“Equity markets may quote at above-average valuation”

September 30, 2014 . Vidya Bala

While the sharp run-up in the equity markets may leave little on the table for those looking for near-term gains, there appears potential for upside  in the equity market with earnings expected to grow at 17-18% compounded annually over FY14-17, feels Sanjay Dongre, Executive Vice President and Senior Fund Manager, UTI Mutual.

In an interview with FundsIndia Dongre talks about the markets and the potential in sectors such as infrastructure, despite their valuations turning expensive. 

Sanjay D - 4

Markets have run up sharply but earnings don’t seem to have kept pace. Are we in for some consolidation in the markets?

In the last one year, the markets have rallied with sensex delivering a return in excess of 35%. With the Sensex at 2,7000 levels, the market is quoting at 15 times earnings of FY16 and is closer to average valuations at which market had quoted in the last ten years. Hence the upside in the market is limited in the near term.

The Indian economy is on an uptrend and is expected to register a GDP growth of 6 per cent in FY16. Hence corporate earnings are likely to grow in excess of 15 per cent in CY15. The market may undergo time correction in next 3-4 months and may rally further if the companies are able to deliver positive earnings surprises in CY15.

What, in your view, have been the factors causing the volatility in the past few weeks in equities?

In the last few weeks, the market started factoring the expectation of FED hiking the interest rates in June 2015 with some risk of earlier hike in March 2015. With no signs of recovery, ECB is expected to embark on quantitative easing (QE) by Dec 2014.

It is creating a lot of volatility in the forex market with the US dollar strengthening against Euro and other emerging market currencies. Exchange rate volatility is also creating volatility in the capital flows which is translating into volatility in the equity market.

Where do you see markets moving in the next 3 years in terms of earnings/valuations?

At 27,000 levels, markets are at 15 times earnings of FY16 and closer to average valuations of the last 10 years. In the past, we have observed that higher earnings growth is accompanied by above-average market valuations and lower earnings growth is accompanied by the below-average market valuations.

As the earnings CAGR growth is expected to be 17-18% during FY14-17, the market may quote at above-average valuations during the period of high earnings growth.

 Are you expecting a softening of rates for credit given to corporate to pick up?

RBI is unlikely to cut interest rates in next 6 months as it sees upside risk to January 2016- inflation target of 6 per cent.

Maintaining high interest rate differential may allow RBI to attract capital flows thereby strengthening its reserves position. Fear of rapid policy tightening by FED may lead to volatility in the capital flows. RBI hopes to rebuild its forex reserve to guard against the exchange rate volatility.

With crude oil prices declining to less than $100/ barrel, fuel group inflation is expected to trend down in CY15. Hence RBI may look at cutting the interest rates in the second half of CY15.

We have seen the infrastructure sector and related themes run up too fast in the last 8-10 months. Are they looking unduly expensive?

Recovery in the economic growth is expected to be led by revival in the capex/investment cycle by FY 16-17. Hence the recovery in the earnings of the cyclical sectors is likely to be back-ended.

Therefore the valuations of cyclical stocks might look expensive from next 12 months perspective. As the pace of economic recovery gathers steam, we could witness substantial improvement in the earnings of infrastructure sector thereby prompting shift of fund flow from consumption related sectors to investment related sectors. Hence Infrastructure as theme is expected to do well in next 3-5 year time period.

 Is there room for upside in the infrastructure space and if so what specific themes are you looking at?

In the road sector, the Govt is considering to increase spending through the EPC (engineering, procurement, construction) mode compared to BOT(build, operate, transfer) mode. The government has plans for increasing investments in railways by way of spending on DFCs and metros in larger cities.

The government is also putting emphasis on increasing urbanization with higher spending on urban infrastructure and smart cities. Hence opportunities available for EPC players are likely to be substantial in next 5 year period.

In recent times, some of the EPC players have repaired their balance sheet by raising equity, selling BOT assets and reducing debt. EPC players having stress-free balance sheet are most likely be winner in capitalizing the opportunities.

Another way to play infrastructure theme would be through exposure to cement sector. In the cement sector, demand- supply gap is expected to narrow considerably with lower supply additions while the demand is expected to be in high single digits on the back of recovery of GDP and capex cycle.

Now, the time period between conceptualization of cement plant and its commissioning is estimated to be about 7 years compared to 4-5 years earlier. It bodes well for the pricing power of cement sector.

Your infrastructure fund has financial service stocks. Do you look at financial companies with higher exposure to the infrastructure credit space or is it a general valuation call?

In UTI infrastructure fund, we have been strictly sticking to the investment objective and hence our exposure in financial services is limited to the banks having high credit exposure to infrastructure sector.

8. UTI Master Equity Plan unit Scheme has crossed over a decade. What has changed over the years in this fund? What is your current positioning for this fund and how different is it from other diversified equity funds in your AMC?

UTI MEPUS is a close ended fund and is open only for repurchase. The fund has been maintaining judicious mix of large cap and midcap ( 80:20) with the objective of outperforming its benchmark index BSE100 consistently. The fund has outperformed its benchmark index BSE100 in the last one-year, three-year and five-year periods.

What is your take on the use of derivatives in equity funds? Does your AMC adopt this strategy for regular diversified funds?

We have been using derivatives occasionally for hedging our equity exposure and portfolio re-balancing.

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