Suresh P Iyengar

An improvement in capacity utilisation could be the trigger for a rebound in corporate earnings, says S Naren, Chief Investment Officer, ICICI Prudential Mutual Fund. Excerpts:

Given the uncertainty over economic growth and the recent run-up in the markets, do you think large-cap stocks are currently overvalued?

When compared to mid- and small-cap companies, large-cap companies are relatively better valued, at this point in time. From a cyclical perspective, the market is yet to reach its peak as the capex cycle, credit growth, corporate earnings and capacity utilisation are yet to improve. Owing to these factors, we believe that the equity market is on the verge of taking off.

What Sensex and Nifty earnings do you expecti this fiscal compared to last year, and what are your expectations for the next two years?

The earnings cycle is yet to play out in India. An improvement in capacity utilisation would be the trigger that could lead to a rebound in corporate earnings. As the capacity utilisation in sectors such as cement, power and several other sectors improve, corporate profitability too will start to grow. We believe it is only a matter of time, before earnings start to play out. Our view stems from the belief that the leveraging cycle can pick up, along with improved capacity utilisation by corporate, which can lead to a pick-up in earnings. Over the next two years, we expect nearly 30 per cent growth in corporate earnings.

Among the large-cap stocks, which sectors are expected to bounce back this fiscal? What sectors should investors avoid?

We expect earning to start reviving next year in sectors such as banks, capital goods, power, technology, pharmaceuticals. We are positive on IT, pharmaceuticals from a three-year point of view. In pharma, many companies are currently trading very cheap compared to their inherent valuations. We believe a turnaround can happen in the pharmaceuticals space with increased traction in key FDA approvals and strong R&D focus on complex generic products. When it comes to IT, growth is stabilising after 24 months of turbulence and is expected to pick up with the depreciation of the rupee and margin expansion. From a near-term perspective, banking and infrastructure are the sectors that are likely to see some traction. Within banking, we like financial supermarket banks or lenders that offer a variety of financial products such as mutual funds and insurance. In the infrastructure space, ports and aviation industry are poised to witness an expansion due to the government’s focus. The power sector is currently going through low capacity utilisation. With an uptick in the capex cycle, we believe the sector will register higher topline growth and earnings.

Why should investors be looking at large-cap stocks at this point in time?

In last two instances of a market boom, it was seen that the participation of companies in the growth narrowed towards the second half of the boom. This is the phase when markets start peaking. Also, the few sectors that gained start becoming part of the benchmark. The large-cap benchmark tends to perform well. For instance, in 1998-99, a number of technology, media and telecom stocks entered into Nifty and in 2006-07 infrastructure and metal stocks made their way to the index.

This trend is currently playing out in the US as the markets there are close to peaking. As a result, it has been difficult to beat the benchmark indices in the US this year. After the bubble phase, there is generally a market correction. During that phase, large-caps tend to outperform mid- and small-caps as seen from 2001 to 2008. So, we have a situation where both on the upside and the downside, large-caps tends to perform better. Hence large-cap benchmark-oriented investing is to be preferred over mid- and small-caps.

What would be impact on large-cap stocks if foreign portfolio investors pull out of the market?

There could be an impact, but historically, it has been seen that in a big decline in India, insurance companies step in and go on a buying spree. They are major buyers in large-cap stocks.

What would you like to advise investors at this point in time?

To make people understand better, I would like to use the traffic signal analogy. We are currently at the yellow light and any switch to green would make valuations expensive. When it turns red, it means the market is heading toward a bubble, which is very unlikely now. When in the yellow zone, one has to look around and be careful. One cannot invest blindly in this phase. As a result, we are of the view that investors should consider balanced advantage and dynamic asset allocation category of schemes of mutual funds for incremental allocation. In such schemes, the allocation to debt and equity is dynamically managed by well-informed fund managers. It allows investors to take an exposure to each asset class, based on their prospects.

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