‘Mid-cap stocks offer considerable value’

In the current environment of gloom, Chirag Setalvad, Senior Fund Manager – Equity, HDFC Mutual Fund, remains optimistic. He thinks that the opportunity lies in the market segment that is currently undervalued and trading at lower price earning multiple.

With revenue growth threatening to go down to lower single digits, is the Indian equity market overvalued at this point?

The Sensex currently trades at a PE of 14x one-year forward earnings and is moderately below its long-term average valuation.

At current levels, the markets seems to be polarised. A 14x PE for the markets is an average of very high PEs for consumer and few other high quality companies and much lower PEs for a large number of other companies.

Thus, there are several opportunities in the latter segment. Also, the current market PE is based on net profit margins that are at cyclical lows in a high interest rate regime.

As the economy improves, albeit at a slow pace, and interest rates fall, it is possible that actual profits would be higher than estimated. Thus, it does not appear that the market is overvalued.

There was an expectation of a revival in the economy and corporate revenue and earnings in the beginning of 2013. But the macro numbers are painting a dire picture. When do you think the economy and the company prospects will revive?

Predicting the timing of a recovery is always difficult and more so now as we are in very uncertain and volatile times.

The good news is that companies are focusing inwards and cutting costs and becoming lean. So when things begin to improve, profitability should increase smartly. Currently high inflation, poor business sentiment and slow policy execution is hampering growth. Inflation also seems to be stabilising.

The external growth picture seems to be improving particularly in the US and Japan. China remains weak which bodes well for lower commodity prices.

Finally, policy makers are also getting more active. Things could begin to improve towards the middle/end of next year.

How long will investors continue to chase growth? Are pharma and FMCG stocks likely to correct anytime soon?

When a particular sector gains momentum, the exuberance can last for much longer than can be rationally expected. Currently, there is a significant premium being paid for these stocks.

While their businesses are better off, they are not immune to the slowdown. In fact recently we have seen some signs of consumer demand weakening.

Valuations are rich and leave little on the table. Thus, while stocks may not correct, medium-term returns are likely to be sub-optimal.

You appear to be bullish on IT stocks (going by your fund portfolios).Why is it so?

We follow a bottom-up approach in creating portfolios and sector allocations are an outcome more than a sector specific call.

A lot of the holdings in IT are in mid-cap stocks, which are attractively valued (at 6-9x PEs) and have good medium-term prospects and hence, I find them attractive investments.

They have good cash flows, strong management and healthy return ratios. Their fortunes are somewhat more dependent on company-specific rather than industry-specific issues.

That is not to say that they operate independent of the industry environment but that, because of their smaller size, they are able to perform at variance to the sector for some time.

Also, sector dynamics with a weak rupee and a recovering US economy are reasonable.

Do you think it is time to act contrarian and try to accumulate fundamentally sound stocks trading at low valuation that can revive with the economy, capital goods and infrastructure for instance?

It is usually very sensible to follow a contrarian approach. It is important to analyse a company’s performance across a cycle rather than at its low point.

This can throw up very good investment ideas as valuations at the low point are usually very attractive. However, one needs to distinguish between well managed companies that are in a bad patch because of the cycle and poorly managed or inherently weak companies.

It is also important to have a long-term perspective and a patient mindset.

What is your view on banking stocks? There are quite a number of banking stocks in the portfolios of funds you manage, including PSU banks such as SBI.

Clearly banking stocks are going through a difficult period. There are significant asset quality issues particularly on the PSU side.

However, I feel that valuations are more than factoring this in. When things get very cheap, there is always a good reason. It is only when the dust settles, that one realises what the opportunity was.

Mid-cap stocks have not really delivered good returns this year? Where do you see value within the mid-cap space?

The mid-cap segment has done poorly as investor attention in uncertain times shifts to larger, more familiar companies.

Thus, neglect in mid-cap stocks is high and as a result they offer considerable value.

We follow a company-specific rather than a sector-specific approach, particularly in the mid-cap area as companies within the same sector can often have very different profiles.

Having said that, banking, IT, capital goods are offering more value at this point in time.

However, even within sectors such as FMCG and pharma, where valuations on the whole are high, there are individual companies that continue to provide good value but not as many.

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