‘Valuations are below long-term average'



When we last spoke to him in July 2010, Vetri Subramaniam, Head, Equity Funds, Religare Mutual Fund, took the unconventional stance that stock valuations had already run up too much and that mid-cap stocks were unlikely to outperform. Now that both these calls have proved correct, we caught up with him for an update on the markets and how the Religare funds are navigating them.

Excerpts from an interview:

In July, you took the view that market valuations had captured much of the upside and that there was a risk of earnings downgrades to Indian companies. Have those downgrades happened?

I think the risks to earnings of Indian companies have gone up in recent months, with high inflation and fears of further monetary tightening to curb that inflation. I don't yet see that fully reflecting in the consensus earnings estimates.

Rising commodity prices for instance, have really increased input costs for companies across-the-board. You are already seeing signs of margin pressures in the earnings of the past quarter.

Smaller and mid-sized companies and companies operating in highly competitive segments may find it difficult to pass on those increases to their consumers.

There is also the risk of an increase in interest rates. Indian companies, especially small and mid-sized ones have always been quite sensitive to higher interest costs.

The way I see it is that the change in the global scenario calls for an upgrade in the earnings estimates for the commodity companies in the index basket and a downgrade in the estimates for the users of those materials.

However, as cyclicals typically enjoy lower valuations than other sectors, the overall PE multiple of the market has trended down.

Is this correction then a good opportunity to invest, for people with a five year view?

Yes, I think so. Valuations currently are below their long term average. The Sensex is now trading at 14.3 times one year forward consensus earnings. Assuming that the consensus estimates will be cut, which we believe is likely; earnings are still likely to grow at about 15 per cent in FY12 versus consensus estimates of 19 per cent growth.

Based on this reduced estimate the market is at about 15 times one-year forward earnings which compares well to the 15-year average PE multiple of 14.5 times. From this level of valuations, investors can benefit not just from the growth in corporate earnings but also an expansion in PE multiples at some point in the future.

How will rising oil prices play out for listed Indian stocks, if sustained? Are you altering your sector weights owing to this development?

The rise in oil prices is more negative for the Indian fiscal deficit than it is for Indian corporate earnings due to the lack of pass-through. But the public sector oil marketing companies will likely do poorly even though the government will provide them with compensation.

The cost structure of the airline companies would also be negatively impacted. The pass-through of the hike to petrol and diesel prices would be incrementally negative for the auto sector. We have made slight adjustments in our sector positioning based on these views.

Religare Contra Fund has a good three year record, but has underperformed the markets in 2010. What explains the slowdown in performance?

Religare Contra is typically the kind of fund that has a “value” approach to stock selection.

After the correction in 2008, the broader markets were trading at very attractive levels, with a large number of stocks available at throwaway prices.

The initial part of any up move, after a big correction is usually led by value stocks and Religare Contra capitalised on that. However, as the rally continues, growth stocks begin to outperform, and that is when the environment becomes more challenging for value stock pickers.

Even recently, though, you will find that this fund has contained downside quite well whenever the market corrected. That will continue to be its key advantage as we head into more volatile market conditions.

The top sector choices in many of your funds include technology and financials. Can you explain why?

If you look at our sector weights relative to the benchmark, you may find us a little underweight on financials. On technology stocks, yes we would be somewhat overweight, basically on account of the improving global environment which suggests good volumes and pricing for IT companies. In some of our funds, materials have a significant overweight position as well.

The call there is that if the global environment continues to improve, metal prices would continue to rise. With many metal companies seeing huge volumes coming onstream, volumes would remain quite strong too.

What is the outlook for Religare PSU Equity Fund?

PSUs did do well for a period, but premium valuations were not the norm. Only a few PSU stocks with very low liquidity enjoyed premium valuations. At this point of time, PSUs are vulnerable to a further fall because they are dominated by rate-sensitives and oil marketing companies. However, from a valuation and growth perspective, the PSU is one portfolio we think is quite attractive.

The growth expectations for the PSU basket too are quite resilient compared to the rest of the market. PSU stocks also enjoy advantages of low leverage and fairly strong cash coffers, except for the oil companies where the subsidy related issues really reduce visibility.

Which fund would you buy from your bouquet of funds in today's market environment?

The Religare Business Leaders Fund is very well positioned because it has the kind of companies that can survive these challenges. Large companies which don't have debt issues and have a lot of pricing power. They may not suffer margin damage that smaller companies do when input costs rise.

The other fund which we would recommend at all times is the Religare Growth Fund, given its balance between large cap and mid cap companies.

If the markets were to go down sharply from here, the Religare Contra portfolio too will get much stronger. It's a good fund to contain downside.

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