‘Stock valuations will evolve with how Covid-19 situation changes’

After witnessing a bloodbath in the month of May, stock markets have been rallying, with huge buyer interest. However, the rally is not supported by fundamentals and macros. Nilesh Shah, Managing Director, Kotak Mahindra Asset Management and Member, Prime Minister's Economic Advisory Council, talks to DH’s Furquan Moharkan about the prospects for equity investors as the current volatile scenario unfolds. Excerpts:

Q. To start with, why are macros and markets moving in opposite directions?

A. If you look at the broader market, Sensex is now about 5-6% below the all-time high. And GDP is seeing de-growth for the first time since the 1980s. But if you go in detail, there are multiple trends that are visible. A bulk of the Sensex and Nifty movement happened with 15 or 20 stocks. These are the companies that were able to raise capital, which have strong balance sheets and where every investor wants to move in during the turmoil. So, these stocks took the lead to move Nifty up. On July 31, the Nifty level was about 11,300, and these 15 stocks were trading at 4,500 Nifty and the bottom 35 stocks were trading at 8,000 Nifty. So, there was a very wide polarisation between companies and the pain of the economy is reflected in the bottom 35 stocks of Nifty, whereas the index is lifted by the top 15 stocks.

Q. Will this polarisation of gains lead to some kind of consolidation, especially given that many small-caps have stress on their debt side?

A. Undoubtedly, this is the law of nature: the fittest and adaptive will survive. Dinosaurs were the strongest, yet they died. On the other hand, cockroaches were adaptive, and they survived. The same is applicable in the corporate world: more adaptive, more innovative companies, and the companies that can digitally transform themselves will continue to grow and survive. In our portfolio today, we are evaluating companies on three parameters: the strength of the balance sheet in terms of leveraging, how brutal is the company in cost-cutting, and innovation. There will be pre- and post-Covid-19 businesses. As my boss tells me, “You are a mutual fund, but you better become a tech company, else tech company will launch a mutual fund and give you competition.”

Q. Given that stocks have rallied heavily since May, without fundamentals improving much, do you think they are overvalued?

A. I think that in many penny stocks, the stocks are overvalued. It is the buyers buying them that is pulling the share prices up. Eventually, they will all crash, and we saw this in post-Harshad Mehta, post-Ketan Parikh time, and 2008. We have seen historically that companies without the fundamentals and proper governance will not create sustainable value. At the same time, there are certain FMCG companies and certain private banks that are trading at a significant premium to their historical average. Now, these companies' businesses are real, but the price which one is paying is historically at the highest level. One can debate whether these companies can deliver shareholder returns or not. My feeling is that if the medical situation (of Covid-19) deteriorates, and we have to go back to shutting down, then these stocks will do well and will be more expensive. But in case, we have a medical solution, and normalcy returns in the economy, then the stocks which have not performed and are cheaper will do well.

Q. Which are the sectors you think are going to provide high returns over the next year?

A. Essentially, one, you have to choose the right management. In the financial sector, the right management will create an HDFC Bank or a Kotak Bank, while bad management may end up creating a YES Bank or a DHFL. It is extremely important that you focus on management and governance. Subject to that, we think that the companies that have lower debt on the balance sheet, companies which are cutting costs, the companies which are innovative -- in any sector -- will do better. With those caveats, I think, sectorally, there are some trends that are visible: Chemicals, contract manufacturing, cement, general insurance, asset management, well-managed NBFCs will outperform the markets. In some other sectors, like pharma and technology, one will have to become stock-specific after a major sectoral rally. The stocks that can be avoided for the time being are real estate, construction and infrastructure.

Q. Do you think mid-caps and small-caps will do better from here on?

A. Last month, after a very long time of volatility, small and mid-caps outperformed large-caps. From the valuation point of view, if a medical solution emerges quickly, then small and mid-caps will outperform large-caps. In the unlikely scenario of the medical solution not emerging, the large-caps will continue to outperform. So, it is a play on valuation as well as future medical scenarios.

Q. Stocks of many banks are way below their all-time highs. With the loan moratorium over, do you think it’s wise to buy such stocks?

A. Once the moratorium is over, we will see one-time restructuring coming through. So, the market will remain blind about actual NPAs till about the first half of 2021. My take is, in the case of financial services, stay with those banks which have a more diversified portfolio and whose credit culture is conservative.