Long term, India going to attract lots of inflows as margins will improve: R Sukumar Rajah, Franklin Templeton Investments

In an exclusive interview with Nikunj Dalmia of ET Now, R Sukumar Rajah, MD & CIO, Asian Equities, Local AM, Franklin Templeton Investments, says sees a lot of positives and a lot of value in emerging markets.

Edited excerpts


We are staring at interesting times. Both locally and globally things have got reset. What do you think could be implications of a Trump victory on emerging markets?

Yes things have changed quite a bit. The Trump agenda is quite different from the current establishment in the US. Trump is a very different type of a person and he has made certain election promises but clearly all of them are not deliverable. He has to focus on a few things and there are still no clarity on exactly how he is going to go about focussing on some of the agenda items.

On trade, there is a lot of nervousness because he has taken a very anti-trade stance during the elections and also some of the appointments are considered to be hardline people. So there is going to be a little bit of volatility in the sentiment as more noise is going to be generated on trade and consequently some of the emerging markets which are exporting substantially to the US might get impacted in terms of sentiment. But we do not think that this issue is going to be longer lasting because a lot of products that are produced in emerging markets cannot be economically produced in (developed countries like the US. So, we do not expect large scale shift of the manufacturing base from some of the emerging markets into the developed countries. Nevertheless when there is going to be a lot of talk, there is going to be some nervousness which is going to increase the volatility of the market, so I think that is one.

The second is, of course, the fact that China related issues have been postponed but the solution has not yet been found. So the imbalances in China continue and at some point of time, they have to deal with that and that could also create certain amount of volatility in emerging markets and especially on commodities.

The commodities have rebounded but we have not probably seen the last word spoken on that subject and I think there can be some more challenges in 2017 if China is going to scale down on the property sector and investments in some of the infrastructure sector as well. So all in all, there are some positive factors like for example the emerging markets margins having stabilised. We are seeing quite a few upgrades in terms of earnings and the companies are generally pretty resilient. Valuations are extremely supportive. So we see a lot of positives and we see a lot of value in emerging markets.

However, I think the news flow particularly in the US, China and potentially in EU in terms of elections, can cause further volatility in emerging markets. But we think that every dip is going to be a buying opportunity because of compelling value that is available today.

Post 2008, central bankers have been following a loose monetary policy, growth numbers in the developed world are not strong and the de facto global money has moved into emerging markets. If indeed the US economy has to make a comeback, do you think you may see serious outflows in emerging markets because emerging markets are struggling, each emerging market has its own challenge and frankly emerging markets have not also given very mouth-watering returns for global investors in the last couple of years?

We have seen flows out of emerging markets in the last few years and clearly emerging markets have underperformed the developed world. While the margins in some of the developed countries, particularly in US are pretty high compared to the historical highs, the margins in the developing countries, the emerging markets are pretty low compared to the long-term average. We think that can improve. So in terms of earnings growth potential, emerging markets potential is much better. On top of it, the valuations discount is also pretty high compared to the developed world. So all these things make us believe that while there might be some volatility in emerging markets, they present compelling value and should outperform in the medium term.

Within the emerging markets if I look at the India appeal, India’s classification has been premium and India’s economy currency promises a better future ahead. But despite the underlying big picture argument, India is underperforming emerging markets. Why is that happening and if this continues to happen, will that create more pressure in terms of India allocation and do you think outflows will start because we have seen massive outflows already in the month of November?

We do not believe that is going to be a longer term issue though some very short term point of view, some outflows are possible. We did see India underperform mainly because India had outperformed earlier and some of the other stocks in other emerging markets were beaten down to pulp and when people realised that things are not deteriorating and many of these stocks are extremely cheap and undervalued, there has been some money flowing into some of those names and also there were some factors in countries like Korea like improvement in corporate governance or potential improvement in the restructuring of the Chaebols and so on. These factors also aided some of the companies in those markets. But from a longer term point of view, India is pretty well positioned because apart from structurally higher growth opportunity, there is also going to be a margin improvement story because margins are pretty low compared to long-term average.
We have seen the margin sort of stabilise and we could have seen some improvement but there have been some local factors which have also postponed the improvement but we do not have any doubts about the potential for improvement over a period of time and we think India will continue to be a market which will attract a lot of inflows though there might be outflows from a very short term point of view.

What is the right way of assessing the demonetisation impact because we can argue the event adjustment both ways? In the short term, economy will get jammed. In the long term, this is positive. But from market standpoint, from an economic standpoint, do you think it is very difficult to decipher the real assessment or the real impact?

Yes I think there are too many moving parts. So I think it is right to assume that in this quarter the growth will be severely impacted because of the lack of cash. Lot of economic activities had slowed down or come to a stand still for a brief period of time. But beyond that, it is very difficult to say what will happen. There will be classes of people who will also benefit from this, especially the lower and middle income catrgories and they might actually increase their consumption whereas lot of products that were bought by people who had a lot of black money like jewellery or some of the luxury goods or luxury automobiles and to some extent high-ticket real estate, might get negatively impacted. So there is going to be some categories which are going to see improved growth and some categories which are going to contract. It is very difficult to take a uniform view on all categories and how they will play out and the timeframe again it is quite difficult to predict at this point of time.

After two reboots, the Trump reboot which is global in nature and the demonetisation impact which is largely local in nature, what will happen to your portfolio positioning because the world will change and the environment will change. So are you looking at reassessing some of your key positioning?

Thanks to the robustness of our investment process, we do not have to do that because when we buy a stock, we are looking at the quality and sustainability aspects of the companies that we buy in. We do not have much of ownership of companies where I think the prospects will change because of the change in the environment. We are looking at buying companies which offer product and services which are very competitive from the customers’ point of view and there is a room to keep growing for a long period of time. So among our portfolio companies, we do not see their long-term business getting affected.

Of course, on one quarter basis, many of these businesses might get affected but that does not warrant change in the portfolio. So we are pretty happy with the robustness of our holdings.

What is your assessment of the banking sector? Interest rates may be coming down but lending activity is still under pressure and most of the banks, at least the retail ones fear that because of demonetisation there could be uptick in collections and NPAs.

When we are buying Indian banks, the current year’s earnings is a very small proportion of the total value or the price that we are paying for the banks. So bulk of it is in the longer term earnings or value creation and that story has got much better. If the black economy is going to reduce by whatever percentage, some could argue it is going to be 20%, some would argue it is 40%, some would argue it is only 10%. But whatever it reduces by, it is going to improve the economics of the banks because most of the money is going to go into the banks rather than be kept as cash and that improves the opportunities for the banks to create value.

The banks that we are holding are pretty dynamic and with the changing landscape, their managements are well equipped to get a higher share of the incremental business that will come because of the changes in the system. And we think it will only improve their longer term value preposition and so while it is very difficult to put exact number to that, but clearly I think the direction is very favourable.

What is your view on IT? You talked about durability and sustainability. Now IT companies are good, well-run companies but the environment is changing. The IT business per se is contracting and there is every reason to believe that in the short term because of the change of IT service offering, the pain is here to stay. So do you now worry about Indian IT sector per se in terms of longevity?

Our job is not to worry. Our job is to make right assessment of the situation and I think we have discussed in many of your programmes earlier over the last three to five years and our view has consistently been that the market is trying to extrapolate the past into the future and our view has been that the rates at which these companies were growing were not sustainable and also there could be margin pressures over a period of time.

The arguments we have been making over the last three to five years is that the market share of Indian companies has gone up within the total outsourcing market and the total outsourcing market itself has increased in proportion to total IT spending because of which our growth will gradually converts, the growth of our IT companies would converge towards growth in total IT spending over a period of time. Those types of projections have already been factored into our target prices. What has happened in the recent past is very much consistent with our modelling of how the growth and margins will trend. We have not had too many ugly surprises. In general, our weights has been lower compared to the benchmark and many of our peers and the reason for that is not because we did not have trust in the IT companies. It is just that how we model growth and margins. It is quite different from how the market has been doing so.

Let me throw in the good part here and good part here is that Government of India’s balance sheet will improve, interest rates will come down and inflation in a sense which was largely a function of a combination of parallel economy and the real economy is going to see a reset. Now these are big structural changes which will happen in India post independence. So from market standpoint, how should one capitalise on these mega trends?

I think one way is to have a higher weight to equities because clearly I think if the interest rates are going to come down and also equity risk premium comes down and the margins expand, the stocks have will have multiple levers to generate good returns for their shareholders. So clearly that is one way of looking at it.

Second is – in India, it is very difficult to generate good real returns out of lower risk categories perpetually because there is going to be more risk appetite and the low risk categories are not going to generate very good long term returns. So, people have to look at other areas of investing other than the traditional investments like bank deposits.

What is your understanding of domestic flows? The good part of this market has been that whereas foreign institutional investors have been selling and they have been trimming their exposure because of ETFs and other compulsions, domestic institution investors have been firm like rock. In this market decline, were you a buyer and do you think there is enough and more visibility about flows for next couple of quarters?

I cannot speak for the domestic institutions as a whole but conceptually, it is like this. In the equity mutual funds, there is not much of cash. So the buying and selling depends on whether the flows are going to be there from the underlying investors and so far, the flows have generally been positive though it is varied from time to time and we have reason to believe. It will continue to be positive because the penetration of equity products is so low. It has a lot of room for improvement and more investors are better educated and are putting money on a period basis into equity products.

So with flows into equity funds, the mutual fund should invest more into the market and obviously, the job of the portfolio managers to look at what are the best stocks to buy and very few of them within Franklin Templeton and definitely none and even outside, there are very few people who are actually timing the market.

What I have always admired about you over the years is your ability to pick up big profit pools and your ability to look at these big profit pools which are sustainable in five, ten, fifteen years. You have identified the IT sector in the ’90s. You have identified private banks also right ahead of the curve. So if you have to identify a multi-year, multi-decade opportunity from stock market stand point, where you think great companies will be born and those companies will be able to scale up and the profit pools are large, what would be that as five, six, seven year opportunity?

Because of the transformation of the economy, some of the sectors, untouchable earlier, are becoming touchable. Otherwise, some sections of the economy where black money dealing was very high, the companies in these sectors were less transparent with more corporate governance challenges. If those types of sectors are available for clean businesses, then that could be an opportunity that we have to look at, that is one.

Second is, of course, there are new business models emerging because of change in technology in e-commerce and payments and a number of other areas. That would be one driver of some companies to or some business models to outperform substantially compared to others. Of course, the other theme is the growth in middle class population is going to be one of the fastest for the next 15 to 20 years. We are going to add many more people into middle class over the next 10 years and we need to look into where the new middle class is going to spend the money and which categories are going to benefit.

These categories can see structural improvement in their growth and their growth is not going to go to all the players. There are certain players who are going to be better equipped and so we are looking at all those things. We cannot speak about the names because we can only speak about the names where we are already invested and they are top holdings in our funds.

Do you think 2017 would be marked with a lot of volatility because lot of resets will happen, the demonetisation impact, Trump will officially take over and then you will somewhere see the GST adjustment in the economy. So rather than being optimistic, is it better to remain cautious at least for a year or so because you do not know which way the winds are going to blow?

So for making such decisions, what I would look at is what is the implied equity risk premium. If the implied equity risk premium is pretty high, it gives us comfort that many of these uncertainties have already been factored in by the market and so we are buying stocks with a good margin of safety. Looking at the current data, we believe that there is a lot of margin of safety and my view is that people are better off with stocks with all the uncertainty and will regret if they do not have adequate equity exposure because when some of these uncertainties lift, the rebound will be so strong that it will be very difficult for a lot of people to get in at the right time.