Valuations not comfortable in context of interest rates: Janakiraman R

Valuations have definitely come off over the past three quarters, said Janakiraman

When seen along with interest rates, current valuations look better than three quarters ago, but not as comfortable in absolute terms, says Janakiraman R – VP & portfolio manager, emerging markets equity - India, Franklin Templeton. In an interview with Samie Modak, he says small-caps are more attractive than large-caps but only from a three-year investment horizon. Edited excerpts:

Do current valuations offer any comfort?

Valuations have definitely come off over the past three quarters. Current valuations, across market-cap segments, are much closer to the long-term averages. There is clearly comfort on this front. At the same time, interest rates have risen on the back of persistent high inflation. When seen along with interest rates, current valuations look better than three quarters ago, but not as comfortable as absolute valuations look.

Are most often-discussed headwinds priced in?

Adverse developments like high inflation, high commodity prices, heightened geo-political tension, quantitative tightening by the Fed and a potential recession in developed economies are, largely, already priced in. Will the incremental movement in these areas be adverse enough to pull down the markets further? On the balance, the valuation level looks comfortable for a three-year horizon. Of course, SIP (systematic investment plan) over the next year covers for the possibility of further correction, should it happen.

Small and mid-caps have corrected more. Does that make them more attractive vis-à-vis large caps?

The potential headwind is that the Indian economy is likely to see a slowdown in growth rates over the next two years. As per current forecasts; such an environment is not necessarily conducive for small and mid-caps. From the perspective of both relative performance versus Nifty and absolute valuation, small caps look more attractive from a three-year horizon.

Within the emerging market (EM) space, markets like Indonesia have done better. Has India lost its edge as the brightest spot within the EMs?

The last six months have favoured resource producers. Being a large producer of iron ore, coal and palm oil, Indonesia has benefitted from the commodity cycle. This has led to a better performance by the Indonesian markets. But such advantages are trumped by long term factors like young demography, trend towards formalisation of the economy, benefits from the gradually emerging competitive advantage in manufacturing, and a relatively more self-sufficient structure of the savings-investment market. I would say that the long-term relative attraction of India over many other EMs is very much intact; just that it is navigating a temporary blip in the form of high resource prices.

Will India continue to get more than its fair share of EM flows? Do you expect a reversal in foreign flows?

Lowering of the interest rate differential, high oil price and a reduction in global liquidity are the key factors that have driven the ongoing outflow of foreign capital. These are largely priced in, and incremental trends may, in fact, offer some relief in some of the above. This view indicates that there is a good probability that Indian markets can see a reversal in foreign portfolio investor (FPI) flows over the coming year.

Has managing funds been a challenge this year?

Certain styles suit certain phases of the market well. My prudent and cautious approach was found wanting over the past two years where the markets saw fast changes, rapid assimilation of narrative trends and re-rating-led returns. In the current environment of nervousness, earnings led returns and a lower role for narratives, I do hope that a prudent approach will outperform.

What cues should one look at from June quarter numbers?

The impact of high inflation on consumer demand, especially discretionary in nature; incremental movement in gross margins of manufacturing firms; order flow trends in short-cycle capital goods.

Which are the sectors you are overweight and underweight about?

A potential slowdown in growth rate and a valuation that is still above the long-term average makes the outlook for IT (information technology) services cautious. Possibility of a weakening consumer discretionary demand due to high inflation is another sectoral concern. In addition, some of the converter businesses saw very strong margins over the past two years, helped by rising commodity prices and inventory gains. Such businesses are likely to see normalisation of margin in the coming year.

Will banks continue to underperform?

Banks, especially mid and small cap, have seen subdued performance over the past three years. The big fear about a large permanent impact on asset quality by Covid-19 disruptions has not come to pass. Levels of asset quality, gross slippage and recoveries are sources of comfort now. Though there is still a degree of risk from fin-techs over the medium term, their threat to displace banks in consumer lending looks much more manageable now. Credit growth is showing signs of life. Valuations of mid and small cap banks are now well below their long-term average. On the back of these, I would expect a much better performance from banks over the next year.