The Hindu Business Line : `It is better to have a calibrated growth than runaway growth'

Whether you don't take an exposure or you take a very large exposure, you are taking a risk by going against the market. Not taking an exposure is also a bet.

When Fidelity made its first foray into the Indian market in 2005, several market-watchers believed stock prices had already peaked at Sensex levels of 6000 and questioned the rationale for entering the market at that time. Fidelity has since proved nay-sayers wrong. In the two years since its launch, Fidelity Equity Fund has been among the top performing diversified equity funds despite rather challenging equity market conditions. The Rs 2,500-crore fund has a diversified portfolio of 70-80 stocks. Though the fund practises a bottom-up approach to stock selection, much of its success in generating returns appears to have stemmed from decisions to invest in sectors such as banking and media. In an interview with Business Line, Sandeep Kothari, Portfolio Manager (Indian Equity) of Fidelity International, shares his perspective on the stocks and sectors the fund has favoured over the past year.

Excerpts from the interview:

What is your earnings outlook for FY08? Will we see the impact of interest rates?

In some sectors we may see volume growth slow down — auto, banks in the form of mortgages and declines in the investment books. I don't think the interest rate spreads for banks will be under pressure as they have already raised interest rates. The volume growth has slowed down but the margins may be maintained in a tight band.

So there are certain sectors where you could see the impact of the interest rate rise. The belief is that it is still not going to be that severe because the underlying assumption is that the investment cycle is going to continue.

If we see any change over there, then the thesis will have to change. At this point, one does not see any significant change. There will be a hit, no doubt; the effect of interest rate hike is always with a 4-6 month lag. Will it be much worse? We will have to continuously monitor that. If investment cycle slows, then the impact on margins, earnings will be significant. Then we will go into that spiral of downgrade in earnings.

Will rising interest rates impact consumption?

We have seen the implications on auto sales. The government is trying to divert spending from leveraged consumption to investment. They are trying to maintain a tight balance. If they manage to pull it off, you are going to see a slowdown in consumption. But if investment is going to continue, then I think the India story would have much longer legs to run on.

It is better to have a calibrated growth than runaway growth. So if there is a pullback in consumption that is fine. But if investments pull back, then we can have a problem on hand. That's something we are monitoring very closely. Till now there has been no sign that there is any lag on investments. There is a lag in mortgages. Talk to the banks, they say there is a conscious slowdown over there.

If the investment cycle continues, however, then the implications for consumption may not be that bad, because there will be income growth. People will just postpone their consumption. We may use a car for seven years instead of six.

Quite a few Fidelity funds are heavy on banking stocks. What is your view on the sector, considering that earnings in the sector continue to come under pressure with every interest rate hike?

Interest rates are an important driver but there are other factors that drive certain stocks. Basically, the valuation, the under-penetration of the sector and the long- term growth prospects make the stocks attractive. Go by the Chinese example; one Chinese bank has a market capitalisation larger than the entire Indian banking sector put together.

The take on banking has been more of a valuation call. Our diversification within banking has played out well over the last 6-9 months, despite banking stocks being under tremendous pressure.

I don't miss out on the long-term growth opportunity that this sector has because inherently I am sure everyone will agree that the valuations and the long-term growth prospects for the sector are good. So, when the cyclical aspect looks better, one can increase exposure to the sector further. When it is not so good, one can be equal weight or slightly underweight relative to the benchmark on banking.

You can take a call not to invest at all, like we did on property stocks. In property, we took a call that we did not want exposure, because we did not understand the valuation although the long-term prospects are very good. That's a more aggressive approach. And it is the same thing whether you don't take an exposure or you take a very large exposure, you are taking a risk by going against the market. Not taking an exposure is also a bet.

Your portfolio has been low on construction stocks as well...

The valuations were running too high, given the basic fundamentals of the business. What is the return on capital employed for these businesses, where does the value lie? These companies have their value in their order book, which gives you 4-6 per cent net margins. There is no other asset. One order going wrong can set you back...

What is the multiple you want to pay for that kind of a business? That's when you take the call on the sector as well. You can stay away and enter when you are more comfortable, because that's the way the sector is. It is not like banking where the long- term secular story, despite the cyclicality, will play out.

In fact, if you look at the last three-year performance, if you draw PE (price-earnings multiple) bands for these stocks, they go up and then fall back to the 8-10 times one-year forward PE range, whatever the market consensus is, after you ex out the value of their BOT (build, operate, transfer) or the land. They constantly test that range. Probably the market is saying this is the way we should be thinking about valuations.

And probably that's why these construction companies are thinking of getting into property, BOT, diversifying their revenue stream, because per se construction cannot become more valuable.

So, then, you take a call on the management, where do you find comfort, do you find the land-bank attractive, their BOT attractive, etc.

Within the consumption space, you have been overweight on media. What is your view on the valuations in this sector and the developments in this space?

If you look at the characteristics of the business, it is a high ROE business. There are entry barriers. So markets tend to give a high multiple to these businesses globally.

Think about media in India. Media penetration is small. Now a number of industries, retail, insurance, financial services, telecom are just starting to spend. Previously, it was just FMCG that was capturing spending. So this is going to drive the ad-to-GDP ratio higher.

Within media we have built a portfolio that includes print media, where again there are high entry barriers. Newspapers are dying world over, but in India there is huge growth potential. Plus newsprint prices globally are at their highest; any decline can be a huge kicker to earnings for newspaper companies.

These are high-entry-barrier, cash-generating businesses. At this stage you do not see Internet killing the newspaper business in India. You can buy and hold these stocks for a long period of time.

Within media, my exposure to newspapers is higher. If you read Business Line you will read only that. The brand value is a lot more. You will have new media coming and how this space plays out will be interesting. It is a domestic consumption story.

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