“More merit in getting the stock right than looking at sector weights”

February 23, 2015 . Vidya Bala

At a time when expert views all converge in the same direction, it helps to balance it with a contrarian view. We therefore had some questions for Vetri Subramaniam, CIO, Religare Invesco Mutual. Subramaniam is known for his unconventional and cautious stance on equity markets but that does not mean he does not see opportunity in cautious state. Here’s what he has to say on the markets.
Do look out for a debt market view from Sujoy Das – Head Fixed Income, from the same Fund house in the next few days.

As a fund house, you appear quite conscious of valuations. How comfortable are you today with valuations?

Valuations have moved up significantly in 2014 and looking back, even further, it has been the key driver of market performance over the past 3 years. The expansion in the P/E ratio explains nearly 2/3 of the 30% rise in the Sensex in 2014.

Photo of Vetri Subramaniam

Going back to December 2011 valuations have moved from a 15% discount to long term average in December 2011 to nearly 25% premium to long term average at the end of January. Given the single digit earnings growth that characterizes this period the near doubling of the Sensex is explained largely by the expansion in the P/E multiple.

The Sensex is now trading at over 20x trailing earnings – this is well short of the highest valuation peaks recorded for the index in the past. But this is not particularly cheap and if anything the risk is that valuations mean revert. Of course, the path to mean reversion is an unknown it could go higher before it mean reverts. And then again it might not.

So we are conscious of this risk that the contribution or detraction from returns can be acute when starting valuations are at a significant discount or premium to long term averages respectively. Further, the baton for market performance lies in the hands of earnings growth.

With P/E re-rating already seen, when do you expect earnings growth to support valuations?

The earnings season has been fairly lacklustre so far. At the halfway mark with 14 out of 30 Sensex companies reporting results, revenues are down 6% and profits are up 1.8% yoy. The decline in revenue has been acute due to the fall in commodity, especially energy prices, but even excluding energy companies, the other Sensex companies that have reported results have shown only 7.5% growth in revenues and 3.8% growth in profits.

This is leading to cuts in earnings forecasts for FY15 & FY 16. In the past 4 weeks, earnings forecasts for both years have been cut by approximately 1.5%.

For the past 4 years, earnings have consistently come in below analyst estimates at the start of the year and so we are naturally cautious about the healthy forecasts for FY16 in the face of fairly anaemic company commentary and data points.

We recognize the case for operating leverage-driven by higher capacity utilization, lower raw material prices and lower interest rates to drive profit growth in FY16 but this requires revenue growth to recover from its current trajectory in the mid-single digits.

You have reasonably long holdings on your stocks. Do your mid-cap funds call for a more active profit-booking strategy in this market?

The trailing 12-month turnover ratios have not changed significantly as compared to a year ago. But within that same context we have reduced our exposure to stocks where we are uncomfortable with valuations and fundamentals. But our focus on quality and healthy capital return ratios is unchanged.

We see sectors such as media find a place in your top exposure? What is your view there are what other sectors are you overweight on now?

Media falls in the consumer discretionary basket. The inherent characteristic of the industry is that its cost is not directly correlated to revenues. In a slightly more buoyant environment for media spends their revenue expands without a necessary corresponding increase in costs and that is the attraction that the sector holds for us.

We favour a pro-cyclical stance but our portfolio strategy is more balanced given the valuation changes that have taken place. The consumer discretionary sector is a key overweight but then so is a sector like IT. Financials are a key beneficiary of a cyclical recovery and are a key holding in most portfolios but the exact position may vary across our strategies.

Right now we see more merit or alpha in getting the stock picking right rather than the sector weights. We have significantly reduced our exposure to the industrial sector because we think valuations there have moved up significantly and the capex recovery is likely to take more time.

You held sectors such as FMCG and pharma for a good while until 2013. Have they lost out in the market’s preference for ‘growth and cyclicals’ or do you see value in those sectors now?

Our issue with the consumer staples sector is valuations followed by a weak growth environment and hence we are underweight the sector. In pharmaceuticals, we have always been more bottom up and at the same time managed risk by diversifying across a basket of holdings.
The actual positioning is an outcome of the fund strategies and choices available to the fund. At a broader level the market’s performance is a bit perplexing. Except for the first half of 2014, this market has rewarded high growth and high quality more than value. The classical out performance of value vs. growth in early stages of an economic recovery that one would have expected has not manifested itself.

The marker for a market preference for cyclicals is evident, if at all, only in the out performance of midcaps. But the most pronounced bias for the market has been for growth and quality and this is reflected in continuing out performance of growth vs. value. Rather than get caught up with labels our focus is on getting the stock picking right for the relevant strategy.

Disclaimer: The above is not a recommendation to invest. Mutual funds are subject to market risks. Please read the scheme information and other related documents before investing.

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