Interview with Fund Manager, PGIM India Mutual Fund

Q) What is your take on the current valuation of the Indian equity market?

Nifty is trading at a one-year forward P/E ratio of 21x – a 25% premium to 10 year median of 16.8x. 

These are close to life high valuations. However, it must also be seen in the context of valuations of the alternative asset class. G-Sec 1 year yields are at 4.32% - which converts into a P/E ratio of 23x. Hence, although equity valuations are expensive compared to historical averages, yet they are cheaper than bond valuations. Historically, markets have sustained buoyancy when their valuations were lower than bond valuations.

With rates looking set to rise in 2022, there is limited scope for valuations to expand from here. Hence, the bulk of market returns are likely to be earnings led.

Q) Which are the market pockets where you still find value and where do you see stretch valuation?    

Select Industrials, most of PSU names in Energy and Banks, Large Banks, Power, Materials, Auto are areas which are offering reasonable growth-valuation matrix.

Select names Consumer, Retail Energy, Power, Finance are trading at valuations which is significantly above their own historical valuations and also much higher than peer valuation, even after considering the growth offered by them. 

Q) What is your take on passively managed funds in India? Do you see passively managed funds outperforming actively managed funds?

While passive investing has its own benefits, especially with respect to investing in baskets of stocks not offered directly by actively managed funds.

We live in a country where the first insurance business got listed less than 5 years ago, several industry leaders in various sectors are either not listed yet or have very little representation in the frontline indices. Speciality Chemicals, Construction, Agrochemicals, Auto Ancillaries, Clean Energy, White Goods are a few of many sectors which have little representation in frontline indices. An active fund can invest in such leaders, whereas a passive fund cannot. Again, there are several examples of companies that were part of the frontline indices, but their financial earnings were falling and/or corporate governance issues were emerging. An active fund can easily avoid such companies, but a passive fund will remain invested in it.

Winners keep rotating. The late 90s belonged to the IT sector, the 2003-07 rally was all about infrastructure (and real estate), 2008 till now, the Consumption sector led the way along with Financials. Interestingly, Consumption + Financials was just 20% of frontline indices in end 2008 compared to Cyclicals (Infra + Capex heavy sectors) at ~64%. An active fund could have easily done the switch from capex heavy to Consumption + Financials, but passive is stuck with what’s there in the index.

Just the way an active fund manager needs to take positions away from the index to beat the index, even an investor needs to select a few right active funds if one wishes to beat the market for equity allocation as a whole. By definition, active funds attempt to beat the benchmark (they succeeded materially till 2017, last 2-3 years not being in their favour). However, passive funds do not even attempt to beat the benchmark, they seek to replicate them. You subtract the cost of the fund (although small), you are almost sure of an underperformance. A ~80% probability of beating the benchmark through active funds seems mathematically better than virtually 0% chance with a passive fund.

Q) How do see the interest rate movement in the year 2022 and do you see higher interest to dent equity valuation and hence returns? 

With inflation rates across several countries at multi-decade highs and corresponding interest rates at almost lifetime lows, there is a strong case for rate hikes and the same is being guided by leading central bankers as well. 

One of the key drivers of higher equity valuation in recent history had been the steady liquidity and low-interest rates. A potentially rising interest rate scenario does limit valuation expansion possibilities. However, earnings growth is coming back. India’s corporate earnings to GDP is close to 9-year highs. Hence, the bulk of returns in 2022 are likely to be driven by earnings growth rather than valuation expansion.

Q) Which factor or theme you are betting on? Is it growth, value, alpha, beta or any other factor that will play out in the year 2020? 

As a fund house, we look at companies offering growth at a reasonable price. Hence, it’s a combination of growth and value factors that we look at. It has been globally that over longer periods, growth as a factor has accounted for bulk of the returns.

Q) According to you what will be the impact of the budget on the mutual fund industry?  

 This year’s Budget was clearly supportive of growth and the lead was taken by the Government by increasing the on-balance sheet capex. Tax Revenues continue to be robust and the Corporate tax rate had been reduced earlier. A growth-supportive Budget is generally positive both for the market as well as Mutual Fund Industry.

Specific provisions like the capping of surcharge and tax on digital assets (potentially targeting crypto holdings) are likely to add to the competitive advantages of the mutual fund industry.

A double-digit estimate of nominal GDP growth with no major new tax, is likely to be positive for personal disposable incomes of individuals, thereby increasing the scope for flow into mutual funds.

Also read: Tax planning with top ELSS Funds