Three Sectors That Will Be Dark Horses In Near Term

Harish Krishnan: So clearly, we do acknowledge the fact that corporate earnings, from a broader perspective over the course of the last three years, have kind of moved up meaningfully as far as India is concerned. We also acknowledge the fact that there has been a significant amount of liquidity that's been chasing Indian equities.

Having said that, and the fact that the corporate health of India Inc. is in the best of shape, I think that, you know, we're taking cognisance of the fact that valuations are quite heavy. There has been a significant expansion of multiples, especially as we go down the curve.

So, when we look at, say, from pre-Covid levels till now, over the course of the last three and our four years, and we see how much of the market-cap expansion in various blocks of market cap, be it large cap, the top 100 names, 101 to 250, which is the mid-cap, small cap and micro caps. What we see is that broadly, as far as large caps are concerned, the top 100 names, almost the entire market cap Delta, can be explained by just earnings. In fact, earnings have gone up even more than what the market caps have gone up in aggregate. So, there's been some amount of derating out there.

But when we look at mid-caps, it's been roughly about 66% of the market cap Delta has come through by earnings. The balance has come in by valuation expansion. When it comes to small caps, it's at 50-50, and when it comes to micro caps, which is 501 and below, almost all valuations account for 67% of the increase in market cap expansion.

So, therefore, we do think that, you know, it takes a lot more time to be a lot more measured at this point of time. Risk has got rewarded disproportionately over the course of the last 12–18 months, and one should be a lot more sanguine about the prospects of equities going ahead, even as you know, one remains positive from a three, five-year perspective.

Harish Krishnan: What we do recommend is to have an asset-allocation perspective for now, of course, it may appear that, you know, equities, and especially lower down the curve, be it SMEs or small caps and micro caps, can hold a lot of sway and promise, but I think you know, three, five years or 10 years down the line, possibly it may not be as optimistic as what things are being made out over the course of the last two, three years. So don't extrapolate the last two-three-four-year cycle into the future.

Third, we do advise that you know, whatever be your risk appetite, and it's, of course, personal to each and every individual. But if you are primarily in small caps, go down one risk notch lower. So, if you are in small cap, be it in mid-caps. If you are primarily getting to mid-caps as a risk profile, move into large and mid-caps. If you are into large and mid caps, move to flexi cap. So, move down at least one notch, so that you know you're not completely out of equities because clearly, the medium and the long-term story, as far as Indian equities is concerned, is still very encouraging.

The balance sheets of corporate India are still very good. The banking system is in good shape. The macros are in good shape. So don't miss out by saying in cash and waiting for the inevitable crash to come through but go down one level of risk and follow prudence of asset allocation at this point of time, rather than, you know, going fully into, you know, SMEs and small caps and micro caps at this point of time.

Harish Krishnan: I mean, to be quite honest, it's not a space that we professional investors actually participate in. So, we are as much as ringside watchers of the phenomenon that you are describing. But you know, we did this analysis roughly. You know, the markets can move in a random walk, as they say on a daily basis, it can go up, it can go down, but there is an equal probability of going up or down on a daily basis.

What we've seen in the last 15-18 months when it comes to SMEs is that markets are going up on the index level. I'm not even talking about individual companies out there. Index levels are moving up 70% of the days, which is a significantly higher number of days that, you know, those indices, especially this in the SME side, have started moving up.

So again, these are great times for those investors. But, you know, one can't be basically predicating only on the fact that you are going to have more liquidity chasing these names, and you will be able to find a buyer for your name. So at least you know, it's purely as an observer that we are kind of making this observation. We don't evaluate any of these companies ourselves as provisional investors.

Harish Krishnan: It also we've been underweight the space about a year and a half back, primarily you predicated on the fact that you had the best of everything going in for the banking system. You had very strong credit growth. You had NIMS, the net interest margins, which expanded quite significantly. You have very low credit costs, so much so that, you know, profit pools of just a scheduled commercial banking system had reached a 25-year high as a percentage of GDP, at 1% of GDP.

From then, you know, as we look over the course of the last 18 months, where banks have underperformed quite meaningfully, we see each of these three pegs normalising. So, credit growth, which was growing quite strong due to regulatory nudges of wanting to, you know, align it with deposit growth has kind of come off.

Secondly, if we look at net interest margins, they have started coming off from the significant highs that they were there, and you started seeing some amount of normalcy when it comes to credit growth. Now, at the face of it, all of these are negative developments from an earnings perspective. So we do think that there is likely to be a softness in earnings, but the space has got de-rated significantly. What used to be some of the best-run private sector banks, which were trading at anywhere between, say, 17 and 18 times, price to earnings forward, have come down to as low as 12-13 times.

To our mind, therefore, a lot of de-rating has happened because these profit pools were unsustainably high. As the profit pools kind of normalise, is where we think that there is going to be a re-rating back into these phases. So that's the approach that we have when it comes to the banking space. You know, the best of the times, ironically, are not the best of times for stock prices to move up, and the best of the times is now behind us.

In fact, we are starting to see that, you know, profit growth is starting to trail off in many of the private sector bank franchises, which, to our mind, ironically, is very good news, because we think that now profit pool levels are normalising to more sustainable levels, which is what a multiple category went on. So we view the fall in earnings or the slowdown in earnings, as a welcome development, than looking at very high earnings and then one thing, while stock prices were not reflecting that kind of earnings growth. So that's what I'll probably view when it comes to the banking space in totality. 

Harish Krishnan: So, I think it's a lot more nuanced out there. There are certain pockets where, you know, valuations have clearly gone up significantly. So from a fundamental perspective, you know, if you look at it, there are certain pockets which are monopoly stocks, no doubt, where the near term outlook is really good. But if they're trading at, say, 15-17, times price to book, you know, these are very, very heavy valuations. Just as a context, the intra-cycle peaked at about seven eight times in 2007-8, so we are well past those levels when it comes to pockets like defence.

But on the other hand, if you look at, say, energy and utilities, or oil and gas or oil and marketing companies, their valuations are a lot more sanguine. We really haven't performed, no doubt, but we haven't seen those kind of parabolic moves in a lot of those pages. So, I think it is not to say that, you know, the trade is completely over and out. But yes, we do prefer the private sector franchises wherever we can, over many of the public sector franchises, but I wouldn't say that. You know, the entire pack is primed for a massive kind of a correction. We do still think that there are pockets within the PSU space that are very attractive and which we continue to own in our various funds.  

Harish Krishnan: That's right. So I think all our investors, we are saying the same thing, which is to elongate your investment horizons, don't extrapolate the past returns. The good thing about the PSU fund is that there is some amount of dividend flow that comes through which is still quite large, compared to many other spaces which are there in the non-PSU space.

But one should definitely be prepared for an underwhelming kind of an outlook when it comes to the next six or 18 months, and not extrapolate what the investors have seen over the course of the last one, two years. So, as long as people are prepared for that, I still think that you know, this is a space that can give you decent returns over the course of the next three, five years. But, I mean, is it a place where you can put in a massive lump sum at this point of time? Possibly not.

One should be a lot more disciplined, like I said, this is the time to take down the risk, rather than embrace risk head along across all our equity products.  

Harish Krishnan: So firstly, I think we have sole exposure in Tech. We have an overweight stance on Tech, in fact, in many of our schemes. So yes, we are. We do have a larger preference to the larger tech-oriented names, as you said, the legacy names compared to mid-tier names, and mid-tier has clearly done quite well. So, we do have some ownership there, but our preference is more to the larger names.

Our view on this AI disruption is it's more an opportunity than a threat. As far as Indian IT services are concerned, I think Indian IT services have seen an impact of two-fold. First is from pre-Covid till now. You know, we have basically seen a greater offshoring that has happened, as far as Indian IT is concerned. Now, as more and more offshoring happen, the revenues do get deflated as a resource out in India can do a lot more than a resource based on site.

Typically, higher offshoring would entail higher margins and therefore, it is a win, win for both the IT client as well as IT service provider. Unfortunately, for Indian IT, over the course of the last two, three years, given the fact that they hadn't hired pretty much the workforce before Covid, they saw a squeeze with the demand coming through, and therefore, they saw massive hiring that had happened in '21 and '22, which led to a squeezed margin.

So, we've actually seen both revenues trailing off, as well as margins kind of impacting. We do think that Indian IT companies will get that margin piece back into shape over the course of the next two, three years. These are some very well-run companies who know how to parameterise their workforce and to get the unit economics and space in place and as and when the recessionary environment in the developed world, especially the US, comes to pass and you know, we are on the other side of it.

We do think that there is going to be a greater spend on Indian IT. So, I think Indian IT is therefore a very good space to be in. Yes, when it comes to the allocation between large caps, we have a greater preference to large cap privately, because valuations are a lot more sanguine out there, but we do also own some very exciting mid and small cap names across many of our other funds. 

Harish Krishnan: So, I think, you know, at this point of time, there are two specific Thematic funds that we do advocate for our investors to evaluate. One is the consumption-oriented Fund, which we call the Gen X Fund, which has been there for close to about 20-odd years, which has seen multiple cycles. Consumption is a reasonably evergreen story in India, given our young population is increasing for that time because, yes, it has hit some kind of an air pocket in the last 2-3-4 years, as the government has focused on supply-side stimulation, far more significantly compared to demand-side boost.

But you know, while that can continue for under six months or a year or two years as well, we do think that, you know, the reasonable underperformance that the space has seen provides us a greater opportunity at this point of time. So we do think that investors can benefit by participating in this kind of thematic.

The other theme that we are advocating, which has reasonable margin of safety, is the Digital India Fund, which has a larger weight on IT services, as well as the Indian IT, or the Indian tech landscape, which is seeing a lot of new listings, a lot of new startups coming through multiple ecosystems developing out here as well.

So, I think these are the two spaces that we would be advocating at this point of time, from a thematic basket that we manage, a whole range of themes, which are there, which we think that investors should definitely evaluate. 

Harish Krishnan: I mean, we're not astrologers, so I really don't know.

Harish Krishnan: I say that, you know, the goal for investors needs to be at least five years out. 

Harish Krishan: I would say at least over the course of the next 12–18 months should be a reasonable time horizon for people to stagger their investments. 

Say tax-efficient products, including arbitrage funds, fixed-income instruments. So you need not necessarily be in cash at all. You know there are solutions provided by the mutual fund industry, including Aditya Birla SunLife, which help you operate that issue.

So, but I would say that, you know, it's not really a call on cash, it's more a call on anticipating volatility and turbulence ahead so that you can benefit from that by staggering your investments.

Harish Krishnan: We do think so. I mean, we think that there's a great amount of safety. We don't see too much of a dispersion coming in from large, mid and small and even if you look at this calendar year till date, you know most of the funds that we are managing are in a reasonably tight range.

So, the point being that, you know, one is not going to see a disproportionate high return coming from micro-cap, small cap, mid-cap, compared to flexi cap or large cap and, therefore, from a risk register basis, we do think that it makes more sense to me, tilted towards large caps.

Harish Krishnan: So, we've got three sectors which are dark horses. So, I mean, over a three-year period, I would say cement seems to be a very interesting juncture, which hasn't really played out over the course of the last two, three years. That will be one.

Consumer durables is an area where we start our neck out at the start of the year. We still think that there is a significant stream out there. The last one, I would say, is metals, which is an area where, today, there is a lot of doom and gloom from China's perspective, but Indian companies have delivered their balance sheet significantly.

So, these are the three pockets which I would say, you know, pretty much nobody is really talking about, in our opinion, and which can therefore bring a surprise over the course of the next three years. 

Harish Krishnan: I think defence would be that.