Large Caps Are Reasonably Valued, Not Expensive, Says Franklin Templeton's Ajay Argal

Ajay Argal: As you highlighted the market valuations are definitely not cheap, but at the same time, there are pockets where they are not too expensive. So if you kind of just segregate even at the market-cap level, there is a clear indication that the large caps are kind of reasonably valued. They are not on the expensive side, but if you look at the mid caps, then the valuations are definitely on the higher side.

The Nifty index, if you look there, is trading at around 21 times one-year forward earnings, which is around five or 10-year averages and median. So it's kind of, in the reasonable range. But whereas, if you look at the Nifty mid-cap index, it is kind of trading at around 27 times one-year forward earnings and which is also kind of a 30-35% premium to the Nifty index. We have seen in the past that typically those are the limits, at which the mid-cap index trades.

So mid caps on a relative basis to the large caps are on the expensive side. Can they be more expensive? Yes they can be, like they were just immediately after post-Covid, though it was a bit different then because the earnings were much more depressed. So, on a normalised earnings, this kind of premium for the mid cap definitely is on the higher side. So that's why we see that the pockets of opportunity which we are getting, when we do our bottom-up stock-picking, it's much more in the larger caps compared to the mid caps.

And just as an aside, even the small caps there are trading at a premium to the Nifty index, which is again close to the peak, which they have traded in the past.

Coming back to your question—what do we do in this kind of market? Our objective has always been to get the better stocks within the portfolio because, as portfolio managers, our main job is to invest the money that the investors have given to us in the market on a fundamental basis. And we, generally don't take too large a cash call—may be 5-6, may be up to 7%, but not beyond that because equity funds are not asset allocation funds. They are the funds to get the best stock ideas into the portfolio.

So we still see pockets where we think that they can do relatively better. And of course, equity is a long-term investing horizon instrument. So you should not be looking at immediate short term—may be six months, one year. So definitely, over the next six months to a year, the investor's return expectations should be toned down.

But from a longer term perspective, all the growth drivers—which India has in terms of demographics, under penetration, young population, and consumption—will keep on increasing as we go forward over the years and decades, those kind of fundamental, long-term growth drivers are there. So it remains a very attractive market, but just a bit of caution for the short term.

Ajay Argal: We are seeing pockets where the earnings growth is very strong. But you have to balance that with the kind of valuations which are there in those stocks. So obviously, some of the retail stocks, for example, have had very good visibility for the growth. But it's kind of, in our opinion, more than compensated for the valuation. So it's just not growth, which you should look at. You should look at the combination of growth versus valuation. And that is where we try to position ourselves—we generally get into growth at a reasonable price.

So from that perspective, we are finding pockets of opportunity when we combine growth and valuations. We are finding that we are positive on the industrial sector, though our positivity has kind of reduced because the stocks have done phenomenally well. But purely, from the growth visibility perspective, that is a sector where growth visibility is the highest because order books have been strong and execution by most of the companies in the sector has really picked up. So the top line growth and then there is the operating leverage, so that improves the margins. So a lot of the companies within the sector have good growth visibility, especially over the next 6-12 months. The valuations, though they are on the higher side, are not terribly expensive. So we are getting pockets of opportunity there.

The other sector, which has not done so well in the recent past is the banking sector, where growth visibility is reasonable, though there is a bit of toned down expectations in terms of growth as well, because the RBI itself has highlighted that there are certain pockets, especially in personal and unsecured loans where they want a bit of a lower growth. But even then, the growth possibilities look very sanguine—in the 12-13-14% kind of band. There, the advantage is that, the valuations are really reasonable. This is the only sector where the valuations are lower than the last five or even 10-year averages. And the margins are kind of normalising, because we saw very high margins in the last couple of quarters, which was because of the timing mismatch between the asset pricing and the liability pricing. Now that is getting normalised. But despite that, we have reasonable growth.

Another sector where we see good growth opportunities is the real estate. So the real estate cycle has really turned because affordability has improved substantially, especially over the last 10 years or so, when the real estate prices didn't go anywhere. If you go back two years, then the 10-year period before that, the real estate prices actually didn't move at all, whereas the salaries kept on going up. So the affordability has increased. Therefore, there is a pickup in the real estate cycle. The launches, the pre-sales—everything is happening at a very fast pace. So the growth visibility is very strong there as well.

And the other sector where we are positive is pharmaceuticals. And there, it is actually more stock specific. So there are a few stocks where we see that the growth visibility is very high. The growth in the domestic market is anyway quite stable, around the 10% band. But certain companies are having specific strategies with respect to the export market. So there is a company, which is specialising in the specialist pharma space in the U.S. And another company is specialising in complex generics, where the competition is much more limited. So there, in those kinds of companies, we are seeing growth visibility with a reasonable valuation. So these are some other pockets where we see that the growth, especially in the near term, is likely to be very strong.

Ajay Argal: So it is there at the back of the mind but it's not a significant part in the decision-making. We should be and we are focused on what the growth opportunities are, and what the market expectations are, as we can infer from the stock prices. So you can work back from the stock prices and try to figure out the imputed growth that the market is indicating in a particular stock, given the current stock price. So we try to assess that and then we try to see whether those growth expectations are likely to be met in our opinion or not and if you see that they are not likely to be met, then obviously, we become cautious in those kinds of stocks. So on the FIIs itself, there are too many moving parts because it's not only India, it's how the other markets are doing and what other opportunities they get. So it's kind of a call for them on the other opportunities. So that's the reason we don't focus too much on what their behaviour could be.

Ajay Argal: We are invested in the banks in a big way. As I highlighted, that it is one of our sectors where we think that the growth versus valuation combination is the best. So purely, by the very reason that the banking sector weightage is the highest in the market compared to other indices, when you look at the large-cap indices or even the BSE 200, NSE 200, even that kind of diversified indices, or even if you look at the NSE 500 for that matter. So any investor, when he is selling, then perforce the banking sector will be the sector where the selling will be the maximum. So typically, you will find that even on the NSE 500, the banking sector weightage is 30%. In Nifty, it might be a bit more. So, if there is any selection whether it is from foreigners or whether it is from domestic, the large portion will come in the banking sector. So, that is something which one has to be cognizant of, but at the same time, it works in reverse as well. When they are buying, then perforce, you will have to take exposure to that. I mean, those are as far as the technical things are concerned. So, we have all these things in our mind. But as I highlighted, it is not one of the critical decision factors because there are so many moving parts here. And within that, I mean it's not a homogeneous category.

Even if you look at foreigners, there might be foreigners who have been invested in India for a very long and they're sitting on a profit. So they might be booking profits, whereas some others might be new and getting in. So they might have a different thought process and same goes for the DIIs and the individual funds which we manage. In certain funds, we might be balancing the sector positions. In certain funds, we might be kind of having a profit-booking. So it's so many moving parts there. If you try to figure it out from that perspective, it gets very entangled. We don't usually go there.

Ajay Argal: Generally, over the last many months, we have been a bit underweight on the consumption side and especially the consumer staples. So as you highlighted, there is a dichotomy. And the mass market on the rural side, the consumption is more muted, whereas on the premium side and urban the consumption is having a better growth.

So, we still think that going forward, that will be the case and we continue to remain substantially underweight on consumer staples because we have seen that even now, most of the companies are having a lot of difficulty in having volume growth and especially the companies which cater to the mass market or more towards the rural markets. Even when they are kind of cutting prices, the volume growth is not kind of improving, which means that maybe this will continue for may be some more months. So we are not positive at all on the consumer staples and this also needs to be dovetailed with the kind of valuations they have been trading at. So despite quite a big slowdown in the growth, the valuations have not corrected meaningfully. So that kind of makes our underweight position.

If you look at consumer discretionary, we have been positive on the pockets of it. We have been positive on automobiles, which have already done well. So OEMs (original equipment manufacturers) as well as certain auto ancillaries, and then we have some positions in the online food ordering, which is part of the consumer discretionary. So there we see that there is a decent growth, both for the market as well as the market share gain from the other players in food consumption, whether it is from the restaurants or whether it is from some of the other QSRs (quick service restaurants). So we are having substantial positions in those spaces. So there are pockets in the consumption, where we see that growth is better. And in some cases, the company's profitability has improved and they've got on the profitability path, if you look at the online food delivery, which was earlier and making a lot of investments and therefore was not so profitable. So these are some of the pockets where we see opportunities in the consumption space. But generally, in the mass market, we are still kind of cautious.

Ajay Argal: Yes, we are constructive, from the opportunity, from a long-term perspective. But as you have highlighted, these stocks have done phenomenally well, which means that the kind of numbers you're showing shows that the expectations are very high in all these stocks. So basically, the market participants are saying that they are very sanguine about the growth opportunities, not only in the near term, but may be even over a three to five-year period, they will have the kind of growth which they have not seen in the last three or five years. This sector requires a lot of investments and a lot of execution skills. There are many approvals required which sometimes take a bit longer than anticipated.

If you look at the stock prices, in our opinion, a lot of them are kind of priced for perfection. So they can still give you returns in line with growth, if they are able to execute the opportunity which is there and the expectations which are there, on a very clinical basis. Basically, if they execute it perfectly, then they might be able to give you some returns. But we think that might be a difficult task to achieve. So generally, we have participated in quite a few of them. But over the last few months, we have been trying to book some profits, because we think that the markets are really getting very, very optimistic on this side. And one needs to be cautious, especially considering what they've already returned and considering that there might be challenges in growth. They may not be able to achieve the growth to the extent that the market is expecting and that could lead to some correction in these stocks.