What is the best way to approach the current market scenario? Nilesh Shah answers

“So, on the whole, it has been a good time so far. In this year, probably for the first time, we are seeing some bit of chinks in the armour in terms of how the geopolitical equation now kind of changes or impacts macroeconomic stability, how crude oil behaves, impact on inflation, interest rates,” says Nilesh Shah, MD & CEO, Envision Capital.

It is not alarming, but it is getting sticky. Markets are hitting a pause button. Do you think we have done for the year in terms of a level, in terms of where market would settle at?
I would tend to think so that we have had a sharp kind of an up move over the last six to nine months and so, this calendar year. This financial year so far has been fantastic in terms of price moves, in terms of re-ratings and then that is got backed by strong earnings growth as well. So, on the whole, it has been a good time so far. In this year, probably for the first time, we are seeing some bit of chinks in the armour in terms of how the geopolitical equation now kind of changes or impacts macroeconomic stability, how crude oil behaves, impact on inflation, interest rates.

These are the kind of challenges which could come to the fore, which can create some kind of pause buttons. But I think barring issues around sentiment, I do not think that we have any other kind of risks that we need to worry too much about.

I think, yes, there has been a lot of talk about this whole geopolitical stuff. But if that were to have had an impact, I think it would have had an impact. It does not take kind of one week or two weeks for these kind of impacts. We have seen in 2022 the whole Russia-Ukraine stuff and earlier on there have been many-many geopolitical challenges the world has faced, that time the market’s reaction used to be very quick, very swift and impactful.

That is not the case so far. So, maybe right now, yes, there are initial signs of worry. But I do not think it is something that I would be too worried about on a very extended basis.

What, to your mind, could be the biggest moving part? Could it be interest rates? Could it be the dollar index or could it be crude once again?
I believe that of the three that you mentioned, clearly crude is the one which has multiple kind of impact. Crude obviously has impact from fuel prices, consumer inflation, interest rates, trade deficit, balance of payment issues and then the currency impact and which basically also prevents a lot of fence-sitters from basically putting money to work, especially international investors because that is one of the key monitorables that they have always tracked for India over not just the last few years, but over decades, so that has been an age-old kind of a variable which does move the needle, which does impact sentiment.

So, I probably think right now, it is going to be crude oil. And as long as we remain sub-100, I still think that is the kind of comfort zone. The moment we cross 100, it will start to tell in terms of sentiment, in terms of incremental flows, and eventually on margins of companies.

Why are private banks trading cheap? HDFC Bank, it is trading at valuations which are lower than what they were pre-COVID and pre-IL&FS, ditto for Kotak and I can also say for Bajaj Finance even though it is an NBFC. The growth is there. You have what we say sometimes a six by six visibility for next two or three quarters for this sector and for these names, yet markets are giving them a step motherly treatment.
I probably think it is more got to do with the growth differential. The banking sector, the lending space, credit plays, they are all kind of growing and growing really well. The challenge is that the big banks probably are growing at about 15-18% versus that the smaller banks, the specialised credit plays, some of the NBFCs, smaller NBFCs are growing at least at around 25%.

And in the process, they are continuing to hold on to asset quality. There has been improvement in asset quality and there has been some expansion of return on equity as well. So, market definitely gravitates wherever there is superior growth and we are seeing this not just for banking, we are seeing this for a whole bunch of sectors, including, say, for example, the IT sector where the large companies are not able to grow or are growing in low single digits versus that the midcaps, the smallcap companies are growing at a much faster pace or the tier II, tier III companies are growing at a much faster pace.

So, I clearly believe this is a phenomenon which we are seeing across sectors. It has obviously become more stark in the banking space versus other sectors but I clearly believe it is more to do with growth differential.

And as long as we continue to see growth differential coming in from tier II, tier III companies or smaller companies or mid-sized companies versus their largecap peers, I clearly believe that that will continue to get reflected in the stock price outperformance as well.

What is the best way to approach this market — raise cash because downside and better entry levels are coming or stay invested, but just prepare for a volatility? It will be volatility. There could be volatility, but no risk per se.
I do not think taking cash calls is going to help meaningfully or is going to help significantly. It may just be a more transient strategy. But clearly, the bottom line is that the Indian economy is essentially going to continue to be a star. It is going to continue to be an outlier in the global context.
Several businesses, several individual companies are performing extremely well. They continue to grow at a healthy pace. They remain capital efficient. And so clearly, the long-term bull market is intact.

Now, within that, trying to kind of tweak here and there with 5-10-15-20% allocation may not really help.
So, I would probably still say stay the course, stay invested, just that remain bottom-up focussed, do not just basically buy a stock because it is largecap or because it is smallcap.

I just think look at every individual idea more from a bottom-up perspective, from a micro perspective and if it is growing at a healthy pace, the balance sheet is intact, governance is intact and if capital efficiency continues to be robust, I think you should be there.

And as long as valuations you believe are reasonable, the price you are paying is reasonable from a medium-term kind of a perspective, then I clearly believe that is the kind of strategy to follow.

So, do you have less cash and more ideas or it is the other way around for the first time?
No, I clearly believe right now, we continue to have a whole bunch of ideas. We are fortunate that in India we have a universe which runs into thousands of companies. There are whatever, 3000 plus companies listed and of which at any point of time you always have a universe of 300-400 companies which you believe meet at least the basic criteria and from there you got to pick maybe your 20-30-40 stocks and construct a portfolio.

So, clearly believe that right now the ideas factory, if I may use that word, the ideas engine, the ideas factory continues to essentially be very strong, very robust.

If one looks at the historical average for largecap, midcap and smallcap, except in largecap, the mid and the smallcap indices are trading above the historical average. The Nifty midcap index is trading at 25 times and the Nifty smallcap index is trading at 19 times which is above their five-year average. So, why should one buy mid and smallcap stocks when these indices per se, which is a reflection of the broader market health, they are trading at a premium to the historical averages?
Maybe along with this data point in terms of valuations, it might just be useful also to have data in terms of the growth differential and currently, the mid-sized companies or the small-sized companies across sectors are having superior growth and there is significant growth differential between largecaps and mid to smallcaps and that I clearly believe is essentially the point, number one.

Number two, the balance sheets of mid- and small-sized companies, I mean, the balance sheets of largecap companies were generally always very good.

Clearly, mid- and small-sized companies, their balance sheets have improved quite dramatically and they have de-leveraged. In addition to that, there are a couple of other factors which I think are extremely important, extremely pertinent.

One is the access to capital at an affordable cost of capital. I think for mid- and small-sized companies has improved and improved quite significantly even over the last four to eight quarters when we have seen higher interest rates.
It is not that the mid and smallcap companies have to pay a lot more versus the larger companies in the sense that they are not starved of capital, they still have capital and they are able to borrow at a reasonable price to fund their growth plans.

I think clearly that is number one. Number two is with the help of technology, online, e-commerce, the access to markets has also improved quite meaningfully for mid to smallcap companies.

So, I clearly believe that access to capital and access to markets has improved quite meaningfully for mid to smallcap companies and I think in a whole bunch of companies, the quality of governance, the quality of investor communication has also improved quite significantly.

So, I think there is a huge amount of improvement which mid to smallcap companies have seen in terms of growth differential, in terms of respect for balance sheet, respect for governance, access to capital and access to markets.
I clearly believe that these are the five factors which are making a huge difference and I do not believe that these factors are transient. These are factors which are very enduring, are very structural and will continue to play out for an extended period of time and will continue to play out for a multi-year horizon. So that to me is the big difference that we are seeing this time around. So, just looking at premium valuations or valuations trading above long-term averages may not be looking at the entire picture in totality. It may just be looking at probably part of the picture.

Where have you been shopping and where are you picking some spots?
Of course, we continue to hold a relatively focussed portfolio, but it is a portfolio across sectors and we have been liking names around capital goods, around defence, around auto components, the tier II banks, very specialised players in the financial space which is online broking, online insurance.

These are the kinds of businesses that we have been owning. Also, our exposure to alcoholic beverages. We think that is a standout sector from a 5- to 10-year perspective, so that is the space that we have been kind of very-very positive about. Most recently, though, a lot of our new investments have been into more of the technology space. I have earlier talked about the exposure that we have had to MapMyIndia which is CE Info Systems.

Newgen is a company that we have liked and we have owned. They came out with some stellar numbers. One of our most recent additions has been a small IT services company called Datamatics.

We clearly believe that in the case of Datamatics, they seem to be on a path of higher growth. They have reorganised their businesses, largely focussed around digital and artificial intelligence, which I think will provide strong tailwinds for them to grow at an industry beating pace.

They probably still have some bit of margins to expand. They are trying to build an interesting products portfolio, which might kind of result into slightly nonlinear growth going forward and valuations are attractive.

It probably trades in mid-teens in terms of trailing earnings basis. So, I clearly believe that there are a whole bunch of sectors which we have continued to kind of be very positive about. But of late, it is just coincidental that some of our most recent investments continue to be around the technology space.