There will be volatility; 2022 could be a period of consolidation: Mahesh Patil

“While mid and smallcaps have done well in the last two years, at the moment they look a bit vulnerable because of the current situation. But if India grows then a lot of small and midsize companies would do well over the next 3-5-year timeframe,” says Mahesh Patil, CIO, Aditya Birla Sun Life AMC.



Just when we thought that it is going to be another great year, there is a war, The Fed is going to increase rates and if that is not enough, oil is at $100 plus. How will anybody make money in this kind of an environment?

In fact, at the beginning of the year, the outlook right was very positive in terms of at least India growth story playing out because I think after a long time, it is time to be positive on India as we were just coming out of the Covid impact. But yes, a lot of things have turned a bit adverse on the global front. What is happening with the geopolitical situation, has left some kind of a scar and we would see some downgrades to global growth and also probably some downgrades to earnings. But I think this is again transient.

I think the fundamental story of India is shaping up pretty strongly and that is not going to change. What this turmoil has shown is that India during this period, normally with oil at around $120, would have seen the currency fluctuate like anything! We have managed this situation fairly well and that shows that India has now emerged. It was once an emerging market right which had the twin deficits; but the current resilience gives us confidence that if we can manage in this turbulent time, then once things ebbs, we will emerge much stronger.

I think that is what I think investors should be looking at. Valuations are probably a bit expensive. This year will be a challenging year. One may not make very great returns but over the next three year timeframe, as GDP growth comes back to around 6.5% – the long-term average growth – corporate India earnings would still have a very healthy growth in the next two-three years. The market should really track earnings growth even if there is some amount of PE derating because of the increase in interest rates. We should still make decent returns from here.

Market price is a function of EPS and PE. The PE rerating has already happened; EPS, if at all, because of margins, inflation, demand pressure will come down. If EPS is not going to go higher and PE will come down, how will one get returns? We are talking about low returns but I am talking about no returns?
This year in FY23, because of the increase in the commodity prices and to some extent disruptions, one could see some downgrades to earnings. This year, if I am not mistaken, we are looking at around 17% EPS growth in FY23. That can get impacted by around 3-4% is what our belief though the market has still not factored it in after the first quarter numbers.

But despite that, we are still seeing a double digit earnings growth right and I agree that PE multiples will not rerate. In fact, we are assuming that they could probably derate a bit because as interest rates go up and because of the current geopolitical situation, this year would be a year where in the early part of this calendar year, this could be a period of normalisation. We have seen policy rates normalising and multiples could also probably normalise, earnings growth which was strong can come down a bit.

This year probably returns might not be that great but going forward, if earnings GDP growth goes back to around 6.5% and nominal GDP growth to about 11%, there is enough room for earnings to reflate over the next three years because earnings are still depressed. Compared to that, the average profits to GDP ratio is still depressed and during Covid, we have seen many corporates actually improve efficiency. There could be short-term impact because of commodities but once we come out of that, there are enough levers for companies to expand their margins.

A large sector like banking, has seen the corporate NPA cycle bottom. Given the fact that credit growth also is likely to pick up, if one combines all these factors, then in the next three years, earnings growth can still be around mid teens. So even if there is a derating of multiples, one can still make reasonable returns over the next few years.

If I have to go from Mumbai to Pune this year, could I be stopping at Lonavala for a vadapav? It is a year of no returns, right?
No returns, no we do not know because markets can still surprise you and we have seen that despite all the negative talks, the markets are still resilient and climbing the wall of worry.

Haven’t we climbed enough walls already – first the COVID and then war?
Within the emerging markets, look at what is happening in China; Russia is totally out; Brazil is still commodity driven. So, India is a market where investors will come in for long term growth. Forget about the next one year; if somebody has to put in money for the next 10 years, India is a place and given that I do not think India will become cheap as anything which has got a good long-term growth visibility won’t be cheap. So it will remain a bit expensive. I think there will be volatility. Last year was a very good year. This year could be a period of consolidation but yes one has to take that in the stride.

Another point which everybody wants to perhaps understand is why are we getting such magical numbers from domestic institutional investors? Whatever FIIs are selling at the end of the day is being bought by DIIs. Now DIIs have limited money or kitty. So, where is this money coming from?
While the flows have been fairly strong in the last one year though the penetration of ownership of equity is still very low. It has gone up from 3% probably to 4.5%- 5% but it is still very low. In the last one or two years, we have seen the new investors who have come in a number of new demat accounts which have been opened and so there is a whole new set of people who have come into the market probably taking a longer term view.

What are the alternatives? With interest rates still being low in our economy and inflation still on the higher side, how can one really hedge against inflation? Given all these factors, the steady flow which is coming into the market through the mutual fund route, especially SIPs, is likely to continue.

The direct retail money which is coming into the market, has come in kind of a speculative way. A lot of first-time investors are coming in, chasing some of the stocks. They might see some kind of a disappointment this year because stocks have been correcting big time. So that can be a bit volatile but mutual fund flows should remain fairly steady and that is a big change in India.

Despite $20-25 billion FII outflow, the market has not really corrected that shows the kind of balance which has been created which is good from a longer term structural market for India.

What happens when both FIIs and DIIs are buying? Then it is actually bad news because that will create a bubble?
Yes, it could happen. We have seen that in other markets. Liquidity is another factor which can take the multiples higher. We saw what happened a year back but it could happen and that is why in the market India, we expect that the PE multiples will again come back to the long term average. It might not happen. Multiples will remain expensive because again it is kind of a TINA factor and again everybody is chasing the same market. We do not know but we have to be more pragmatic and make assumptions based on more realistic multiples.

But that could happen when things normalise. After all, India could be a market where everybody wants to chase and you might not get. One might expect the markets to correct 10% from here and make it cheaper, but that is the way it is. So, look at the long term picture. As long as the picture is good, do not get too worried by the short term. If there is a correction at all, it is an opportunity to invest is what we would look at.

So this year is more like a pit stop at Lonavala. Next 2-3 years. we will reach the final destination which is Poona. Should that be the ideology?
Yes.

Voyage is about understanding the trends, understanding the medium term picture and the challenges and understanding the long term asset allocation. We are talking about three to five years now. What to your mind should be the projected returns from debt, some of your corporate funds – a balanced advantage fund and a midcap/small cap fund?

In three to five years more or less, the rate should converge with the long term rates. At least for the next one year, we are not expecting any great returns on the debt side because interest rates will go higher. Even if one is able to manage, the maturity will be somewhere around 5-6% or so. That is where we are. On the equity side, looking at our view on earnings growth and some normalisation, I would say a 10-12% return…

We are talking about CAGR returns?
CAGR returns. I mean it is not a great return compared to what people expect but that is still a good return in the context of where we are. The market is not exactly cheap, we are buying it on the higher side. And funds should be able to probably give slightly higher returns.

While mid and smallcaps have done well in the last two years, at the moment they look a bit vulnerable because of the current situation. But if India grows then a lot of small and midsize companies would do well over the next 3-5-year timeframe and one can expect slightly better returns than the market returns.

If you are investing through the mutual fund route through a balance of largecap, multicap or a midcap basket, then one can expect another 1-2% higher return than the market returns.

On a three year basis which would be double that of inflation is the point I want to bring out. Inflation will also start normalising in a 3-5 year period. If you think equity could give 12-14% return, I am sure adjusted inflation will be almost double of that, broadly speaking.

Longer term, if you look at equity returns and the inflation in the country, has been around that range which is a good return.

Let us understand the phase of the market. They always say the markets follow a cycle, it starts with disbelief, then comes the participation, earnings expansion, complacency then euphoria and a bubble. Where are we right now?
It is slightly complex because there are so many external factors but when we started looking at the beginning of the year, we were seeing that the markets probably had rallied slightly ahead of the fundamentals but looking at the catch up on economic recovery and the earnings, I think we were somewhere at the beginning of the economic cycle.

Even pre-Covid, we were trending down below 5% and then it came down. Things were building up so the economic cycle recovery was probably in the early stages, earnings recovery probably slightly higher earlier because post Covid we saw despite the GDP growth contracting, earnings growing. They were slightly ahead of that. If you take a sum total of that, I would say we are still in the middle of that cycle. The journey is still half done.

The last phase is always an exciting phase. That is the time returns will be super normal, participation would be wild and that is the time one would not need a SIP but you will still get a tip in a lift. We are not there. So the best in terms of an euphoric return is yet to come…
To some extent there was some amount of euphoria to be fair in the last one year…

When the internet companies went wild?
Yes, yes. Internet companies. Liquidity itself we saw but again it was slightly ahead of the fundamentals. Now economic recovery and earnings growth and all those things are yet to peak out but over the next three to five years. India’s best is yet to come I would say. Until then, one need not really worry.