better as one example. The challenge we faced is India is still dealing today with a legacy of the prior five years. So, we are still dealing with the unwind of prior corporate spend, weak economic activity. The economy has improved slightly, however, has failed to really pick up in the way that many were hoping for and expecting.
So the consequence is that there has been a lot of optimism, foreign investors have allocated tremendous amounts of capital to India because they believe, they see this long term story, which we think will play out in due course.
However, there has been a lot of disappointment. So, the companies have been disappointing, revenues have been coming in below what we expected and margins have also been falling. So that has caused a bit of disappointment as we digest the current environment. The key question of course is when does this environment change and when will our long-term potential actually come through into company earnings.
Q: Do you see a pickup as far as corporate earnings is concerned, because the hope was that perhaps this quarter would be the quarter that we would start to see earnings pick up. But it has been a mixed quarter and it has been a disappointing quarter even as far as corporate earnings and growth in itself is concerned. Do you see a revival in corporate earnings anytime soon?
A: It has been a very difficult quarter as we kind of go through the results everyday, it has been actually one of the weakest quarters. When we go through various sectors, you look at energy, you look at banks, you look at some of the pharma companies, domestic facing industrials and see the misses continue to build up. So, this as we see for a market trading on one of the more expensive multiples globally and especially within emerging markets, we see this a set up for a near term disappointment. As the price earnings (P-E) multiples are high, and the earnings need to come through to justify those.
Q: So what would that mean then in terms of your own allocation to India, given that where the valuations are and given that the fact that you continue to see disappointment on the earnings front?
A: We have had this long term positive view point on India. But we have seen some of the long-term reforms being pushed back, seen the earnings growth not come through and this has caused us to actually scale or reduce our allocation to India. So, we still have a long term constructive view, but we find better opportunities elsewhere in near term.
Q: Since we were talking about the government’s reform process; there has been a lot of talk around FDI and trying to trying to attract foreign investors, in fact, only a couple of hours ago, the government has unveiled more measures, FDI now being allowed into completed real estate projects, which was not the case earlier. Now fungibility in the private sector banking space which could open up headroom for stocks like Kotak Mahindra Bank and Axis Bank for instance, media FDI being allowed to go up to 49 percent in broadcast news media. Would this mean a change of view for you for instance?
A: This is very much a part of what we are looking for and expecting, so this is certainly helpful. What it just means is there will be increased capital coming to India, which will help with the Rupee, as the foreign capital comes in and will increase the efficiency of life and business environment in India. So these are all the small reforms that we need to see for India to meet its potential and it certainly helps because after the recent setback and the disappointments of the last government’s reforms not coming through, this shows that the impetus is for continued improvement and change.
Q: There has been a lot of talk around infrastructure. The government of course upping its allocation as far as infrastructure spending is concerned, we have finally seen a big deal which was stuck for over a decade now, the GE locomotive deal being done. There has been a lot of effort to try and resolve the issues as far as the state run discoms are concerned, the government unveiling measures there. Infrastructure, is that a story that you believe in India at this point in time on the back of what you have seen being announced on the reform front?
A: We see it being better than what it was. The industry was really struggling a couple of years ago and so all the changes which have been put in place, are slowly feeding through. But when we track on the ground activity, things have certainly picked up but they are a far cry from where they were in the hay day of the infrastructure investment cycle.
We think it has happened. It is just a question as with all things about when does it actually happen, when is the timing.
Q: So where are you underweight currently as far as sectors or stocks in specific are concerned and where have you brought down your allocation, where do you continue to see good prospects at this point in time?
A: So, I will talk about some of the changes and also where the bright spots are. So, where we have reduced allocations over the last six to nine months? We have reduced our exposure to one of the global sectors the technology, the IT services companies. There we see increased commoditization. The industry has gone for a sea change over the last five-ten years, the landscape has changed, global MNCs which were previously not competitive, are today far more relevant. So there we see medium term pressures on margins.
Q: So you think the 25 percent plus kind of margin story is over for now?
A: We do indeed. We think this will gradually play out over years, but what we saw in the past is certainly not what we are going to see in the future.
Q: So would you look at technology at all?
A: Within any sector, there are always great opportunities. We think there are opportunities within it, but as a sector we think this sector will struggle over the upcoming years. Another area where we have reduced our exposure is financials.
This is the sector that performed extremely well, valuations had gone to more normal levels, as the stocks perform very well, we took profits in our positions. This is an area where we would to allocate back to, if the stocks are cheap enough. This is a valuation story. So these are some of the areas where we have taken profits.
Where are we still constructive? We think the consumer discretioners or the auto space, still remains very interesting. If we look back, look at what is actually happening with monetary policy, interest rates have been high for a prolonged period of time and we like the discipline. We say we like it because it sets you up for the long term.
So with the interest rates being high, they are now are starting to fall and as these rates are falling, the cost of auto loans is also coming down. So we see, when we look at the penetration, there is a long term opportunity here for this space to grow and having been very weak for the last few years, we are seeing a turn in the data. So, we think this is a sector which is actually delivering on the margins, unlike most of the sectors in India and we see the topline actually improving and the valuations are still reasonable. So that would be one area where we quite remain quite constructive.
Q: So passenger car makers, two wheeler makers, heavy commercial vehicle makers, the entire gamut or would you stick with the like of the Maruti ‘s of the world?
A: We have exposure in this space, we have the greater focus within the two wheeler space. We do have exposure within that complex.
Q: On the two wheeler side, it actually has been a sort of patchy performance over the last several quarters now and we are starting to see a pickup just about come in. Are you concerned there because of the hypercompetitive nature of the market that perhaps margins are going to be under pressure because we have got the Bajaj Auto ‘s of the world where the margins are significantly higher than the industry average. What is your take there as far as the margins are concerned?
A: When we look back at this sector last 15 years, it is always competitive and there is always a new model, there is a new competitor entering the fray, so there is always competition. But you also have companies which have well established brands and then trained franchises and with these they are able to actually make very good margins. In a global context, Indian auto is extremely profitable, it is important to have that context, and they deliver very attractive cash flows and returns. The key thing is, you have seen margins actually improve in the last couple of quarters, which is very different than most other than India and topline having been very weak for a while, yet you see volumes pickup as the economy gradually improves.
Q: Besides auto and two wheelers in specific where else would you be constructive?
A: We have got exposure within the banking space. We think the Indian banking space specifically the private sector banks remains one of the best long term stories. So, these are companies which have excellent franchises, delivering very good growth. We have reduced slightly but we still like them a lot because we see some short term margin pressure and some issue with restructured loans.
Q: Not public sector banks though?
A: When you step back and you view this thing on a 3-5 year horizon, you don’t need to own the state owned banks. I think the private banks offer compelling enough growth, strong enough franchises that you don’t need to own a public sector banks. These private banks continue to deliver 15-20 percent growth per year and they keep on delivering it. So, in that sense you have got to keep it relatively simple.
Q: What about the traditional defensive plays, the pharma sector, ofcourse it has been going through a fair degree of trouble because of FDA related matters in the recent past. However would that be a sector that you would look at, FMCG, HUL s of the world in terms of valuations as well as growth prospects how is it looking for you?
A: On some of the more defensive spaces, when you look at the FMCG space, the valuations have become very rich and the growth they are delivering has moderated a bit. We do still like it because when you look back globally there is this tremendous long term growth story and these companies do keep delivering but for us these are not the most compelling right now because of the valuations, but we still like them.
On the pharma space you have got to be careful. You have had some great tailwinds. If you look at what pharma sector has done globally, improved pricing, it has all been extremely helpful to delivering very high revenues, very high margins but it is tricky. A few years ago it was almost as a slam-dunk, today we view it would be lot more difficult and so likewise as the valuations become more expensive and we become little bit more concerned about pricing going forward we have also reduced our allocation.
Q: Since you have reduced your allocation in India, where are you putting your money to work today?
A: There are two things, one is on a tactical, other thing is on a long term basis. So, when we look out that where are the opportunities, one of the other great stories within emerging markets, obviously India is one of them, Mexico is the other. So, we have had a large overweight because Mexico has been a reform story and they have delivered on these reforms. So, they will lead to very strong growth rates in the long term. So, we have got a very large allocation to Mexico and companies are also delivering very good results currently, some of the best globally. So, that is kind of one of our long term allocations we have. Elsewhere on a slightly more shorter term view but where we see opportunities there are two areas, China and there is also Brazil.
In Brazil we find companies which have been for a very difficult period, margins have fallen considerably, the currency has been very weak and we actually find for those reasons a great starting point to make investments.
Q: So, again it is a valuation story in Brazil, not really growth prospects that are starting to look significantly brighter?
A: Currently the growth prospects are actually quite difficult but what we see is the scope for the politics to improve.
Q: So, you would bet on Brazil as opposed to India today?
A: It is tactical. It is a question of tactic over strategic. So, here we find the market has become very cheap and in spite of the difficult macros companies are still delivering, selectively they are delivering some very good results and which is important because we focus on stocks within the wider macro. We see Brazil as tactical opportunity and also within China we have been increasing our allocation more recently. So, there is a strong valuation argument and companies when you look at the earnings being delivered in China they have actually been quite reasonable. They actually have been amongst the most resilient within emerging markets. So, companies are delivering, valuations have been very cheap because China is one of these markets, the market can get very schizophrenic about it.
Q: You are seeing people being whipsawed in China but that clearly is not a concern for you at this point in time?
A: When we are presented with a very cheap opportunity in terms of valuations, for us it is a great opportunity to buy.
Q: What is going against India today is valuations being stretched?
A: It is valuations and also companies are not delivering. So, it is a combination of both. From a tactical standpoint that valuations are high because the market is hoping for, expecting a lot of long term growth and the challenge is the margins and revenues aren’t coming through. As equity investors the two things that we care the most about are valuations and the earnings that you are delivering. So, this will dictate what are the returns you will get in the medium term.
Q: Since you are talking about China and you are talking about how that is a tactical play for you at this point in time. What is your own sense about what really is going down in the economy and try and link that to corporate earnings and profitability as far as companies are concerned because there is so much sort of newsprint around how bad things really are in China, is it going to slowdown even considerably from the current levels, what is your own take on what is going on in China at this point in time?
A: There are lot of areas we can explore. I will focus on some of the more nearer term ones. We have seen the availability of credit improve since the middle of the year. What the market has been frustrated with is the credit availability, the liquidity has got better but the economic activity has still been very weak. This has impacted commodity prices globally. What we are seeing more recently is that the activity levels have picked up. So, we look about the housing sector, look at land sales, we look at auto sales. So, all these lead indicators actually have started to turn up having been very weak for the last 6-9 months. So, the question for us is, we have seen this pickup in activity but what is the duration and what is the strength of it? Cycles in China tend to be 3-6 months but we think we are right now at the beginning of an uptick in the cycle but there is an element of being data dependant on it.
Second in terms of companies there is an old economy and there is a new economy. So, there are parts of China which are suffering from excess capacity and lack of pricing power. So, it is critical, you stay away from these companies because they are really struggling, there are few winners in that but you have got to be very selective and you have got the newer parts of the economy which are actually delivering still reasonable levels of growth, reasonable earnings and the valuations are interesting because in general most people are underweight or under allocated to China. So, we think this presents quite an interesting opportunity.
Q: Speaking of opportunities and red flags of course we don’t know what Fed will finally decide to do or not do in December but if there is a hike in December what is it going to mean especially for markets like India?
A: We have been talking about Fed hikes for a long time. My message here is we think, a few in terms of myself these rate hikes are priced in. So when we look in terms of four emerging markets so what do we look at? We look at the level of bond yields in emerging markets and there were not priced in or Fed hike was not priced 18 months ago. However, after this taper tantrum bond yields in emerging markets, India was obviously a victim of that at that time increased quite considerably. So, we have been leaving almost in a non quantitative easing (QE) world for the last 18 months waiting for these Fed hikes to actually come through. So, we think that small rate hikes from the Fed are actually well reflected in both fixed income and equity markets within EM. So, the question then is if the Fed hikes is considerably more that can have negative impact on EM. If the hikes are moderate we feel this is well reflected.
Q: Which is the expectation at this point in time, right?
A: We think it has been very well documented. I think that this will not have a relevant impact.
Q: So you don’t expect any sort of, forget the tantrum part but you don’t expect any knee jerk panic moves if there is a hike in December?
A: The market is 70 percent is expecting a hike. So, we think this is reasonably well reflected in markets already.
Q: Let us go back and talk about India Prime Minister Modi is going to be here wooing foreign investors in the UK, meeting with his counter parts here. The appetite for India, the shine about the India story, the new government has it worn-off, is it on the vain already?
A: I think people understand the long-term opportunity in India and they understand what the initiatives that the government has taken and so I think the financial markets gyrate but actually in terms of the wider public opinion and perspective has not changed on India. So, it still represents a phenomenal long-term opportunity.
Q: So what would get you to change your mind about India is it just going to be depended on corporate earnings picking up and then of course linked to valuations?
A: Absolutely, if the markets sold off considerably we would use that opportunity to add and in terms of the fundamentals if we got the conviction that actually corporate earnings are picking up, we would marry the two together and that will certainly lead to us allocating more to India.
Q: What about broader markets in India because we have seen a fair degree of actions especially on the small cap and the midcap side. Does that look compelling from valuation as well as growth point of view to you?
A: So, once again when investing in small caps you need to be careful, you need to be selective and so there are some stocks that have done phenomenally well. We have reduced our exposure because the valuations were not as compelling. When we look back 18 months ago the small caps and midcaps were extremely cheaply valued, broadly ignored by the market so we have gone through that discovery phase.
Lot of stocks have been forgotten about five-six years and these stock have performed well and continue to deliver. So, we still think India is a great market for stock pickers especially within the midcap space. So, there are opportunities but today they are not good as they were 12 months ago.
Q: So how much money is at work in India currently?
A: We have got a fair amount of apple fairly allocated.
Q: What would be the red flags besides of course what happens with the Fed but what would be the other challenges that you would watch out for and would determine your tactical strategy for India?
A: So, something we would be very mindful of and which has been a tailwind for India but can become a headwind again is oil. So, we know that India imports a lot of oil and oil price collapsing to USD 50 has been a huge tailwind. India’s FX reserves have increased, their current account has got better and liquidity is got much stronger.
This can change so the oil markets is correcting, it is adjusting. What we see is there is scope for oil prices to recover. The question is when is this going to be and the quantum. Is it a USD 10 move in oil price, is broadly manageable but if the move were to become greater than that this will actually start to reverse some of the liquidity tailwinds that we have seen so that is one thing.
Q: Do you see a larger uptick as far as the commodity price is concerned because that has been considerably sort of on the decline?
A: We are in the period of stabilisation within energy. It is a liquid, it is a complicated market. Some of the lead indicators that we look for say like capex curtailments of the major exploration and production (E&P) companies. So, they are reducing capex, their demand is very strong globally because oil prices are low people are consuming more. So, this is helping the market come into a balance and Shale production in US is falling these are all helping.
So, this to me suggests that we are going to get improvement in oil prices. Predicting the size of the move is difficult. My central case is it is going to be USD 10-15 when it does happen. However, we have to always entertain the upside risks that it can be more than that so that we aid risk. This is what we need to factor about. Rest would be the global economy.