Stock returns to trail earnings growth this year and the next: R Janakiraman

Over the next two years, equity returns will be lower than earnings growth, said R Janakiraman, portfolio manager, emerging markets equity - India at Franklin Templeton Mutual Fund, who manages equity assets worth ₹15,000 crore. In an interview, he said the big outperformance in midcaps in the past two years is unlikely to continue. Edited excerpts:

What is your assessment of India's market valuations?
Indian valuations are high compared to other emerging markets. There is a reasonable possibility that you will see some fall in valuations. In the past three years, out of the overall stock market returns, only some part of it came through earnings growth. A large part of it came through PE (Price to Earnings) expansion. In 2022-23, you will see high earnings growth but you will see PE multiples coming down a bit. This year and next year, the returns will be lower than the earnings growth. The big outperformance that you saw in midcaps in the last two years is unlikely to continue.

What should investors watch out for in the near term?
Investors need to be wary of high valuations. While it was at a peak in October 2021, we have seen some correction that has removed some of the excesses. While FPIs have been sellers over the last year, the large levels of outflows have been compensated by domestic inflows, with retail investors putting in a large amount of money through mutual funds. One can always argue that domestic flows are structural, but all of us know that flows are cyclical. If you see weakness in domestic flows and combine that with the fact that valuations are high, that is a clear risk one should be aware of. Another risk one should be aware of is the Fed's unwinding, which could lead to a sharp reduction in global liquidity.

Which are the sectors or themes that you find interesting?
Mid-cap banks look interesting due to sharp earnings growth simply because credit costs will come down These banks made high levels of provisions for NPAs (non-performing assets) in 2021 and 2022. This year should be good for some of the services sectors like hotels and real estate which had a tough time in the pandemic. Real estate seems to be in a reasonably good condition, with the demand numbers gradually increasing. After being in a downcycle for seven years, it is ripe for a revival.

How will mid-cap companies be impacted in a rising interest rate scenario?
Rising inflation and interest rates are big challenges. The consumer is paying more for fuel, which means spending in some areas will come down. It takes time for corporates to pass on raw material costs. For example, if a commodity price goes up by 50% in a quarter, it will take three quarters to pass it. If the situation becomes volatile and the level of uncertainty is high, well-run companies will do better than average companies.

Franklin India Prima Fund, the mid-cap fund you manage has lagged its peers over the past three years. Why is it so?
I follow a more careful approach while picking stocks. So, when there is a very strong bull market, there will be some performance issues. However, bull markets don't last forever and as and when the market goes into the consolidation phase, the portfolio will get an advantage and come back into reckoning. Secondly, some of the bigger positions did not perform and there was a gap in market performance and business performance. In mid- and small-cap financials, the Street believed that banks here have high exposure to the SME segment and due to Covid, stocks fell sharply. Somewhere towards the middle of 2021, these banks started to show better resilience as the damage was far lower than what the market feared. Unfortunately, they are yet to recover fully, with some of the prices still at 50% of the pre-Covid levels, despite business coming back reasonably strongly in the last couple of quarters. Some large positions in auto and consumer discretionary did not perform and we missed out on new themes like outsourced manufacturing.