‘We are Clearly a Couple of Years Away from Peak Equity Valuations’
S Naren, executive director at ICICI Prudential AMC, believes that asset allocation is very important as shares race to record highs almost every day. The lights are not flashing red yet, he says using a traffic light analogy. But they are not green either. They are yellow, which means investors need to look on all sides and invest carefully. In a wide-ranging interview with Prashant Mahesh, Naren says peak equity valuations will come in the next few years and worries that a rapid rise in earnings growth could make valuations lose touch with reality. Edited excerpts:
The market has been moving up almost one way from Feb 2016, with the Nifty moving from 7,000 to 10,000. Is the rally overdone? Actually, we try to look at the market on four parameters, namely valuation, cycle, sentiment and triggers. Today, on valuation basis, we are in a situation where on a price-to-earnings (P/E) basis we are costly; on price-to-book (P/B) we are above average; on market cap to GDP, we are just above average and if you look at interest rates and take the inverse of interest rates and earnings yields it is slightly above the average. So on a valuation basis markets are not cheap but not extremely expensive in our framework.
On the second parameter, namely cycles, we are clearly two years away from the market top. From a cyclical perspective, the market is at a top when capacity utilisation is high, interest rate cycle has turned and there are only chances of rate hikes. On that basis it looks like it will take two years for the capex cycle to come and for capacity utilisation to be higher than where we are.
On the third parameter, namely sentiment, you have to be careful. Foreigners are investing and domestic investors are investing with gusto. So sentiment is the most worrying part. In December and January, FII flows were negative, but now locals and FIIs both are investing and locals are investing with gusto.
Finally, on the last parameter, namely trigger, I believe till earnings come we are safe. The moment earnings come, that is the time when you have to be most worried. Earnings growth is the biggest risk to the market. Bubbles get formed when you have excellent fundamentals with irrational extrapolation. So what worries me most is earnings coming quickly. The day it comes, investors will give high multiples on high earnings and make their biggest mistakes.
Where are you allocating money now? Oil PSUs, power PSUs look very cheap at this point. These are the only few sectors trading at 15x trailing price-to-earnings and with a price-to-book below 1.5. Six months back we were bullish on telecom, but they got re-rated. Some of the corporate banks are in the process of re-rating. We have had four years of money coming in, so there is no cheap bargain. We are not in a phase of risk aversion.
You are in the fourth year of continuous money inflow, so pockets of deep value do not exist. Three sectors have not moved up namely IT, pharma and PSU banks. Each of these areas has its own fundamental issues in the short term. In case of IT, it is growth; in pharma, it is the US FDA issues; and in PSU banks, it is the NPL problems. The one which we like most is pharma, because pharma as percentage of GDP goes up as a country prospers, and we also feel the FDA issues will be resolved over the next two years. However, pharma was very cheap in 2007, but not very cheap now compared to that time.
SBI cut savings rates on Monday. Many of the smaller PSU banks have been hit by NPAs. Can the smaller PSU banks survive? Indian banks are an unconsolidated industry with a fair amount of competition from NBFCs. Challenge exists for all the smaller PSU banks. Since they are sovereign, it is easier to collect money. Its only on lending they have to do a good job. They have to create a good business model and able to become more local and focus on SMEs as an area and handle them well, it could be a good area. The moment the government supports them and gets them out of this problem of NPLs, there is scope for banks.
Retail investors are pouring money into equities. ₹ 4,850 crore is flowing into equities through SIPs every month. What has changed? Can the flow intensify further? Corporate profit as a percentage of GDP has come down from 7.1% to 2.9%. We believe this 2.9% will go to 4%, which means a 30% growth. There will be a cyclical rebound in earnings. You have high ROE, high PE stocks now in Nifty. Today equity is in a TINA (there is no alternative) factor. In India, investors have a feeling that anything that gives less than 8% is low. Hence you have reached a TINA situation, driving money into equities.
SIPs can go even higher, but it is important for us to communicate to investors, that past returns were high and this may not be replicated in the future.