‘The market is in a beautiful spot’

Nobody is buying empty promises today. But the rewards are high if companies deliver, especially in an environment blessed with robust demand, said Madhusudan Kela, head of equities at Reliance Mutual Fund, in an interview with Raj Nambisan & Sachin P Mampatta. Excerpts:

There is a consensus building on the markets rising to new peaks in Q4. What can upset the applecart?
I think we have come a long way if you consider that the world was supposed to end in October 2008. At that point, the markets were extremely oversold technically and there was so much pessimism.

Even the die-hard believer of equities actually had given up. The rise later is a result of that overcorrection. Of course, fundamentals have clearly improved since then.

Coming to problems, there are many in the world — sovereign risk in Europe, slowdown in China, anemic recovery in the US and other developed economies, etc.

As far as India is concerned, there are two or three things. One, the rain God has to be kind. This will be even more meaningful this year as we did not have a great monsoon last year. Preliminary numbers suggest that the rainfall deficit is near 14% — this has to reduce.

On the macro front there have been positives such as the 3G auctions, disinvestments, reforms related to deregulation of oil sector, buoyant tax collections, etc, so the fiscal deficit for the current year to remain under control at below 5.5% of the GDP.

However, there are few one-off positives and what government does to reduce structural deficit in coming years has to be seen. Even though there are these positives, on the negative side, liquidity has become tight.

Banks’ credit growth at 21.7% year on year (yoy) is far outpacing deposit growth at 14.9% yoy. The incremental credit to deposit ratio is as high as 100%. On the external front, non-oil imports have risen significantly. India’s trade deficit and current account deficit are widening, thus creating pressure on the overall balance of payment. If the monsoon is bad and inflation stays high, the RBI (Reserve Bank of India) will have limited scope to ease liquidity. This may put pressure on interest rates and also on growth.

This may not be imminent but if the situation remains like this, it may happen over the next 6 to 12 months. It’s a Catch-22 situation because, as we have seen in the last two years, fundamentals may have nothing to do with the markets in the short term, but eventually they have a lot to do in the medium-to-long term.

How long will liquidity be an issue?
M3 (or broad money supply) growth is low at merely 14% yoy. As I mentioned, slow deposit accretion and wider current account balance are the key reasons for that. So, either there has to be significant rise in deposit growth or there has to be deceleration in loan growth, which is not desirable.

Eventually, the RBI may have to come up with some measures such as reducing the statutory liquidity ratio or cash reserve ratio to address the tightness. Of course, inflation has to be tamed in the meanwhile. But the point is, you need more than 13-14% M3 growth if you wish to have 8.5-9% real growth expectations.

What about fund flows?
External capital inflows have been very good in this calendar year, be it foreign institutional investors ($12.7 billion in the first half of calendar 2010 versus $3.2 billion in the same period of calendar 2009), foreign direct investment ($9.4 billion in January-May 2010 as against $10.6 billion in the same period of 2009) or external commercial borrowings ($11.3 billion in January-May 2010 against $3.7 billion a year ago). Despite the capital inflows, widening current account deficit is leading to tight liquidity conditions.

We also had a liquidity delta event in the 3G auctions…
Yes, roughly 2 percentage points of recent credit growth could be assigned to 3G borrowing. But this money is somewhere with the government and will return to the system through spending. So that’s a temporary reason. The bigger reason is more structural. A lot of liquidity is funding consumption rather than investment. The widening trade deficit indicates that. Till such time India’s current account deficit and fiscal deficit remain high there will be liquidity constraints.

When do we bridge the gap?
Investments, though picking up, are inadequate to fund 9% growth year after year. In many industries, domestic demand is so strong that the gap between capacity and demand are being met by imports. For instance, we are importing tyres after a long time, if not for the first time. Capacity constraint is a key issue, but thankfully more capacities are coming up.

It won’t remain a structural issue if overall investments are steady. You will see a lot of capacity additions in the next 6 to12 months. Apart from that, like software exports, India’s merchandise exports also have to rise and more value-added exports need to happen as against basic materials now.

You speak with companies... What’s the picture on capacity utilisation coming through?
One can see it at high levels across industries — autos, ancillaries… everywhere you go. Barring cement, where there is overcapacity, there are constraints in the system today.

So the capex cycle is reassuring? It has good traction?
Yes, it has. A lot of companies are investing. See, they have very bad memories of 2008. The first tranche of money the companies raised after the crisis was used to repair balance sheets. Now companies are investing selectively. There has to be capex otherwise you cannot sustain 8.5-9% growth. Indeed, more money should come to fund capex, it will improve investor confidence.

What about the global situation, especially Europe?
I think there are may problems in a lot of countries with no quick-fix solutions. For instance, indebtedness is 3 to 8 times gross domestic product. Eventually there are only three options: 1). Devalue the currency in nominal terms so that debt level goes down; 2) Start saving significantly through austerity measures, which, according to me, is the best way out; and, 3) Defaulting.

All of this is time consuming, and can have serious repurcussions. I really don’t see these problems getting addressed at the structural level. The best outcome is slow pace of growth in the developed markets for a long period of time, which, effectively, is very, very good for India. Consider the $25 to $30 trillion of institutional investments globally. If we don’t have a meaningful double dip (in the US) and things carry on like this, then a lot of capital would come to India.

But wouldn’t slow growth perpetuate the debt problems?
See, high growth is  not possible. So the only option is to reduce expenditure and increase savings.

What’s the impact of global volatility on commodity earnings? There is talk of a possible Sensex downgrade…
It’s a possibility. Commodity prices have been fluctuating quite a lot, so on an overall index basis, we could see earnings getting impacted by commodity stocks. The structure of the market over the last 18 months has been pretty much sector-specific or stock-specific.

The pharmaceutical sector has returned about 50% in the last one year. On the other hand, there are stocks that are down 30-50%. In my opinion, the market is in a beautiful spot. It is disproportionately rewarding companies and managements that are delivering and punishing companies that are only telling stories.
Reliance Mutual Fund is known to make aggressive cash calls, usually before crises. Are you buying now?

The only time we took an aggressive cash call was in 2008. This time round, we are well-invested. As a fund house, on the whole, we may have 5-7% cash which is not unusual.

Would you buy at current levels?
Selectively, yes. We are married to returns and risk-reward. If we find a favourable risk-reward ratio anywhere, we will buy.

How would you advice investors to position themselves to take advantage of the coming growth in India?
First, we need to increase the investor base in India. The penetration of equity investments as a proportion of overall savings is very low. Most of the money is being directed either into real estate or gold.

My advice would be to simply keep investing a portion of the savings into equities, no matter the market rises or falls. Buy consistently and buy quality. But be consistent — the retail investor tends to turn away if there is a panic. And don’t forget a lot of investors are parking money at 6-7% interest rates (post tax), whereas most good equity mutual funds specifically from top three or four fund houses have products that have consistenly delivered over 20% returns over a ten-year period. That’s a huge gap. I think investors will have to pay attention to what to buy and how much to buy rather than when to buy.

The weird thing is, equities are the only place in the world where normal logic is turned on its head: higher the prices, higher the demand, and lower the prices, lower the demand (Laughs). Our long-term call on India has not changed. This country will get a disproportionate allocation in due course of time. India has the potential to grow at 8-9% over a long period of time and to be a $4-5 trillion economy over the next 8 to 10 years. Markets will eventually have to recognise this and reward investors.

Why can’t the FIIs read this story and pump it in hand over fist?
Of course they are seeing it. The point is that everyone is running their mandates. FII investing is broadly governed by the Morgan Stanley Capital International weightages and it is a very courageous task for them to invest more than India’s weightage because we are still considered a risky, developing market — politics, corporate governance etc, are issues. Eventually, all that will change.

How have the results been so far? What does the remaining earnings season look like?
So far, so good, but I expect earnings will not grow as much as the January-March quarter. And there could be deceleration in the July-September quarter compared with the first. But overall, we still believe the Sensex could grow more than 20% this year in terms of earnings. The Sensex earnings per share would be close to Rs 1,025

Is deceleration due to base effect wearing off or something else?
It is a combination of both. There is uncertainty among oil marketing companies about subsidy sharing. Similarly there are concerns on the earnings for companies in the telecom and cement sectors. All this has a bearing on the computation of the index earnings numbers.

Which 3 sectors a retail investor can look at for the long term?
Companies participating in the growth of the domestic economy will be the ones to benefit. These include in the financial services, infrastructure and capital goods sectors. Our belief is that though the pharmaceutical sector has run up quite a lot, it is still a very attractive sector to invest. What one should avoid are companies very heavily linked to the global markets because of the heightened uncertainty outside.

How do you lure India’s massive 30% plus savings rate into equities?
That’s what we are working at. I must tell you with pride that 10 years ago Reliance Mutual Fund had 20,000 investors and today we have 70 lakh. A lot more needs to be done. It calls for a collective effort from the government, the regulator, mutual fund companies and banks. It will happen. Remember, money only goes where the returns are. Returns are the only magnet.
How has the retail mindset changed in the last 10-15 years?
People are beginning to invest more — the younger generation, the engineering population, the software professionals, they are all beginning to look at mutual funds. They are not as traditional in their views. These things take time. It is a new wave and that is our biggest opportunity. Look at it in this context: if you can maintain a 35% savings rate, then in less than three years the size of savings will be equal to GDP. Where is all that money going to go?