After being one of the biggest generators of wealth in the last few years, the valuation of PSU stocks isn’t as attractive anymore, says Akhil Kalluri, VP & Portfolio Manager – Emerging Markets Equity-India, Franklin Templeton. “While near term euphoria subject to actual election outcomes cannot be ruled out, I believe going forward performance in PSU stocks is likely to be selective driven by company specific factors,” he says. Edited excerpts from a chat in which he talks about market outlook and whether the likes of HDFC Bank, Kotak and Bajaj Finance are attractive now.
Following a correction in February and March months, small caps bounced back with a bang in April. Isn’t this leg of rally largely led by retail liquidity?
Akhil Kalluri: I agree, retail liquidity could have been one of the drivers for the rally over the past month or so. There is also an element of funds probably deploying some of the excess cash into ideas, but we still await that data.
How much valuation risk do you see in the broader market in FY25?
Akhil Kalluri: The sharp rally in broader markets over the past couple of years has meant that valuations are stretched in select pockets. While a part of the re-rating can possibly be explained by pick-up in earnings growth, the implied long-term earnings growth in many of the stocks is also much higher now. Most businesses are cyclical and while the medium-term growth prospects for India seem quite attractive, some near term cyclicality can’t be ruled out. With multiple external events lined up in FY25 (both in India as well as globally), some increase in volatility can’t be ruled out. Instances of such volatility were visible earlier this year and even during last week. The higher the implied growth expectations, lesser the margin of safety and therefore I believe there is risk of some volatility in broader markets in FY25.
What is your reading of the numbers that we are seeing so far in the March quarter earnings? Anything that caught your attention?
Akhil Kalluri: The numbers so far seem to be a bit of a mixed bag. While banking stocks’ earnings have held up better than expected (both growth as well as profitability), earnings of tech stocks have disappointed (weak growth outlook). Earnings performance of consumption names has been a mixed bag, but growth seems to be picking up in that segment. I believe near-term earnings growth expectations are relatively muted for consumption stocks and it will be interesting to see if growth in that segment holds up going forward. Only a few industrial names have reported so far, growth numbers seem to be holding up better in that segment.
With investors betting on political continuity in this election season, PSUs remain a hot favourite. Do you see more re-rating if BJP comes to power?
Akhil Kalluri: I think the market is already discounting BJP coming back to power. Over the past few years there have been a couple of fundamental changes which, in my opinion, have benefited PSUs. First is a change in the government approach towards value maximization instead of plain divestment – Bharat 22 ETF approach to meet divestment target was creating supply overhang. The other is including total shareholder return as part of performance evaluation of senior management of some of the PSUs which probably could have helped in further alignment of management incentives with minority shareholders. Over the past few quarters, the PSU rally has been quite broad based, driven, in most cases, by improvement in fundamentals coupled with undemanding starting point of valuations.
However, post the current rally, I believe valuations aren’t as attractive for the pack and probably stretched for select PSU names. While near term euphoria subject to actual election outcomes cannot be ruled out, I believe going forward performance in PSU stocks is likely to be selective driven by company specific factors.
Themes like power, defence and capex have been hot favourites of both retail and institutional investors with many stocks giving multibagger returns. Do you think more steam is left in this trade?
Akhil Kalluri: I think so but again it is important to be selective going forward and I don’t expect the indiscriminate rally to continue.
Themes like power, defence and industrials have rallied sharply given the expectation of longevity of these themes over the next few years. After a decade of consolidation, the balance sheets of both corporates as well as banks are quite healthy. This coupled with supportive policy initiatives and a possibility of tapping export opportunities can drive multi-year capex recovery themes. Similarly, given the possibility of shortages in power supply, likely thrust on renewables and need for investments across the entire value chain from generation to distribution, even power themes are likely to sustain over the next few years. Pick-up in defence related capex and more importantly policy initiatives towards higher self-sufficiency is likely to open up interesting investment opportunities in the defence space.
However, given that these themes are well discovered, valuations in many names is more than adequately factoring in the future growth optionality and therefore we believe there is need to be quite selective in identifying the right opportunities within these themes.
Financial giants like Kotak Bank, HDFC Bank and Bajaj Finance have suffered a lot. Gradually, the consensus buy calls are also fading with investors choosing the likes of Axis Bank, ICICI Bank or PSU banks. Do you think patience in some of these OGs will pay off well if held for the next 2-3 years?
Akhil Kalluri: Absolutely, I think so. All these 3 names that you have specified are going through company specific challenges and at least some of these factors are probably transitory, in our view. Typically, in a favorable macro cycle, there is convergence in performance between good quality and average quality franchises which has led to some convergence in valuations across banks. We believe that the favourable macro cycle for the banking sector is likely to last for the next few years but there could be some deterioration from current levels. Therefore, while we don’t expect these names to trade at significant premium to peers as was seen in the previous cycle, we believe the underperformance for at least a few of these names could reverse going forward. Post the price / time correction, the starting point of valuations is also quite attractive given the quality of franchisee.
Over the past few years, valuations of all large private sector banks have converged with ICICI Bank now trading at a premium to other banks. We believe one of the reasons for the significant valuation differential during the previous cycle was the material gap in performance of these banks in a tough macro environment. There were relatively few investment options within BFSI space which were delivering predictable performance thereby resulting in premium valuations. With a reasonably benign macro environment as well as process improvements in peer banks, the performance differential has narrowed thereby increasing the overall investible universe.
For someone with a moderate risk profile willing to invest Rs 10 lakh now, what should be an ideal asset allocation strategy considering a holding period of 10 years?
Akhil Kalluri: I believe many of the structural reforms in the country over the past decade like IBC / RERA / GST / JAM, etc coupled with multiple policy initiatives have set the stage for a healthy growth rate in the economy over the next decade. Therefore, I remain optimistic about cyclical growth sectors – the likes of industrials, real estate, consumer discretionary, etc. The number of investment opportunities into these sectors is much higher in mid and smallcaps as opposed to large caps and therefore I am a bit biased towards maintaining reasonable exposure towards mid and small caps, especially if the investor has a long holding period.
Given the investors’ long holding period, I would probably recommend 100% allocation to equities given the favourable macro set-up but given the moderate risk profile I would recommend a flexicap allocation – 70% largecaps / 30% mid and smallcaps.
(Disclaimer: Recommendations, suggestions, views, and opinions given by experts are their own. These do not represent the views of the Economic Times)
