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India's stock market price to be set by FII flows: Ajit Dayal, Quantum AMC
June, 03rd 2011

In an interview with ET Now , Ajit Dayal , Director, Quantum AMC, talks about the markets and their portfolio. Excerpts:

Is the big picture for Indian markets looking slightly scary?

I wrote an article in June 2009 and then I probably put my foot back in the mouth by writing another article recently about why this index could head upwards and very sharply upwards to a level of anywhere from 26000 to 31000 between now and July 2012.

One of the key things that you have to remember about India is you have an economy growing on average over the last 31 years at 6.2% per annum in real terms. It has slowed down as we have all been reading about in the last four quarters, but we still believe a number of 6.5% per annum on an annual basis compounded over the long run is very possible in India and in fact probably very likely in India and with that, we have got companies growing their earnings.

Earnings are the key for long-term investors in stock markets. Long-term earnings will drive this market and FII flows will price it everyday. So if you are a long-term investor, you are buying the beauty of India's GDP, the solidity of India's corporate earnings. However, you are worried about what the FIIs are going to do on every second, every five minute stand as you look at screens from around the world because there is no powerful domestic mutual fund industry to counter the buying and selling off the FIIs. So, unfortunately, the price of the Indian stock market will be set by the FII flows.

If you look at the macro story, India still remains one of the best macro stories in the world. Everyone is so focussed on inflation that they forget about the fact that there is real growth and real corporate earnings without hyperinflation, which is what you could be seeing in the US. In the US, you have got the Dow at 12000. It has come very sharply of the lows of 8000. The Dow could be 40000 for all we know, but then the US dollar will be collapsing at the same time. India does not have a collapsing currency, and it has strong corporate earnings. So I love the Indian macro story a lot.

Why do you like financial stocks at a time when the cost of capital is moving up and the capex in general for the country could potentially slow down?

Most of the financials tend to readjust pretty quickly to their cost of raw material. They are able to re-price it and pass it onto consumers. That may bring down the slower sort of demand for money the way you put it in terms of capex investments or on the consumer side for home loans, but you can expect a 17-25% increase in credit and in that sense profit margins in most of these companies going forward for the long term. We do not focus on what happens on a quarterly or a monthly basis to interest rates.

Going back in history between 1996 and 2000, real rates of interest in India were extremely high, about 350-400 basis points. If you take the nominal rate of interest minus the inflation, India has lived in situations where the real rate of borrowing for companies and for consumers has been very high and our GDP has not slowed down and the demand for credit overall has not slowed down.

Yes, there have been some marginal people who could not afford the higher interest rates and they will fall off from the demand curve, but you have got a long-term approach in India in terms of investing. Again we look beyond what's going to happen in one month or one quarter. We believe that companies can re-price effectively their selling price of the loans to the market and the market can absorb it.

Quantum AMC is a value/growth-oriented AMC, but the stock you own there is HDFC Bank, which is actually Asia's most expensive bank and it is trading at a price-to-book of about four times. Where is value in HDFC Bank and why is HDFC Bank your largest holding?

There is HDFC and HDFC Bank, both at the upper end of what we would call a valuation criteria for starting to trim it and starting to sell it. When we talk to the portfolio managers at Quantum long-term equity fund, that's probably one of the stocks that gets debated the most in terms of the valuation criteria which we have for these stocks, but they are clearly at the top end of their range. We see some upside, but not dramatically more upside in terms of where those stocks could go.

Having said that, you have got a certain quality of management within HDFC, which we like and you have got a certain quality of management within key elements of HDFC Bank, which we also like. They tend to be a lot more conservative than, for example, ICICI Bank has been in the past. So you are also paying for the quality of management and the ability of the management to navigate through difficult times.

We do not run the banks, they run the banks. So when we take investors' money, we have to find the metrics which give us trust in the managements that we invest in. If you look at ICICI Bank, it grew very aggressively in 2006-2007 and went for market share in a big way and that hurt its asset quality.

SBI, which we actually do own, had a recent cleanup, if you will, of its fast aggressive growth over the last year-and-a-half or two. You do end up in situations where certain managements tend to get carried away. We believe that HDFC and HDFC Bank are those managements which do not get carried away and we are willing to pay a bit of a premium for those quality managements.

As my ex-colleague told me way back, 'value like beauty lies in the eyes of the beholder' and we see a lot of value. We have seen a lot of value in HDFC, HDFC Bank, but currently of course they are moving towards what we would call the 'sell criteria' as opposed to the 'buy criteria'.

Are valuations looking attractive for some of these mid-cap names and is it time to cherry pick when it comes to the mid caps because valuations there for some of the companies are looking more attractive than the large caps?

You have to cherry pick across all market caps,large, mid-cap or small, and the reason I am smiling about mid cap and small cap is because whenever liquidity flows tend to be positive, people again highlight the great opportunity, which is there. And I am sure it is there in small cap and mid cap.

But look at the indices, look at how the small cap and mid-cap indices have performed since a recent peak of November 2010 and see how they performed in the 2007-2008 cycle. Basically you throw money at mid caps and small caps. They tend to be less liquid. So by throwing money at them, their share prices go up. When people get nervous, they take the money out, and the share price goes down.

Yes, there are some great managements, I am sure, in the small cap, mid-cap space. We have not found a process to consistently identify those. Which is why we do not have a small cap, mid-cap fund. So on the Quantum long-term equity fund, we are kind of multi-cap, I guess, what we are classified as.

We have some very small cap stocks, we have some very large-cap stocks, but the one common theme, which we spoke about before, is that it is value and their very good managements. If you can find the same thing in the mid-cap, small cap space, value and good management, sure, please go ahead and buy them, but so far, we are a little nervous about this mid-cap, small cap space in general.

I would like to complement you for your call on HUL. When you picked it up, it looked expensive, a dead stock. But HUL call has worked very well for you. What is the way forward for FMCG in general and then HUL?

The long-term consumption story still remains good for India as it does for many products, including consumer staple. One of the problems with HUL over the last decade has been that they had been nibbled at by competition.

So you had Nirma's originally, then you have other people who have come in to hit the shampoo market or the soap market etc. It is big company and people come and nibble at certain portions of it. We have not been particularly enthralled with the way HUL worldwide has reacted to this product competition, but at the same time it is a good company.

It has stable research going on which will allow it to come out with better product, improved packaging in the future. We are not sure where exactly the water business will end up. It is a small part of the business locally in India, but we all know the demand for clean water is quite high. We like HUL, good management, a bit slow I would say in some sense, but in general it passed our test of value criteria. So we own it.

FMCG as a sector is great, but you should be careful. There will be more and more competition, and margins in general could be under pressure. But I will clarify that by one thing which is if commodity prices start to fall, then the pricing power goes back in the hands of FMCGs.

Cost of raw materials comes down and the operating margins will actually widen and I do not think many people in the market have actually factored that in. Not only for FMCG, but for corporate India as a whole, if all this inflation fear that we are talking about rolls over or kind of flattens out or starts to decline, then operating margins could expand substantially more than what people expect.

If I look at your portfolio, there is a big position change there. TCS is out completely, Infosys has come back and you are currently underweight on IT...

TCS is not out completely. I will have to check that. We are underweight IT relative to what has happened in the index. We liked IT a long time ago. We were actually buying it post Lehman. We were buying more TCS and also buying more Infosys.

We still like IT, but like HDFC I guess TCS and Infosys are also getting to an extent where the prices, even though they have corrected a bit recently, are not cheap buys any more. They certainly are more on the expensive range, though they are not yet at the sell out range.

What are the pockets that you would completely stay away from and would infrastructure be one such case in point?

One of our criteria is transparency of the businesses which the companies are involved in and there is no transparency in real estate. There is little transparency in the infrastructure space. So until there is more transparency in those sectors by and large, a direct investment by us is not likely to happen. We discussed DLF at length in February-March 2009. We like the valuation. The stock had come down and of course it is double since then, but we do not mind missing a double of a stock.

If we still have not got a feel of the management and the business, we rather be saved by being careful than get whacked on our face by making a mistake and misjudging management and the way the entire sectors are run in this country.

So we like infrastructure as a theme. We think real estate is a great theme, but we have not really found any transparent way of or any sort of ways of buying businesses that are run on very transparent ways in India as yet.

How are you planning to differentiate Quantum AMC from the industry and which are the concentrated bets where you are convinced that it makes sense to be a buyer?

From the business perspective and that is what the question is of the AMC, we have not paid distributors any commission over the last five years and few months that have been in businesses largely because again there is no transparency in the system.

I do not think we will change the way that we run our business. We love to work with people, we can pay them and we do not mind paying them as long as they disclose to their clients, to their investor base what they are getting from us. If they do that, then we will be very happy to work with all the banking channels out there and all the distributors out there. So until the system changes, I do not think we are going to change.

The other thing is in terms of where we see in the portfolio, we are bottom up stock pickers. We do not wake up in the morning and say we like FMCG or we like infrastructure, let us go and look for stocks in that space. We look at separate companies, try to understand the managements, the businesses and then we buy the stocks and build up a portfolio bottom up.

We would not get frightened if we are excessively underweight in IT or excessively overweight on the consumer discretionary. If I look at that, all I can tell you is that we will continue looking for managements we trust for those businesses that we think have great opportunities in the future and where the stock price for whatever reason gives us a buying opportunity for the long term. We do not understand one week, one month, one quarter, even one year movements in what happens in shares. We like to buy shares with a long haul.

You have a 9.6% exposure to Reliance. What is the expectation from the AGM today?

We do not have any exposure to Reliance in Quantum long-term equity fund. We have not owned a Reliance stock for years, multi-multi years and that probably is not going to change based on what I said on management transparency in the long time. But we probably own it in the ETF. We have got a Nifty index. So we have to track the index, but we do not own any Reliance share in any of our actively-managed things, tax funds and the long term equity funds.

Do you like commodities or they are too cyclical for you?

We had been buying cement stocks, strangely enough, I would add over the last few quarters. When you talk to the portfolio managers at Quantum long term equity fund, we have the discussions on the investment committees, at the board level. They show us the valuation matrix that is coming up in cement stocks. Everyone is nervous that there is an over supply and but there is an over supply in an industry there tends to be less capacity addition.

So for the next one-and-a-half years, cement may not be good, but if there is no capacity addition for the next 18 months and demand continues to grow at 6%-8%-10% per annum, 1.3 times, 1.2 times India's GDP growth rate on average, then you will find in the next 18 to 24 months there will again be a shortage. Then the earnings power of cement companies will be good and they will be able to raise their prices. Then they will make profits and then everyone will kind of jump into the stocks. So, tend to look very long term. We identify the catalyst and in material we have liked cement the most so far.

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