Tridib Pathak, senior director (equities) at IDFC Mutual Fund, believes markets are likely to remain volatile in the near term as there are too many cross currents not just in the domestic scenario but globally as well. He tells DNA that despite some near-term concerns, India’s relative long-term position is definitely improving.

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What do you make out of the sharp pullback in Indian markets despite some serious domestic headwinds like rising inflation and interest rates?Unfortunately, the Indian markets have largely been influenced by global macro factors for many years now. The recent upswings have largely been due to liquidity, which is quite obvious in the way dollar is depreciating. Interestingly, the Asian currencies index has been appreciating which is a reflection of large fund flows. So there is a conflict in the way markets are behaving.

How do you see foreign flows in the near-term?Liquidity is the key in the near-term and it is becoming even more unpredictable. Because of liquidity, we are seeing a commodity bull run globally. There seems to be erosion of faith in the printed currencies of the developed markets, causing precious metals such as gold and silver to hit new highs almost every day. Liquidity along with supply fears due to the ongoing Middle East crisis is the reason for higher crude oil prices which in turn is causing higher commodity pressures. If the US persists with quantitative easing even after the end of QE2, liquidity will find its way into commodities and emerging market equities, which is good for markets.

So how would markets react to these inflows?The biggest paradigm facing India is that though you have money coming in, it is hampering your growth. Beyond a point, excess liquidity starts to hurt in terms of higher crude prices and other industrial commodities. It is a disturbing sign if liquidity is freely available due to developed markets explicit pump priming their economies, which unfortunately they have to continue doing even after two years of recession. The inflation data of last two to three months shows that after almost a year of high food prices, now the inflation is getting reflected in non-food manufacturing items leading to rise in core inflation. If core inflation continues to go up, it would be pretty dangerous and RBI would have to take some serious measures. And if interest rate rises, the growth would slowdown. But at the same time, our valuations have corrected to around 15 times one year forward earnings, which is neither too cheap nor expensive. Also, there are still some concerns on the global front like sovereign debt crisis in Europe and weak recovery in western countries.

In the short-term, we would continue to see volatility in markets due to these cross currents. But as the year passes by, the markets would reflect the earnings growth and same would get factored in share prices even as there may not be valuation kicker.Over the long-term, will higher inflation and interest rates tend to hurt growth?Interest rate hikes are good as its reveals that economic growth is healthy. To ensure that you don’t go out of control, if there is interest rate hikes to moderate it, then so be it. Think about it in comparison to western countries that are facing issues in growth. A slowdown in GDP (gross domestic product) by 25-50 bps (basis points) won’t hurt the long-term structural growth story. On the contrary, higher interest rates would attract more foreign money in the form of external commercial borrowings, foreign direct investments or foreign institutional investments.

How do you see corporate earnings in this fiscal?Last quarter we observed that though top line growth was fine, margins eroded due to higher input costs. This quarter also the top line growth should be fine. But key thing to watch out for would be that whether companies are able to pass on the burden of higher raw material costs to protect their margins. Last quarter they did not pass on entire raw material and wage hikes considering the lag effect. This quarter would be a test of pricing power. Though companies have been increasing prices in autos, cement and consumer goods, it remains to be seen whether that’s enough to cover the cost pressures. We have seen some earnings downgrades last quarter and we would watch these results to ascertain the level of impact. But on the whole, earnings growth is likely to see slowdown due to margin pressures.

What is your strategy for picking up stocks in the current environment?As a fund manager, while buying portfolios we look at three to four basic things. First is the visibility in earnings growth which is less dependent on global or domestic macros. One should find a company that shows strong growth which is better than or equal to market growth. While visibility on earnings growth is important, we do not want to compromise on quality either because in a rising interest rate environment, growth should not get impacted by higher interest costs. Therefore, one needs to look at companies having free cash-flow generation capacity or those who are not dependent on raising resources or money to achieve growth or maintaining their plants’ output in next 2-3 years at least. Third parameter is to see whether a company is capital efficient—-one which has decent return ratios like return on capital employed more than the cost of capital.

How do you view mid-caps in the current environment?When it comes to investing in mid-cap, one needs to have a long-term horizon as the long term growth story for India remains intact which would benefit these companies even as there are challenges in the near term. We continue to find brilliant long term opportunities in mid-caps at this point of time when they are trading at significant discount of 15-20% against large-caps.

Going by your portfolio, you seem to be overweight on financials, technology and energy? Has there been a change in stance.With results season underway, there may be changes in weightage. We are currently underweight on technology as all the good news and the expected growth is by and large priced in. We are neutral on banking though we might be concerned about further increase in interest rates and may look to go underweight selectively.

Which are the sectors that you are overweight on then?We are positive on consumer-oriented sectors in general, especially those who are getting strength from rural India and are immune to interest rate hikes. We are overweight on telecom where the competitive intensity has reduced a lot and many of the newer entrants find themselves involved in the heat of scam. We are neutral to marginally positive on autos. In a small way, we are also trying to play on consumption-oriented companies which may additionally benefit from this whole debasement of western foreign currencies leading to higher gold and silver prices.

What’s your outlook on investment-oriented sectors?Within the investment oriented sectors, we are positive on resource-based and non-ferrous companies which have their own mines as there is a huge demand-supply mismatch globally for some of the critical resources. We are positive on capital equipment companies. However, we are not comfortable with infrastructure stocks at this point of time as high interest costs may drag their performance.