In conversation with Ashutosh Bhargava, Fund Manager and Head Equity Research, Nippon India Mutual Fund

The ongoing war between Russia and Ukraine and the rise in inflation have certainly made the markets jittery. In this context, Ashutosh Bhargava, Fund Manager and Head Equity Research, Nippon India Mutual Fund, points out the safe way ahead for investors

What is your overall assessment of the current equity market scenario?

The current market scenario is a bit confusing. The news flow is overwhelming. On the one hand we are seeing proper opening up of the economy while the domestic demand is strong at an aggregate level. We are likely to see a shift in growth leadership from manufacturing to services going into FY23. At the same time, inflation is a genuine concern both globally as well as locally. So, this is not a usual cyclical environment as the supply side is dominating the demand side and investors are struggling to ascertain where we are standing from a typical cycle standpoint. Despite cost pressure, at an aggregate level, corporate profit to GDP may continue to rise in the next two years.

That’s because sectors like financials, commodities, technology and telecom are least impacted by rising inflation. Therefore, despite many sectors facing the risk of earnings’ downgrades, overall profitability at the headline index level is limited. We acknowledge that while the breadth of earnings’ revision may be on the downside, the current environment of decent growth with elevated cost pressure is where the mix of earnings is changing and investors will see new sectors taking the growth leadership. On the valuations front, rise in interest rates and reduced capital market liquidity is a dampener. To sum it up, the environment of strong earnings’ growth with deteriorating breadth of earnings’ revision along with rising interest rates would mean the returns per se may be much more measured versus what we have seen in the last two years.

What is your outlook on large-cap stocks for 2022? Will they outperform mid-cap stocks?

This debate of small-cap versus large-caps is a bit overrated. Over time, index composition changes. All other things being equal, which kind of portfolio or index should get what kind of multiple is a function of a) extent of cyclical companies, b) leverage of stocks, c) terminal growth risk of the businesses, d) pricing power, and d) quality of corporate governance in the index companies, and so on. In the past, small-caps used to be inferior on most of these counts and therefore deserved lower multiples versus large-caps. However, things are different now and small-caps’ index composition quality has improved over time.

So, maybe some narrowing of valuations discount of small-caps may have some structural underpinnings. That said, there has been massive outperformance of the broader market in the last two years. Small-cap and mid-cap indices are trading at a slight premium to large-caps. Given that the broader market earnings’ revisions are no more positive and valuations are higher for the broader market, the overall risk reward is relatively favourable for large-caps. As such, opportunities are available across the size spectrum and there are many profit pools which are only available in the broader market. It may be prudent to prefer a multi-cap approach with a slight tilt in favour of large-caps.

Which three sectors you would bet on for the long term?

I would bet on the following sectors:

1. Financials: India’s credit to GDP ratio has broadly stagnated for the last 10 years at around 50 per cent. As the economy develops and matures, we will see a rise in credit to GDP and maybe move towards 100 per cent. At this point, the NPA cycle is largely behind, banks and corporates’ balance-sheets are very strong and we are at the bottom of the credit cycle. Further, banks are not only about lending as their profit pools are diverse and allied services like insurance or mutual funds offer tremendous value. Pricing power is returning and valuations versus the rest of the market are undemanding.
2. IT Services: The sector has delivered above estimate earnings over the last 18 months. The management commentary remains extremely buoyant as many expect multiyear demand acceleration. We remain confident on growth as Indian companies are set to gain market-share versus captives and global peers. Within defensive sectors, IT services remain our preferred sector. Valuations have also corrected in the sector despite earnings’ upgrades. During periods of rupee weakness, IT services fall less and thus provide meaningful diversification advantage to investors.
3. Capital Goods: There is a need for capital expansion and capacity creation at a global level. In the near term we will see certain growth in government capex and then private sector capex will follow. Strong national infrastructure pipeline, focus on localisation and coordinated execution of infrastructure projects will propel the government capex. Improved capacity utilisation, strong commodities’ cycle, strong corporate and banks’ balance-sheets and reforms like production-linked incentives would aid corporate capex revival. While the valuations are not very cheap, there are good long-term risk-reward opportunities available in the sector.

Against the backdrop of heightened global geopolitical uncertainty, how should investors deal with rise in volatility?

First of all it’s important to acknowledge that Indian equities as well as the rupee have been remarkably resilient despite unprecedented adverse developments in the last few months. It’s not that the Indian markets are completely unaffected, but the extent of impact is limited so far. If one considers the sharp jump in oil prices, global war concerns, record FII outflows, hawkish Federal Reserve, renewed worries about a virus resurgence in many parts of the world and some earnings’ downgrades for sectors particularly impacted by higher commodity prices, the resilience of the Indian market is praiseworthy. Strong DII buying partly led by strong inflows in mutual funds as well as continued direct retail support have contributed to the Indian stock market’s resilience.

That said, the situation is fluid and one can’t say if things will worsen in the short term or turn around for the better. Going ahead, the extent and duration of the conflict between Russia and Ukraine and inflation trajectory would be key variables to watch for in the performance of Indian equities and bonds. From investors’ viewpoint, it’s very clear that they need to diversify and focus on the right asset allocation mix in their portfolios. In this context, asset allocation offerings like multi-asset allocation funds or balanced advantage funds offer good options, particularly when forecasting has become extremely difficult. Volatility can lead to mistakes due to varied associated emotions. If investors opt for a systematic approach towards asset allocation, they would have better odds of weathering the kind of volatility and uncertainty that we are witnessing now.