Market not overbought; comfortable on valuations of large banks: UTI AMC’s Vetri

Vetri is positive on auto, banks, pharma and IT, and feels the animal spirits among businessmen needs to be unleashed if the capex cycle has to take off in a big way

The market may be at an all-time high, but it is still not overvalued the way it was it was in October 2021 when share prices were shooting through the roof, says Vetri Subramaniam, Chief Investment Officer, UTI AMC. In an interview with Moneycontrol, he said foreign institutional investors were bullish on India’s structural growth story, but no longer looking at it as a high-beta play they used to till recently.

“Last year we argued that India is getting decoupled from the world because the world is worried about a slowdown and we won’t get badly impacted. The year-to-date rally is telling you exactly that; we don’t get impacted on the upside as well,” Subramaniam said.

He is positive on auto, banks, pharma and IT, and feels the animal spirits among businessmen needs to be unleashed if the capex cycle has to take off in a big way.

Edited excerpts from the interview:

Markets at a record high, FIIs bullish, local funds bullish, retail investors bullish. Is it time to get worried since every class of investor is buying?

Yes, the market is at an all-time high, but it is not a valuation high as yet. Many valuation metrics are in fact lower than what they were in September-October of 2021. The market is only up 5-6 percent from October ‘21, but the valuations are actually cheaper than what they were then. As an investor I worry more about valuation highs than price highs. Price high is to be expected if a company or a sector is expected to do well. I would say that we are not as extended as were in October ’21, but we are gradually pushing in that direction.

When you say market is cheap, which are the parameters you are referring to?

Nifty price to earnings, price to book and dividend yield. Maybe the bond yield versus equity yield is at par with what it was in 2021.

How would you place India’s performance in the global context What explains foreign investors suddenly turning bullish on India after a long spell of selling?

India has done well in 2023, but the question is how do you define “well.” To me, the most significant trend is the strength in global equities, and the resilience of the US economy. Nasdaq is up 40 percent this year, Nikkei is up 24 percent, S&P is up 20, Daxx 15 percent…when I stack these indices, India is somewhere middle of the class, or slightly above the average. And that seems to make sense. Last year we argued that India is getting decoupled from the world because the world is worried about a slowdown and we won’t get badly impacted. The year-to-date rally is telling you exactly that. We don’t get impacted on the upside as well. Our growth was going to be 6-6.25 in the event of a US recession and looks like it will be the same even if there is no recession in the US.

We are no longer a high beta play, this is an unusual situation to find ourselves in. What global fund managers seem to be saying to India is that we like your structural story, but you are no longer our beta play. If I (global money manager) want to put money because US is not going into a recession, I will go to Brazil or Japan or Korea and all those markets are doing well year-to-date. They fell the hardest when US recessions were there, and have risen the fastest when those fears receded.

Lot of investors are now looking at fixed income instruments. Many fund managers say that other asset classes like debt and real estate are competing with equity fund flows. Your thoughts?

Fixed income can never beat equity in terms of absolute returns. I don’t mean 3 months or 6 months, but over longer periods like 5 years, 10 years , 20 years. What every investor needs to keep in mind that there needs to be diversification not just in the equity portfolio, but across asset classes. The question you then need to ask is whether the asset class is attractive. The mid-tenure (2-3 years) bonds are definitely attractive at this point. For a reasonably.  high quality portfolio, the yields are above 7 percent, and RBI is saying inflation for the full year will be 5.25 percent. So the spread that you are getting for taking low risk in fixed income is actually quite attractive.

There are signs of private sector investments (capital expenditure) picking up. The market has also rewarded the stocks that benefit from an uptick in the capex cycle. Weak private capex was one of the major concerns. Do you think the tide has turned decisively for the better?

The two essentials ingredients for capex are there. Corporate balances are at their best in 20 years, and so is the case with bank balance sheets. Companies have the ability to invest, banks have the ability to lend. The other two ingredients are capacity utilization levels and animal spirits in businessmen. Capacity utilization levels are getting to a point where companies are thinking about expanding capacity, but it is not a slam dunk in terms of being visible. One reason is that there is a splintering of supply chains because of the tension between the US and China, and businesses are wondering how to invest without being caught in the crossfire.

Also, the nominal economic growth over the last four years is still nothing to write home about. So you have not yet reached the inflexion point where companies are feeling the pressure on capacity and feel the need to invest. They are investing, but the rate of pick up in investment is not high. It needs a spark. But the bigger issue is that of animal spirits, which I don’t see with a large cross section of corporate India. One, many people in corporate India have a sense of ‘been there done that’. They spend heavily in the previous capex cycle and then spend a decade cleaning it all.  What’s changed between a decade ago and now is IBC, because now if you run into financial trouble, the company can be taken away from you. Even good companies went through serious trouble over the last decade, so nobody wants to find themselves stretched. The honourable FM too has been asking corporate India why they are not investing aggressively now that the government has done its bit in terms of tax cuts. The good part is that the basic ingredients are there, without which animal spirits along would be of little help.

What is your view of the banking sector? The rally we saw late last year and during the early part of 2023 has moderated because of concerns that banks net interest margins may be under pressure. Are the worries justified?

Banks are well placed. The top 6 banks—five private sector and one public sector—now account for 70-75 percent of the incremental credit and deposit. This kind of consolidation has not happened in a very long time in India. There is a long tail of private and PSU banks, but on the corporate side, it becomes very difficult for anybody to compete with these six banks because these banks have a far superior deposit base. I am not so much worried about the pressure on margins because they have the deposit base to manage that. My concern is that credit costs are unsustainably low (meaning banks are extending loans at rates that do not fully factor in potential risk of default). What we are seeing today is the 180 degree opposite of what we were seeing in 2015-16-17 when credit costs were unsustainably high as banks were in the midst of cleaning up their balance sheets. Assuming the credit cycle continues for the next 3 or 4 years, then the credit costs that we are seeing now is unlikely to sustain, if I am thinking 10 years out. But we are comfortable with the valuations which are still mid-cycle, though there could be some margin pressure, because they still have pricing power.

Where does that leave the rest of the banking sector other than the top 6?

Increasingly challenging is how I see it. Whenever we meet the top six players, they are either investing in technology or ramping up their branch network. And that’s creating a significant challenge for the smaller and mid-sized players because they don’t have the profit buffer to either invest in technology or building out their branch network.

What about small and mid-sized companies, isn’t that a big enough market for second line banks?

The trouble with small and medium sized corporates is that many of the arguments revolve around labels than data. Compared to 20 years ago, who is a small and mid-sized entity is well-known to the banking system, because in one way or the other, you are part of a supply chain, so somebody has identified you. The economy is far more data rich today, thanks to the GST... anybody who is part of the organized system is being picked up. Twenty years ago, a bank would sit down with an auto company, understand who its 30 top suppliers are and then try to build a relationship with them.  I am not sure if it can be said that SMEs are not able to access credit from the banking. Of course, credit is more expensive for the smaller firms, but that is a trend even in the US.

NBFCs have managed to do well in a high interest rate scenario, defying concerns that they would struggle. How do you see this space evolving?

Most NBFCs have liability access but they do not have a liability franchise (meaning they can source funds from various sources, but do not have a deposit base for a steady source of funds). And some of them are doing wholesale borrowing and wholesale lending, like corporate lending, developer funding. That business model is risky because of potential asset-liability mismatch. The strong point of NBFC is that they are the point of sale and hence they can originate loans very well. I may be sitting at the dealer who is seller a car, and so may be able to get the customer easily. Lot of them have relied on their ability to be at the point of sale and use that as a driver of their credit. We think some of the NBFCs will continue to do that well and co-exist with the banks, but the moment an NBFC becomes very big, there will be the question coming from both the company as well as the RBI if they should be converting themselves into bank.

You have been bullish on the auto sector for a while now. What are the triggers you are seeing there?

We are bullish on automobiles as they are still in the very early stages of the growth cycle. Car sales have crossed their previous peak of 2019, commercial vehicles will do that sometime next year, two-wheelers are still running 20 percent below their 2019 peak. So autos are just recovering lost ground. The cycle still has more to run, and as they grow there is scope for operating leverage.

What about disruption because of the transition to electric vehicles? You are already seeing that in the two-wheeler segment where many new players have entered the field.

In two-wheelers the entry barriers are lower because it was possible for new entrant buy the components and launch. In four-wheelers that is not option because it is a far more complex product. Even in two-wheeler, new entrants were able to survive because of subsidy. And consumers are not switching to electric to reduce pollution, but because it makes economic sense because of the subsidy. Without the subsidy, it is not clear if consumers would still go for electric. Also, the new brands don’t inspire the kind of trust that the well-established players do, because people in India own two-wheelers for 8-10 years and they must have the confidence that they will get the spare parts till the end.

The challenge in automobiles is not the issue of EVs, of course there may be one or two disruptors who may become successful, but many of the incumbents would play a significant role in the future as well… not every one of them. The challenge, for four-wheeler makers, particularly is how do they produce good internal combustion engine (ICE) models, hybrids models that are bridge between ICE and EVs, and at the same also invest in top-of-the-line EVs. Indian companies throw up a lot of cash. Now if you have to simultaneously support this entire spectrum, the demands on your cash are going to go up quite dramatically. You had a well-established product like ICE on which you were not doing any great research. But if you want to be a leader in EVs, you will need to put money into some serious research because technology is still evolving. When the demand on cash flow goes up, that will have valuation implications.

IT stocks have underperformed in the recent rally, and unlike the situation last year when the majority view was bearish, there are more investors willing to look at the sector favourably. What is your strategy for the IT sector?

We are yet to see a recession in the US, but concerns about that has led to US companies cutting back on their spending plans, which in turn is hurting Indian IT companies. We have seen this time and again in IT. At the slightest sign of weakness in the economy, companies do curtail their spending in the very short term. When that happens, Indian companies tries to figure ways to adapt to the changed scenario by becoming more competitive, and the offshoring trend has only grown stronger every time. Our sense is that the valuation correction is almost fully done. The structural growth is inherent in the sector because of global competitiveness they have demonstrated over the last 20-25 years. So, every time there is a global slowdown, Indian IT companies quickly see a slowdown in spending, but they are equally quick to ramp up when things start looking up. You could use a combination of news and valuations over the next six months to buy into the companies you like.

Pharma has been the other big underperformer. Do you see any opportunities there?

Pharma and healthcare services is a heterogeneous sector with each business distinct from the other—like products companies, diagnostics, hospital chains, CRAM. Lot of the challenges that the sector has faced are in the price, and I find that companies in this space are increasingly talking about how to put their house in shape, get their financials in shape, and start generating a decent ROC and reasonable cash flow. And that is a good time to get invested in a sector, instead of companies giving a -we-will-change-the-world spiel. That’s an area that we like. I have liked it for the last one year, but it has not done much, but that does not change my view. What the sector lacks now is a spark, but who knows, that could come when nobody is expecting it.

Your thoughts on the commodities sector in the context of the weakness in the Chinese economy?

In commodities, China has been the one big disappointment in terms of not emerging from COVID in any degree of strength. So far, the (Chinese) government has not given indication of wanting to support growth. China already has a debt problem and so policy makers may not want to complicate things further. At the same time, they would also not want China to go into deflation, so they may use some fiscal response to provide support. We don’t know when that will happen, but when that happens, it will give some balance to the Chinese economy and also to commodity prices. I don’t expect them to do anything dramatic.

A lot of money is now flowing into passively managed funds like index funds and exchange traded funds. The market is divided on whether this is the best strategy. Where do you stand in that debate?

In US, the entire net flows into mutual funds going all the way back to the global financial crisis is into passive funds. Active funds have now seen an outflow for 15 years now. That tells you how dramatic the swing has been in the US.

I would love to see research showing that market returns are connected to growth. The US is a classic example; the economy grows just three percent, but factors like innovation, creativity and competitivity drive far superior market returns. So let us not make a virtue of our growth. It is a virtue no doubt, but it is a stretch to co-relate economic growth with passive or active fund returns, one way or the other. I don’t buy that argument. There could be an argument to be made about under researched versus over researched, but even that is tenuous.

Just look at the 42 mutual funds all running their own investment teams. My team may have a certain thought process, but I am not going to argue that the other teams don’t have people as well qualified, well trained and good thinkers as my team is. To the 42 AMCs, add 20 insurance firms, 150 PMS providers and all the global investors, many of whom have been investing in India for the last 20 years or more…they have discovered many multi-baggers in India before we Indians discovered them. I don’t think anyone can argue that the Indian market is dramatically under researched. You can have an impact based on the portfolio size. Someone managing a Rs 50 crore will be able to create a portfolio that is very different from someone managing Rs 5000 crore. A large fund can never create a very differentiated portfolio because size creates restrictions in terms of the stocks it can buy. So a size difference may be there, but not knowledge difference.

Some industry players say that actively managed funds have better scope in a market like India as it is still evolving. Do you buy that argument?

Active fund managers may have an edge since a large number of individual investors are now rushing in to the market. History, and my own experience tells me that whenever there is a burst of retail activity like there was in the 90s, pre-global financial crisis, these new investors learn some hard lessons. That could create alpha for active fund managers (the retail investors’ loss being the fund houses’ gain). But I don’t think they manage funds at a scale that can completely capture the benefits. But I think the knowledge and research edge is largely eroded.  Which is why I don’t the buy the argument that the US is different and we are different. For everything else we take US as the example and here we say, no India is different.

Are you saying passive is a good strategy and maybe even better than active?

I think there is great scope in passive. Passive is an acceptable form of investing. All passive is telling you is that I will deliver you market returns. And I don’t see any fund manager in India saying that the market return is not a great return. If the market is doing great, then a retail investor may think: hey why do I need to pay a fund house 2 percent more, when I can get market returns for a low cost? Plus, you do not have to worry about so many other things, like has my fund manager changed his thought process. Somebody can have a mix of passive and active in the hope that the combined portfolio will give me better returns.