Expect moderate returns from here on; no scope for expansion of market valuations: Vetri Subramaniam

“Some of the areas which have underperformed in recent times – financials, autos, pharmaceuticals – have the benefit of strong structural growth prospects but they have been going through fairly muted near term trends. That has now reflected adequately in the valuations and therefore makes these sectors attractive for value investors,” says Vetri Subramaniam, CIO, UTI AMC.

January has been quite pleasant so far but then we are in the thick of earnings and the Budget is just a few days ahead. How do you expect the market texture to be going forward?
We do not really think too specifically in terms of what the market might do immediately or not. From my point of view, the sort of message that I would want to share is that essentially we have had a nice rally over the last 18-20 months, valuations have moved up to fairly rich and expensive territory. The medium term growth outlook for India corporate earnings is looking fairly robust and solid; but really there is no scope now at an aggregate market level for valuations to expand. If anything, at some point, one has to expect valuation normalisation. One needs to have more modest expectations from the market at this point of time.

What pockets are looking richly valued to you or is it an overall market call that you have?
There are actually two parts to that. One is that historically seen, the aggregate market valuation is certainly expensive – whether one looks at the Nifty500 or separately break it down into Nifty 100 which are the largecaps. The Nifty150, which is the midcap index and then finally the Nifty Smallcap 250. Each of these segments is actually trading at quite rich valuations.

Secondly, another way of looking at whether the asset class is particularly attractive is to compare it to an alternate asset class which could be bonds. When we look at the forward earnings yield that we are getting in equities and compare that to what we are getting on the 10-year bond, there is a historical relationship between these two. Right now, we are trading at a point quite far away from the historical figures, again making the case for equities slightly weak. So, at an aggregate level, there is an issue in terms of valuation.

You asked about pockets that might look attractive; they are always there. Some of the areas which have underperformed in recent times – financials, autos, pharmaceuticals – have the benefit of strong structural growth prospects but they have been going through fairly muted near term trends. That has now reflected adequately in the valuations and therefore makes these sectors attractive for value investors.

Should we compare historical benchmarks and historical valuations with future valuations because while valuations may look elevated, that is a forward looking data point we are comparing them with after seven or eight years of depressed earnings?
You are not necessarily comparing the last seven years’ earnings. We are comparing forward earnings and so we are already recognising what the companies are likely to earn in FY23. I am not sure about how you want to completely distance yourself from earnings. I think you have been in the market far too long; eventually everything is related to the earnings capacities of companies and when one pays a very rich price, one is essentially presuming that nothing can go wrong in the next three, five, 10 years. To my mind, that is the risk.

Just like we never knew the events that would happen in 2020 or going back before that, it need not be as dramatic as that either. it could just be a few years where stock prices sort of cool off, stop responding to earnings progression. So we do not know exactly how it will play out but essentially it is all connected to earnings trajectory and one cannot disconnect it from earnings.

People keep making the point that the cost of capital is very low. Sure that can be incorporated but one reason why the cost of capital is low is that the inflation expectations that are being built into the cash flow assumptions one is making for the company are equally lower. Secondly, the threat of competition when the cost of capital is low is also much higher. This is really a balancing equation. One cannot just ignore earnings at any point of time. Those who do that are asking for grievous trouble at some point.

The biggest debate which is perhaps the most common debate is that the Fed will increase rates and how that will impact liquidity and valuations. This is the most anticipated event of this year. What is your understanding of the market’s preparedness?
You have put the context very well there. It was reasonably well anticipated. In November-December, when the Fed suddenly made the pivot, a little bit of tremor went through the markets. But it is important to recognise the context and many of us remember the context of the last time the Fed made a pivot, which was all the way back in 2013.

In 2013, the current account deficit was running at closer to 5%, the trade deficit was running at 10%, reserves were quite weak and we had high inflation. Today thankfully we are not in a similar situation. We have got forex reserves of $650 billion, which is very comfortable in terms of the months of import cover that we have. FDI flows have been very strong, the current account deficit is tracking at about 2% for the year ended March 2022. From all those points of view, India’s situation today is very different from where it was in 2013. Therefore, I do not expect such a destabilisation of markets as happened in 2013 because the context and data points for India are very different this time.

Given that we are so different from where we were in the last financial crisis, from the last time the central banks around the world started winding down the quantitative easing programme, can this outperformance really continue?
I am not so focussed on whether we outperform the rest of the world or not. We will continue to do well and generate reasonable returns but what do you put in the context when you say how good the time will be? Look at the data for the last 30 years; there has never been a year in which the peak to trough drawdown during a year, not necessarily the full year, has been on an average about 12-15%. So drawdowns are part and parcel of the market mechanism for correcting excess valuations. I would be very surprised if that were to be outlawed.

When we talk about the Indian market having delivered a 15% CAGR over 30-40 years and maybe about 11-12% CAGR over the last 10-15 years, that happened despite the falls that have happened during this period. We do not outlaw volatility or drawdowns in the stock market. As I keep saying, drawdowns are a feature of the equity market, they are not a bug in the system. If we are thinking about this in terms of the fact that the market will be up every day, every week, every month, every year, we are barking up the wrong tree.

My message to people would be that it is very normal for the market to experience setbacks. When things look great, when they are reflected in the valuations, that is when the unexpected can cause equity prices to get a setback or go through a period where the earnings come through but the valuations start to mean reverse. So it does not necessarily mean that we will see something cataclysmic but falls happen on a regular basis. There is nothing unusual about that in the equity markets, look at the history of the last 40 years.

Financials are top of the charts with almost 29% in your portfolio. We are all waiting for financials to perk up. Would you rebalance your portfolio where you have financials, IT seems to be overstretched and maybe increase in materials and industrials given the pickup in activity?
Look, materials is a very big basket because it includes everything from global commodities to chemicals to paints and those kinds of things. It is a very wide basket. As far as global commodities are concerned, the best part of the rally from very cheap valuations and trough levels of prices is now behind us. That is not to say that metal prices will necessarily collapse at some point to the lows that we saw in early 2020; but the peak is behind us and therefore they are now trading more at sort of reasonable mid cycle valuations.

We do not see any reason to expect a significant runaway movement over there. So till the valuation equation gets more favourable, metal stocks are not something we would be excited about. You also mentioned financials. Yes, that is an area which we tend to feel quite positive about. The reason is very simple, India’s credit to GDP ratio is still about 56-57%. Forget the developed world, most emerging markets have higher credit ratios than this. If you are eventually looking at the Indian economy returning to the growth trajectory, then the demand for growth will also be quite strong.

We think there are now a handful of financial institutions which are very well placed to outgrow the market and continue to gain market share. I do not know when the tipping point is, but we have learnt over time that when the valuation is favourable, one can keep queuing up over there and wait patiently. Aapka number bhi aayega (your turn will also come) is what I would say to those who might feel disenchanted with financials being weak. The opportunity is certainly there given the low penetration numbers that we have in loans to GDP.