After the recent troubles, it is important to be selective in the NBFC space and focus on businesses that have a genuine competitive advantage, Harshad Patwardhan CIO,Equity, Edelweiss Asset Management tells ET Wealth. Are you treading with caution amid the selloff or is this a time to be aggressive? This year has been tough for investors and fund managers alike. Compared to 2017, which was an unusually unidirectional year, this year has been quite volatile. The sell off that we experienced—first in mid-and small-cap stocks and recently in largecaps— was driven largely by non-discretionary selling and the resultant panic and fear. If you were to analyse what caused these price changes in terms of contribution from earnings versus valuation, you will find that valuation de-rating rather than earnings deterioration has been a dominant factor impacting equity prices.
This is not just true for large-cap stocks. Analysis of mid-cap and even small stocks will yield similar results. This means that liquidity driven valuation de-rating and not deteriorating fundamentals is the main cause behind the sell off. In the Sensex and Nifty universe, earnings growth over the past 10 years—from 2007-08 to 2017-18—has been barely 5-6% annualised. We expect a pick-up in EPS (earnings per share) growth trajectory as nominal GDP accelerates. Hence, our outlook on equities is positive over the medium to long term. Moreover, lower valuations post the recent correction has strengthened that case further. While looking at valuations we should keep in mind where we are in the growth cycle. A look at the Nifty ROE over the past 15 years will tell you that we are likely at the beginning of an upcycle. While our market outlook is constructive, given the political uncertainty, we would advise investors to spread out their investments. We expect the trend of aggregate earnings downgrades to taper going forward. There are many businesses that are experiencing earnings upgrades as the nominal GDP accelerates. While there are some EPS downgrades at the aggregate level, EPS growth over the next few years will still be significantly superior compared to the last several years. Is the reprieve from high oil prices a boost for weakening macros? The steep correction in oil prices has come as a huge positive for Indian macro. However, it is important to see where oil prices settle. Nevertheless, compared to a few weeks ago, things should be a lot better. What sectors or themes make for a good investment proposition now? We believe consumer discretionary will continue to be a structural investment theme for the medium to long-term. We expect industrials to start getting attractive as there are early signs of private capex pick up. This trend, however, might strengthen only after the 2019 elections. We continue to be positive on private sector banks. After the recent troubles in NBFCs, what is the right play in the financial services space? In the NBFC space, previous assumptions of profitability and growth trajectory need to be revisited. The future is unlikely to be as good as the recent past at least in this cycle. One should exercise caution while investing fundamenhere. It is tempting to conclude that after the correction, NBFC stocks are now available at low valuations. However, as future prospects have deteriorated, this line of thinking is misleading. It is a good idea to stay on the sidelines to see how things settle over the next few months both in terms of operating environment and valuations. It is important to be selective in the NBFC space and focus on businesses that have a genuine competitive advantage. There are certain segments where a few NBFCs have a proven track record and developed expertise which others have found difficult to replicate. As the dust settles, some of these NBFCs will emerge stronger. The turmoil in the NBFC space might benefit banks with strong liability franchise and adequate capital. Competitive intensity in certain segments will reduce as NBFCs grapple with a pressure to slow down growth and also face higher incremental costs. In this environment, stronger banks will be able to grow faster either by buying asset pools from the beleaguered NBFCs on favourable terms or just by being more competitive. Stronger banks will experience faster growth. Is the mid-cap space still not ripe enough from the risk-reward perspective? A larger part of the decline in mid-cap stock prices can be attributed to valuation correction rather than earnings deterioration. So, mid-caps are a lot cheaper now than before. From a historical perspective, 2018 is turning out to be the worst year on record in terms of relative performance of mid-caps versus large-caps. From the 17 years of relative performance data available for the Sensex and Nifty Midcap 100, it is clear that more often than not the mid-cap index has outperformed the large-cap index. The mid-cap index has delivered superior performance in 11 out of 17, 10 out of 15 and seven out of last 10 years. The worst year on record for midcaps versus large-caps was 2016, when the mid-cap index under-performed the largecap index by 18 percentage points. In 2018, the mid-cap index has under-performed the large-cap index by 22 percentage points. We find the risk-reward equation in mid-caps compared to large-caps getting attractive.