On a bottom-up basis, in corporate-focu

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sed banks, telecom, pharma and global conglomerates, profitability in 2020 could swing significantly over 2019 as well as 2018, Nilesh Shah, MD, Kotak AMC, tells ET Now.Edited excerpts: Why do you think Indian markets are underperforming? Is there serious merit in buying stocks because stock prices are pricing in an awful scenario? People are worried about election, debt and think all Indian promoters will go belly up. We are underperforming the global market for last two months. In year-to-date performance, India is the odd man out with negative performance whereas most other countries have given positive performance. But if we look at a five-year basis, India is a standout performer. I did some analysis where Indian markets were outperforming Chinese market by almost 50% in US dollar terms over five-year period towards end of 2018. With some performance in China, 50% would have become 40% but if you are outperforming Chinese market by 10% in US dollar terms for every year, that is a significant outperformance. If you outperform so much, then there is a reasonably good chance that at some point of time other people will play catch up. The Chinese economy is 4.5 times bigger than us; their market cap is barely 2.5 times bigger than us. So, obviously people would like to take their profit out of India and allocate into other emerging markets. That is one side of explanation. The other side of explanation is in relation to election uncertainty. As there are elections approaching over next three months, people want to be cautious. They want to keep their money on the sidelines and they will take investment view probably as the market starts pricing in election results or post election. The third thing which is happening in the market is that the flows have become shallow. Domestic mutual funds have witnessed slowdown in flows. FII flows are marginally positive but combination of institutional flows have turned a little bit shallow and all these things put together is creating its impact on the market. As an investor, what do you do? If you are sitting on some amount of cash and have kept the power dry for some clarity on elections, do you jump in to invest post elections or do you start nibbling in right away? We do not take cash call. My job is to outperform the benchmark index. Our fund mandate is not to generate absolute return. Taking cash call is double-edged sword. It can work very well in a falling market. It can hurt quite badly in a rising one. So we do not take cash call. We remain fully invested at all possible times. We know there is an event risk coming ahead and that is the election. The history tells us that elections matter on the result day but over a period of time, over the tenure of the new government, it is the work done by the government which matters. While we do keep a watch on election, our better analysis will be focussed towards what work has been done by the government in last five years and what will be done in the next five years. Markets have started pricing in electoral risk. Many small and midcap companies are available at a significant discount to their historical averages. Even in largecaps, there is wide polarisation. 9-10 companies are trading above their historical average. Many companies are trading below or around their historical average. As a fund manager, our job is to keep on meeting managements and understanding how their businesses are running and also to find out what is available at a reasonable valuation. But if fresh money has to be deployed, where does it go? As of today, we are playing on a couple of trends. One more talked-about trend is the financialisation of savings. There is a little bit of slowdown in mutual fund flows but if I look at over a period of time, flows have been fantastic. Increasing financial savings will benefit banks, NBFCs, mutual funds, insurance companies and microfinance institutions. Within this, we have to pick up right banks because there are some retail-focussed banks which are trading at one valuation. There are corporate-focussed banks which are coming out of NPA cycle. There are some NBFCs which are facing tremendous issues related to their growth expectations. There are some NBFCs, whose liability franchises are enabling them to continue their growth path. You have to then create a bottom-up portfolio out of this broad trend of financialisation of savings. The second trend which we are trying to capture is imminent improvement in investment. Over the last couple of years, tight liquidity, high real interest rates, lower capacity utilisation and debt-ridden balance sheets came together, leading to subdued private investment. The capacity utilisations have started hovering around 75-76%. Interest rates are on the way down. Liquidity, hopefully will improve, and many companies have repaired their balance sheet. They will be looking from an investment point of view. Combination of this creates revival of capital goods sector. Within this capital goods sector, the number of participating companies, have come down vis-à-vis 2008. Now companies will be able to demand their margin because their capacities will be limited and a combination of this can create better days for the capital goods sector. Again on a bottom-up basis, you have to pick up which sectors will do well. For example, in power, there is little hope right now of new investment but in sectors like refining petrochemicals, steel and cement, there could be better expansion. Again on a bottom-up basis, you have to pick up the portfolios. The third trend which is a little longer-term trend and which we believe will continue, is construction. There is a huge demand for construction activity, led by government as well as private spending. Clearly, with RERA’s introduction, the real estate sector will start bottoming out. It will invite or will attract serious players. It will attract foreign capital and we will see a reasonable amount of longer term bullishness in construct in India trend. The way to play this again is not via real estate sector per se because of governance issue, but maybe it is worth playing via cement, via building materials and other ancillary sectors. These are some of the trends which we are trying to capture over a longer period of time but more importantly. it is the bottom-up analysis which is telling you which stock to invest into.N Chandra has been at the helm of Tata Group over last two years and the kind of interventions that he has made with Indian Hotels and Tata Steel, really seems to have paid off. Now he is training his guns on Tata Motors. What have you made of the progress that we have seen for N Chandra so far? What would you like to see happening in Tata Motors?I would like to refrain from stock specific comment but while Tata Group provides a particular branding for the group, for us every investment is an individual company. If TCS does well, there is no guarantee that Tata Motors also will do well. So while we do respect the Tata brand, we evaluate all the companies on an individual basis.Over last three years, Nifty gave 50% return, the midcap index gave 38% return and the smallcap index 28% return. So small and midcap stocks are now underperforming the Nifty. The argument against small and midcap stocks a year ago was that small and midcap indices were trading at valuations which were richer than the Nifty and were outperforming the Nifty. Now, is there a case for anyone to start a midcap SIP?Undoubtedly, smallcaps and midcaps are attractively priced vis-à-vis their historical average. They are trading at a marginal discount to historical average. Largecaps are trading at marginal premium to their historical average. More importantly, if the economy starts growing at a faster pace courtesy the overvalued rupee correcting, limited Chinese dumping and higher liquidity. As we have contained the menace of inflation and lower real interest rates, then the small and midcap companies should benefit from the revival at a much faster pace compared to largecaps. Many larger cap companies are exposed to global cycle and there is fear in the global markets that growth in 2019 calendar year and in 2020 calendar year could be subdued. There are many economists who are talking about recession in US towards 2019 end and 2020 beginning. We really do not know what will happen over there but if global growth is slowing down, that is going to have more impact on largecaps compared to mid and smallcaps. If Indian growth is reviving, it is going to be more beneficial to small and midcap compared to largecaps on a portfolio basis. Hence keeping in mind the growth potential and the valuation differential, one can start allocating towards small and midcaps. The only caveat is that there is an event risk of election and in case the market gets a shock in terms of the new government, then small and midcaps will be impacted far more than largecaps.Every year. we start with an assumption that this year will be better. By the time we wrap the year, we say this year was bad, next year will be better. We started 2019 by thumping tables, saying it will be a good year, but two months into this year and everybody is trying to find an island of growth!Your point is absolutely valid. Over the last 10 years. between 2008 to 2018, Nifty earnings growth has been just about 5%. There is no debate about what you stated. Let me give the counter picture. In 2003, corporate profit as a percentage of GDP was roughly about 3.5%. It went up to 5.5% as we went on a credit spree. Money was available easily, foreign investment was coming in. We pursued the path of fiscal prudence from 2004 to 2008 and all that combination resulted into profit growth speeding up quite dramatically. It reached at a peak of 5.5% of GDP. Today, corporate profit is back at 3.5% of GDP. So, somewhere we have completed a full cycle. There has been a sharp drop in profit as a percentage of GDP and which is why Nifty earnings have compounded 5% between 2008 to 2018. Where has this drop come from? If you look at the EBITDA margin for corporate India, at 18.9% for FY18, it is above average but the PAT margin is below average. Between EBITDA and PAT, there are three things; depreciation, interest and tax. Tax rates have come down and so tax could not have impacted this drop. Depreciation is unlikely to have gone up substantially because very few investments have happened in the last few years. Effectively, it is the burden of interest which has pushed corporate profitability down and that is reflected in high real interest rates. We sustain that high real interest rate and tight liquidity to bring down inflation from double digit to single digit. Now that inflation is well below RBI’s comfort zone, we might see real interest rates getting realigned and liquidity improving. If that happens, then corporate profitability will start improving. In a certain fashion, we are where we were in 2004, rates are coming down, liquidity is going up, rupee is stable. If the government pursues the path of fiscal prudence which this budget has indicated, then there is a reasonably good chance for corporate profitability to jump from 3.5% of GDP. It it may not go to 5.5% but certainly it can go towards 4.5%. The third argument is, again on a bottom up basis, the three corporate-focussed banks, two private and one public will swing into profitability on a massive basis in 2020 compared to consolidated losses in 2018. We also see some of the pharma companies delivering better results in 2019 as well as in 2020 over 2018. There is a brutal war going on in the telecom sector which has depressed profitability of all the telecom players. Our expectation is that at some point of time in future, that pricing will end. There will be some uptick in pricing and that will result into a swing in profitability. You yourself talked about two global conglomerates from Tata Group which are trying to improve their performance and contain the losses. On a bottom-up basis there is hope from corporate focussed banks, from the telecom sector, from the pharma sector and from global conglomerates that profitability in 2020 could swing significantly over 2019 as well as 2018.