Enter Nifty at current levels from 3-5 years’ perspective: IIFL Wealth

‘The biggest driver for economic recovery will be demand revival and consumption’

Over the next three to six months, consolidation will be the key, says Karan Bhagat, managing director.

You sound fairly confident that this is the time to tap into opportunities where we are seeing lower valuations and build one's portfolio. But how confident are you that this recovery will come through and that we will see concrete signs of economic revival over the next couple of quarters?

It is certainly impossible to say the exact time when the recovery will happen. But it is fair to say that the recovery will happen. As we have seen in the US markets, eventually valuations will play out and at 9,000-9,100 on Nifty, I think we are relatively valued at close to around 16.5-17-17.5 times, which is close to the lower end of the valuation range and we are also close to 2.3-2.4 times Nifty on the book value multiple. For a long-term investor, these are definitely levels you can come in at. Are these the lowest levels you can come in at? It is extremely difficult to decide that. I think markets can head lower but over the next three to five years, if you enter at these levels, there is definitely money to be made.

However, these definitely may not be the lowest levels possible. In terms of economic recovery, I think it is too early to decide. The biggest driver for economic recovery will be demand revival and consumption. These are two things for which we will have to wait and see how they play out over the next 60 to 90 days specifically. Businesses which are obviously dependent on local demand and consumption are the ones which are most likely to rebound first.

Do you think the market is becoming increasingly polarised? When it comes to the broader markets, there is still a lot of uncertainty. What is the strategy that you are taking when you are looking at a bottom-up approach?
There are two or three things. I think the big will become bigger. Over the next three to six months, consolidation will be the key. It is extremely important while picking stocks or picking mutual funds that you are extremely cognisant of the fact that these are times which are not extremely well-understood by anybody and therefore by investing in larger companies or the top five or ten companies in every sector, you definitely got a higher chance of success. It is also possible over the next 12 to 18 months as things recover, the bigger boys will end up with a much larger market share. It is also happening as we have seen in the case of a lot of NBFCs and banks that the quantum of capital available and the cost at which the capital is available are both extremely different for small to mid-sized NBFCs as compared to mid- to large-sized NBFCs.

Obviously the raw material availability itself is at such polarised levels that effectively at some point or the other it will reflect in the stock price. Polarisation between sectors where capital is not a requirement to do business and polarisation where the size of the business or the parentage is allowing easier access to raw material will result in consolidation. Therefore, you will see money chase these businesses much more than going after smaller businesses.

What are HNI investors doing? Are they using the decline to increase allocation to equities or are they of the view that right now it is time to hold back?
It is fair to say that high net worth individuals are feeling a little nervous even about fixed income over the last 1.5-2 years, which is not only driven by the Templeton episode but also the IL&FS episode. Credit funds in specific have underperformed the market and ended up with returns of 3.5% to 4%. While it is true for credit funds, it is not necessarily true for the rest of the AAA funds and the sovereign market. Most of our clients would have close to 75% to 80%, if not 85% of their fixed income allocation, in AAA and sovereign paper. The stress there has actually been very little. In fact, over the last six to eight weeks, the interest compression in these papers has been substantial. Obviously there was a systemic problem in the form of asset-liability mismatch in credit funds with a larger number of investors going to redeem and mutual funds were unable to liquidate those papers to facilitate the redemption. Investors are a little cagey. They will end up flocking a little more to tax-free bonds; more specifically to AAA quasi sovereign bonds and sovereign funds. For example, Bharat Bond ETF, papers like HDB, HDFC bonds and some selective fixed deposits and tax-free bonds at around 4.7-4.8% will continue to be the flavour of the day.

From an allocation perspective, investors have over many years evolved and become extremely smart in their allocation. Broadly, it is fair to say that it seems as if 8,500 to 8,700 to about 10,000-10,200 is the new normal; either south of 8,500 or 8,700 or north of 10,200. You will really see a lot of our clients either coming back into equities at below 8500 or 8700 or if for any reason, the markets were to shoot up in the short term to 10,500. Without similar recovery in demand, you would end up seeing them lighten their position.

If someone has to make an asset allocation for six months, three years and five years, what do you think would be the ideal allocation and the ideal mix?
It is really difficult to make an allocation for six months, three years or five years. Most of our clients have the allocation divided into two parts; one is essentially what we call strategic allocation and the other is the tactical allocation. The strategic allocations are obviously driven by longer term needs, traits, behavioural aspects, ability to manage volatility and so on. Most of our clients today would be 60% in fixed income, 32-35% in equities and potentially 5% to 10% in a combination of real estate, gold and currency.

The way the tactical adjustment in asset allocation essentially happens is a function of the movement outside the normal range of valuations. For example, on the equity side, as you see the valuations stretch below 17 times or 20 times, we may potentially come down from 30-35% all the way to 20% or go up to 50%. As we speak today, we would be invested close to about 35% into equities, 60% in fixed income and 5% in real estate and as I said earlier, if Nifty was to drift further below 8,500 from here on, then progressively keep adding to equities till we reach 50%. If it goes beyond 10,200, we keep reducing equities till it progressively reaches down to 20%.

On the fixed income side, the largest split is essentially more in terms of credit quality. Credit quality essentially would imply a split between AAA quasi sovereign and sovereign and other credits. That is really where the split in asset allocation comes in. We strongly encourage clients to have at least 80% to 90% of their fixed income allocation in the first bucket, which is AAA quasi sovereign and sovereign and fixed deposits included and 10% effectively in everything else which would include AA and some structural credit.

Do you feel there is going to be capital destruction within the HNI community and that could have an impact on both the fixed income as well as equity inflows?
No, I would not go to the extent of calling it capital destruction but there will be multiple demands on an individual savings. One has got three things to think about today and therefore would plan very differently. One, he has to plan for a scenario where businesses and demand takes much longer to recover and therefore he may need to infuse capital into the business at different points in time. Second obviously he has got a demand for potentially saying that there might be very large opportunities which might come out on account of dislocations in the market over the next 12 to 15 months. And thirdly and most importantly, he wants to keep aside a pool of capital which represents a safe bucket given the hard work and the quantum of efforts he has made over the last 25-30 years building his businesses.

I think what is happening is we are still not seeing capital destruction but individuals want to be safe. They want to conserve capital and most importantly split their capital allocation into these three buckets and play out a scenario in their minds that if things were to not improve substantially or get delayed, they have enough capital to provide for these three buckets.

What are you telling your clients when it comes to financials? How should they be approaching it as it was an over-owned space?
Post IL&FS, there were a lot of concerns on the liability side for all financials. The entire commercial paper market in some sense post the IL&FS episode has got decimated, especially smaller NBFCs and therefore resulted in a much higher cost of borrowing as the liability side has moved away from borrowing from mutual funds and banks and potentially raising debentures from individuals and other institutions. What we are facing today is a very confused estimate on what is the problem on the asset side. Obviously there are NBFCs which are more on the secure side of lending but there are other sets of NBFCs which have a large amount of exposure to SMEs, real estate and today it is extremely difficult to accurately estimate the probability of loss in some of these sectors.

When you look at your balance sheet, you have got a twin problem with a certain set of challenges on the liability side and potentially a much larger challenge on the asset side. Therefore, it is intelligent and to a small extent sensible to ensure that balance sheets are extremely well-capitalised. The problem really is in small and in some cases even in the medium to large financials. Obviously, Kotak Bank, Axis Bank and some of the names you have mentioned continue to be fairly well valued relatively. Obviously they are less valued than what they were three to four months back but they are still quoting potentially at a two and a half-three times multiple to book in the case of Kotak and gives the bank the ability to raise capital even in today’s environments.