Mid and small cap stocks frothy, large cap valuations comforting: Anish Tawakley of ICICI Prudential Mutual Fund

Anish Tawakley, Deputy CIO Equity & Head of Research, ICICI Prudential Mutual Fund
 
Q. After a long time, markets have hit record highs and surprisingly, even the smaller stocks have been participating in the rally. Does it feel different than the last time the markets hit a record high in December?
Before we go to the markets, the economic outlook matters. From an economic outlook perspective, things are looking reasonably positive. We should see a healthy recovery in cyclicals. I think a good cycle of house building is taking place backed by development of urban infrastructure.
 

So that gives me a reasonable, positive view about the economy. Also, I think the monetary policy is taking a very good approach of saying, ‘Inflation does not have to hit 4 percent immediately, but as long as it remains sub-6 percent, inflation is reasonable’. I think this approach supports growth. That's my view on the economy.
 
Now coming to valuations, our equity valuation model is suggesting that the markets are in a neutral zone. They are neither cheap nor expensive. When markets are cheap, it does not really matter how the economy does. On the other hand, when markets are expensive, it means that even if the economy does well, you will not get great returns. Currently, market valuations are in the neutral zone, which means if the economy does well, markets should deliver reasonable returns.
 
We are more comfortable with large cap valuations. We do think froth has built up in the small and mid cap space. People are getting very optimistic in the small and mid cap space around some relatively weak business models. 
 
Q. Are you optimistic about the rally now? Do you think it will continue?
For a longer-term perspective, multiples, at current levels, are reasonable. Going forward, market returns should follow earnings. Given that the view on economy is positive, I think the earnings outlook is also reasonably healthy.
 
Earnings follow the economy, and then the market returns come from either multiple expansion or from earnings growth. There is no third source. We think price-to-earnings (PE) is reasonable. So, instead of taking a view on PE expansion, I would rather take a view on earnings.
 
Q. Both December and March quarter earnings were lopsided, and most heavy lifting was done by two sectors—BFSI and auto. Is this trend healthy as earnings recovery is not broad-based?
When an economy recovers, it is the domestic cyclicals that do better than staples. It is a normal pattern that in a recovering economy, cyclical sectors see bigger earnings upside.
 
I have, for a while, held the view that in some of the sectors like FMCG, the problem is not the economy, but that these companies’ margins are too high, and their growth is slow because their margins are too high. They are not investing enough in new product development, marketing and generating consumer demand.
 
Demand does not come on its own. At the end of the day, the company has to invest. Somebody has to tell people, brushing two times a day is important. So, when you switch on YouTube videos at night, there should be an ad saying, ‘Have you and your children brushed twice?’ If you take up margins too high, then obviously you don't have the money to invest in that kind of demand stimulation. So, my view on FMCG is that the problem is not the economy, but margins for these companies are above where they are required for them to be making the investments in growth.

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Q. There is a wide divergence in urban and rural consumption demand. Your entire bet is on economic recovery which is dependent on consumption. Does it worry you with a delayed and erratic monsoon?
No, I don't fully agree with that. During Covid, when people migrated from urban to rural areas, I think some of that was a boost to rural consumption. People came back and the people who migrate are the earning members of the economy. So, to some extent I think rural weakness is explained by the earning members moving back to cities.
 
The impact of monsoon remains to be seen. But if the rest of the investment cycle sustains, like home building activity sustains, some of the cyclical sectors could do well. The excuse of weak rural demand is being overhyped by companies that are under-investing.  
 
Q. What about global economy-focussed companies or export-oriented companies like IT in context of fear of recession in Europe and in the US?
A: I do not believe there will be a recession in the US. Data shows that the US economy is very strong, labour market is booming and unemployment is at multi-decade lows. I expect the US economy to get stronger because it is healthy despite their house building activity right now being low. Going ahead, house building is likely to pick up. So, the US economy is not weakening, and the probability of recession looks very low.
 
Q. What is your stance on Indian IT companies?
IT demand is just normalising, after abnormally high demand post Covid. Those who had got too excited and extrapolated one year of very strong demand are being disappointed. There is no reason to panic, frankly.
 
Just a year later, India is getting into election mode, which brings a lot of uncertainties in terms of policies and an overall business environment. Is it going to shake a bit of the confidence that investors have in the markets? How are you going to approach the markets?
 
I will focus on policies. Fiscal and monetary policy should be countercyclical, which means that when the economy is weak, the government should spend. When the economy gains strength, the government spending should taper. Because when private sector is spending, then the public sector needs to spend less. My focus will be on policies.
 
If I find that the policies are fine and people are needlessly worried about elections, then it will be a chance to scale up the investment. If I find that fiscal policy is not appropriate for how the economy is positioned, I will adopt a different approach. 
 
Q. Your views on primary markets which have slowed down considerably?
Almost two years back, I found the IPO (initial public offering) market overheated. There is a disconnect in new-age companies with lots of them going public with no profits or big losses.
 
The market view was that these companies need to scale up to become profitable. Whereas when I looked at the numbers, I felt they needed to shrink to become profitable because they were already serving customers who were unlikely to be profitable customers. They had grown fast because the market was rewarding growth without concern for the economics. When the market does that, then obviously the managers will spend. Due to this, I stayed away from a lot of IPOs, which was not a difficult decision to make. I don't think that's changed.

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Q. How are you picking stocks as a fund manager? What are you doing for due diligence?
That is why there is a role for active fund management. If everything was clean, there would be no need for active fund managers. There are challenges when it comes to smaller companies. Generally, people go out looking for multi-baggers in these pockets. What they do not realise is that there is a lot of alpha to be created just by avoiding extremely difficult situations. This does not mean never taking any risks… but avoiding what can be avoided. 
 
Q. What kind of due diligence?
Actually, a lot of stuff is evident. Look at the balance sheet, promoter leverage, consider the risk both at the company and promoter level, and act accordingly. If you are worried about something, you might take a smaller position. A lot of it is risk management, both by deciding to avoid or by sizing the position appropriately.
 
The bluechip fund that you manage has completed 15 years. In these 15 years, markets have seen multiple cycles of highs and lows. As a fund manager, what has been your investing strategy?
 
The bluechip fund follows a bottom-up stock picking approach. The fund does not take very big sector skews, but within sectors, it picks stocks with the most promising outlook. It has a bar-bell approach to investing. This means we will buy cheap value stocks that are available at a discount to their intrinsic value which, over time, will mean revert. That’s playing for mean reversion.
 
Or at the other extreme, we buy companies that are about growth and quality. Such a company has to satisfy three conditions: Have a demonstrated track record of profitability, be a market leader and present compounding potential. What I will exclude is stuff which goes by the name of growth at a reasonable price.
 
My view is if I am paying for a company, I want it to be a market leader as market leaders have inherent advantages. Such a company will typically be large, have a robust balance sheet, has the advantage of scale economics etc. This approach has aided in avoiding a lot of mid-size, smaller banks that were once in vogue. We have steadily avoided buying the next big aspirational company—with business models that were work in process. Instead, we opted for leaders with strong competitive positions.