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S Naren and the art of contrarian investing

5-10 quality mid and smallcaps are overvalued. Rest are reasonable, says Naren

ET Now|
Updated: Mar 15, 2019, 01.39 PM IST
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Going by my past experience, I am never worried when there is too much disinvestment in any area. I am only worried when people come out with disinvestment or IPOs in an overvalued sector, said S Naren, ED & CIO, ICICI Prudential AMC, in an interview with ET Now.

Edited excerpts:

Everyone is mesmerised. There has been a 10% rally from recent lows -- 7-8% uptick in Bank Nifty and 2-3% jump in Nifty. Everything has happened in a matter of 15-17 days.

You should look at what happened in early January in the world. Through 2018, the US Central Bank was tightening monetary policy and doing a quantitative tightening of $50 billion per month.

In early January, the US Fed said they were not going to increase rates and at some point of time in the year would stop quantitative tightening. Historically, when dollar becomes weaker, the whole emerging markets get huge amount of oxygen and that is the kind of situation we are in.

In the earlier part of the year, the money went primarily to markets which crashed in 2018 like China and in India that money came a bit delayed. There was a period when India had underperformed China 10% this year and the money started coming to India, albeit late, because people were worried whether they should put in money before election results are out.

I believe it has a lot to do with what has happened to the Fed and what the Fed has decided to do this year and that is the factor which we always tend to miss because we look very narrow in our country but the reality is the India rally is not just an India rally, it is an emerging market rally of fairly large proportions.

How should one understand the current price action? How does one deal with this kind of dilemma when there is an event risk and the valuation support is missing yet markets continue to go up?

First of all, we are not in euphoria like one year back. The market mood has been somewhere in between euphoria and fear. Consequently, this worry that you are talking about hardly exists because local flows have been moderating. Bulk of the flows that are still happening are SIP flows which is very, very positive. You have a situation where earnings growth is going to improve largely thanks to banking, but banking is a very big part of free float of all indices and the fact that banking earnings will go up is a very positive development.

It is not that earnings at this point of time are extremely expensive. They may not be cheap but earnings are at fair value for bulk of the market, except a few mega caps. Barring those megacaps, markets are fairly valued. With the PSU pack being cheap and the rest of the market at fair value, 5 to 10 megacaps and 5 to 10 quality mid and smallcaps are looking overvalued at this point of time.

I do not think we have to worry that we are in the state we were in one year back where there was extreme euphoria, huge local flows, huge valuations of large and midcaps and a very different environment .

Now we are in a much more reasonable environment. I do not think this worry that you have is a problem. The only thing I would say is not in equity market.

It is in debt that people have been very cautious at a time when I believe that they do not need to be so cautious because valuations in debt is reflected by the yield to maturity of many of the categories is so high that they ought have been much more positive but they have been reluctant to invest in debt funds. The beauty about debt funds is even past performance was good and despite the past performance having being good in most of the funds, people have been very cautious in debt.

There was the event risk which markets were not able to see from IL&FS crisis to NBFC liquidity crunch?

Last year, we had quite a lot of euphoria and quite a lot of positives. For example most of the financial services companies were trading at extremely high valuation with the exception of banks. The situation then was very different from what it is today and after the IL&FS issue, a lot of derating happened and after that derating, many of the sectors had become cheap.

I do not think people are thinking that they are in a state of extreme optimism. Having said that, is our equity valuations at the level where you can make mega money at this point of time? The answer is no. Equity valuations at this point of time are at a level from which you can only make reasonable experience and which is why from our point of view, we have been pushing all our categories like asset allocator balanced advantage categories.

Markets are not cheap, markets are not expensive. There is neither euphoria or nor fear. I would say that you are exactly in the middle. When you are in the middle you have to push these middle of the road categories like balanced advantage and SIPs.

The portfolios which you have managed show you are revisiting high dividend yield stocks and especially high dividend yield PSU stocks. Why?

PSUs got derated for 10 years and at this point of time I have a simple metric look for stocks which are at single digit trailing PE. Look for stocks which are at around 5% dividend yields and look for stocks which are not too leveraged. If I look at this combination of high dividend yield, low trailing PE and not too much leverage, I get a number of PSU stocks and that is the reason we are massively overweight PSU stocks.

I am hoping that the new government which forms after May 2019, recognises that most of the PSUs are deeply undervalued and there are huge opportunities to rerate them through effective management of the shareholding in the next five years. The strategic value of many of these PSUs have been fantastic. The other interesting thing which people have to remember is if you go back 10-12 years, everyone was entering sectors like power and in those sectors the capital allocation mistakes by the public sector power companies were much lower than the amount of capital misallocation done by the private sector power companies.

There are sectors like power where in the last 10 to 12 years, it is the public sector units which have become stronger because in those heady days of 2007 they did not make capital allocation mistakes whereas many of the private sector companies entered into power purchase agreements which were extremely bad for earnings. I would say that contrary to what people think, there have been PSUs which have actually done a much better job of capita allocation in the last 10 to 12 years and they have got derated.

The government in the next five years would recognise that this derating can be reversed and people make money out of that.

But what about the legacy capital allocation problems and constant selling from government in terms of the disinvestment requirements? Wouldn’t these act as impediments for PSU stocks?

Yes. A private bank which went and told people I am going to do an issue or a prior high valued NBFC comes and tells people I am going to do an issue, what happens is they get rerated. I am a believer that whenever, say Morgan Stanley pulls out a stock from their index or adds a stock to the index, those are all contrarian opportunities for me to either buy or sell.

So if public sector disinvestment makes sense to me and I feel that the shares are attractively valued, that is actually an opportunity because I am adding to my holding in a stock which is trading at single digit PE, very good dividend yield and is a non-leveraged company operating in a big sector like power and many other infra spaces. That is how I look at it.

I do not worry so much about it and going by my past experience, when you have too much disinvestment in any area, I am never worried about it. I am only worried when people come out with disinvestment or IPOs in an overvalued sector!

In our last conversation you hinted towards buying exporters. Was that call primarily based on global growth and weakness in rupee and is it time to revisit that call because the rupee has appreciated?

Actually in between is when the call actually failed. What happened was when we last spoke, oil was on an ascend and if oil goes up, there was a situation where dollar kept going up against the rupee and that was a phenomenal period for exporters. But what happened after October-November is that oil crashed and with oil crashing, rupee started appreciating. The tactical view which we had on exporters, first worked and then failed and my belief is with the rupee having appreciated again significantly, I would say again we are at a time to consider because you have a good combination of rupee having appreciated and oil again going up and once that happens, you move to a situation where exporters look interesting.

Having said that, I feel that the way oil has been moving it causes more volatility and the exporters are reasonably valued but not dirt cheap. So, it requires more tactical handling than what I would have thought six months backs. At that point of time, everyone believed that oil will keep going up in August-September and consequently, we had that view but oil is more range-bound now.

I would be tactically pretty positive on exports at this point of time, given the fact that rupee has appreciated.

What is your view on the current metal cycle? Historically fund managers do not buy metal stocks but you have not shied away from making your 15-20-25% gain in metal stocks when you can smell an opportunity.

People believe you cannot create a detergent brand in this country but people believe you can put up a big steel plant. My view is that it is difficult to put up a big steel plant or a big aluminium plant at this point of time in India. So if people are willing to pay absurd valuations to consumer stocks because you cannot create a big detergent brand or a soap brand or a liquor brand, frankly at least a part of that valuation has to be given to companies which have put up big steel plants or aluminium plants or coal plants.

The 2007 to 2011 phase actually made the sector extremely aggressive and people lost lots of money and decided that they would have to be very cautious there. Post 2014-15, there are very few new big sources of supply in any commodity and periodically you have events like what happened in iron ore where the Vale plant in Brazil had a big problem and consequently today we are in a much better situation for metal stocks.

It is difficult to put up plants. No one is putting up plants globally. The sectors are trading at extremely cheap valuation.. My favourite metric is trailing PE. On trailing PE, most of the stocks are single digit some of them are are cash flow generating.

Also Read

Investors should shift to value stocks from overpriced names: S Naren

Smallcaps good bets from 3-5 year perspective: S Naren

Asset allocation a sure shot way of making money: S Naren

Why S Naren is betting on small and midcap stocks in power and infra

S Naren and the art of contrarian investing

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