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    Market out of harm's way as long as next govt is not a mishmash of parties: Manishi Raychaudhuri, BNP Paribas

    Story outline

    • In the midcap and smallcap space, investors should be selective.
    • Look at companies which have a strong growth story, good management and corporate disclosure practices.
    • As we head into the elections, volatility in India would possibly be higher than its Asian peers.
    The best idea to play in the Indian market is domestic consumption.

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    BNP Paribas rates India neutral in its Asia ex-Japan portfolio, said Manishi Raychaudhuri, Asia Pacific Equity Strategist. In a telephonic interview with, Raychaudhuri said India still remained the fastest growing large economy despite the recent slowdown.

    Edited excerpts:

    Where does Indian equity stand on your Asia preference list and why?

    Right now, in our Asia ex-Japan model portfolio, we are neutral on Indian shares, due to various different pulls and pressures on India, both on positive and negative sides. If I look at the positives, despite the recent downturn in GDP growth that we have seen in the last quarter, India remains the fastest growing large economy – one growing in the range of 7 per cent or so, which is rare to find today.

    At the same time, this reasonably strong growth is not really translating into corporate earnings growth. If you look at last six or seven years barring fiscal 2018, we have really seen single digit, possibly low single digit earnings growth for Indian corporates.

    This year, I notice that the analysts are starting with quite an optimistic outlook. I think the initial consensus earnings growth estimate is about 20 per cent. We think it will eventually settle around 12-14 percent, which implies that we are likely to see some more earnings downgrades. The phenomenon of earnings downgrades is hence not fully behind us.

    On the other hand, another positive for India is the availability of a decent array of large frontline stocks which have good corporate governance and disclosures, backed up by significant sell-side research. Stock selection, therefore, is easier in India than many other markets.

    Valuations remain a bit daunting though. India remains at a premium compared to the rest of the peers in Asia. This has always been the case, but today the premium seems to be about one standard deviation higher than the long-term average, both in price earnings and price to book terms.

    There are various different reasons for why we are neutral on India. We downgraded India from overweight to neutral in late June last year and we have maintained that stance for the past 8-9 months.

    Election jitters are also adding to your negatives?

    We now have the exact election timetable with result declaration scheduled for May 23. I think for the next couple of months as we head into the elections and the period of anticipation for the results, volatility in India would possibly be higher than the Asian peers.

    I must also mention that much of Asia is actually likely headed towards elections. On March 24, we have Thailand elections and in April, we have Indonesian elections, followed by Indian polls in April and May. Domestic political uncertainty could be a routine ongoing phenomena across Asia in the near term.

    The most important out of these are the Indian elections because not only is India the largest in size among the democracies, it’s also the largest market among the ones headed for elections. The likely elevated level of volatility over the next couple of months could add to the uncertainty that we already face.

    So what impact do you think in two possible election scenarios that results could throw up a) one party has a majority or close to majority or b) it ends up in a hung Parliament. In both the scenarios, how do you think the market could really react?

    In a scenario where the current ruling party continues to run the government, we believe the market wouldn’t be perturbed. There are two possible options here -- that the BJP has a majority on its own or the NDA forms the government but the BJP does not have a majority of its own. We think in both scenarios the market would be okay.

    Even if we have an NDA government without a single party majority, we think the basic economic policies of the previous government would likely continue.

    The first of these policy directions was formalisation of the economy spearheaded by GST implementation in 2017, the second was gradually reducing the fiscal deficit and improving the degree of fiscal balance and the third was lay down a road map for reducing the bad assets of the banks through IBC.

    We think that these three major planks of economic policy would not change under these two circumstances we discussed. If, however, we have a worst case scenario of a hung Parliament giving rise to a mishmash of political parties, euphemistically called a Third Front, coming to power, the market could react negatively - so that’s something we clearly have to watch out for.

    We are closer to the elections and considering where we stand in terms of valuations, what do you think is the best theme to play in the Indian market currently and why?

    The best idea to play in the Indian market, and this transcends the timeframe that we are talking about, and goes way beyond into the next 3-5-7 years, is domestic consumption.

    Structurally, the Indian population and the Indian consumers are changing in terms of what they consume and what kind of occupations they come from. A few years ago, more than 50% of the workforce was dependent on agriculture. That number has dipped significantly below 50% now.

    With urbanisation and steady increase in affluence, the consumer discretionary sector is possibly the first to gain, especially when we consider the accompanying scenario of low penetration of most consumer goods. The consumer sector would be clearly one of our major favourites.

    Aiding this process would likely be private banks and some of the non-banking financial companies. Investors would have to focus on those sectors as well.

    In the long term, we think industrials would also do well because India is underpenetrated not only by consumer goods, but also in terms of infrastructure availability. Particularly, the large industrial companies which have expertise across diverse sectors are possibly best suited to bridge that gap.

    Here again, we think the banks and some NBFCs in infrastructure financing should benefit, albeit with the caveat of paying close attention to leverage and asset quality.

    We think these are the two main long-term themes that one should work on. Now, in the near term, we think a few select chemical manufacturers and refiners and some of the IT companies could also outperform.

    That said, private capex in India has not really picked up. Does that worry you?

    You are right, but at the same time, if you look at some of the macro indicators, the most recent data points are more buoyant. If I go back about 5-6 quarters, the average capacity utilisation that the RBI OBICUS survey indicated was around 70 per cent. Today, from the most recent data available, it seems close to 78 per cent. When it reaches the range of 80-85 per cent, we think that the private sector capex proposals shall come back on the drawing board.

    And I would add to that the fact that now cost of capital is beginning to decline with RBI revising monetary policy stance to neutral and cutting rates in February. Real rates are still relatively high in India, especially when we compare India to other countries with similar credit rating.

    We think this is now beginning to change and therefore, the gap between return on capital and cost of capital which was not remunerative for the companies till recently could change in favour of the companies. I think these are the two main indicators that tell us we could be at the cusp of a private capex revival over next two to three years.

    Everybody keeps talking about the consumption theme in India. If you look at urbanisation and everything, taking a very basic example of the urban middle income group whose salary were to rise, he or she is going to spend more on Amazon, probably buy an Apple phone, or Xiaomi phone, or Oneplus phone. So in that sense are you using any proxy play for India consumption story? Listed consumption space is quite narrow compared to the opportunities available, correct me if I am wrong there?

    You are partly right there. If one looks at consumer staples or some of the cosmetics manufacturers, there are only a handful of liquid companies that one can play and there are valuation concerns in some of them. Investors would have to be a little selective in those spaces.

    However, increasing consumption has a multiplier effect. When a middle class person buys phone or some other discretionary item online, not only does it generate jobs in the “online-to-offline” confluence – i.e. for delivery partners, but also expands the revenue base for companies supplying domestically manufactured components to the discretionary products or those in packaging.

    But are you using any proxy plays to play in the India story like I mentioned maybe Chinese smartphone makers or something of that sort?

    As of now, in our model portfolio, we do not have any of those you talked about. There are a few other Asian companies trying to use India as the manufacturing base. We know of Chinese and Taiwanese companies trying to do that. We believe in the long term large global manufacturers could adopt a “China plus” manufacturing policy which is a direct fallout of, among other factors, the US-China trade conflict - driving large manufacturers to move away from putting all eggs in one basket.

    As of now, we are hearing more about Vietnam and Bangladesh in this context.

    With gradual improvement in ease of doing business and increasing encouragement to FDI, India should also be a beneficiary in the medium term. But significant improvement in domestic infrastructure is a necessary condition for such investments to accelerate.

    Midcap and smallcap pack has seen some significant rally over the last 10-12 sessions. Do you think the rally is here to stay or it would be volatile and could fizzle out over the next quarter or so?

    It is difficult to paint the midcap and smallcap universe with a broad brush -- that space is not uniform. We think that in the midcap and smallcap space, investors should be selective and look at companies which have a strong growth story and most importantly, have a good management quality and corporate disclosure practices.

    That said, we think the broader midcap and smallcap indices are now relatively cheap because of the massive underperformance that they had in 2018. The recent rally you referred to could be a case of partial mean reversion of valuations.

    Which other sectors are you overweight in India and why?

    I gave two examples – of consumer discretionaries and private sector banks. In consumer discretionary, we includes autos – both four-wheelers and two=wheelers. We are more positive on the premium two-wheelers. There are some companies that are the dividing line between consumer staples and discretionaries that we find interesting – in the tobacco sector, for instance.

    Among private sector banks, until recently, we were focussed entirely on the retail lending private banks, but now we think selectively some of the corporate lending banks are beginning to look attractive. Many of these incidentally have had management changes. Right now, a combination of retail lending and corporate lending private banks look appropriate.

    Third, we also like select IT companies primarily the front-liners because these are the companies that have the capability of changing their business models and of moving into fast-growth areas. We also like select industrials due to the potential for revival of private sector capex – in particular companies having a broad footprint in all areas of infrastructure and private capex.

    You have mentioned autos in this pack, autos have particularly not been doing pretty well, if we were to look at the auto sales numbers. Why autos in that overweight pack?

    You are right in saying that the two-wheelers and four-wheelers have not done too well of late. Having said this, we believe that this is possibly providing investors a buying opportunity. Over the medium term, premium two-wheelers and four-wheelers are significantly under-penetrated. Companies catering to niche product segments or which have a very large distribution footprint are likely to gain market share even further. If investors are a little selective in this sector, then there is still significant potential for alpha.

    And which sectors are you underweight currently in India and why?

    We do not have any exposure in the Indian telecom and metals and mining sectors right now. Neither do we have any stock in the Indian healthcare sector, or in the property sector. These are the sector we are underweight on.
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