How would you assess the market right now? We have seen a grand rally in 2023 and a mid-air turbulence in 2024. Do you think the excesses in the market have been weeded out?
Vetri Subramaniam: I would not really say the excesses have completely been taken out of the market to be very fair. If you look at the largecaps, the valuations are punchy, but I would still say they are not blinking red. But in the midcap and smallcap segments of the market, the valuations still give us cause for concern. There is really no margin of safety over there. They are, in fact, trading at a premium to the largecaps which is not something I have typically experienced in my 30-year career. The midcaps sometimes trade at a premium to largecaps, but it is very unusual for smallcaps in aggregate to trade at a premium, which they have been and that is why, there is the valuation comfort there. I know they have corrected a little bit more from the top as compared to the largecaps, but still there’s no margin of comfort to speak of.

Is that happening largely because the nature of the economy is changing? Suddenly, there are a lot of new niche companies which are the new high growth companies whether it is in defence, energy or food delivery. These businesses never existed and these are the new businesses which are growing at higher run rates, so markets are giving them a premium.
Vetri Subramaniam: That is one way to look at it, but I always look back at a wonderful question which Jeff Bezos once asked and he said that people ask me what will change in the next 10 years and I prefer to tell them what will not change in the next 10 years.

So I will tell you what will not change in the next 10 years; what will not change is that there will be macroeconomic cycles, interest rates are going to go up and down, there will be regulatory changes, there will be winds of change, there will be disruptions. We know from history thatit is the smaller companies which tend to be at the receiving end of these changes – be it in terms of regulations or cost of capital. Smaller companies struggle to deal with some of the disruptions and changes because they typically lack the kind of management depth, they lack management breadth, and they do not have access to technology and capital that their larger brethren have.

If you ask me, that is going to change. But I will also tell you what does not change and these are the things that do not change and that is why I would argue that as an aggregate, the largecaps typically are better placed to deal with these changes than the smallcaps.

But for markets to go down in a significant manner, barring a mid-air turbulence, what we saw in mid-March, what could be the reason? Could it be valuations? Could it be macro? Could it be global factors? What will drive the markets significantly lower from here?
Vetri Subramaniam: One never knows these reasons beforehand. This is a futile discussion saying what will cause it to go down. We could have had this discussion in April of 2020 and I suspect if we look back through the archives, you will see me talking to you sometime then and we would have said, look, valuations are cheap, that is all we need to know you would have said, what will cause it to go up? Now, who the hell knew that the wonders of modern science, people putting their effort into it, we would get vaccines, we would re-engage with the world, we would emerge so much stronger and believe it or not, we would get a 70% pop in Nifty 50 profits over the next three years?

It was unbelievable going into the pandemic, being locked up at home, four years ago that such a thing could have even happened, but it did. The point I am making is that you do not always know what is going to happen. So, this is a very futile question to say what is it that will happen? We do not know and that is my simple answer.

But largecaps are better placed versus small and midcaps. But again, within largecaps, is it more of the same which is going to do well or should one now look at bottom-up stories? Many peg largecap private banks to be the pocket to be in within largecaps right now?
Vetri Subramaniam: If you look at the largecap space, of course, the valuations or when you look at aggregates, it will always give you a different picture. But if I were to point to one segment that very significantly dominates the largecap space, it would be the banking and financial services space. Large parts of that have significantly underperformed. In fact, many of the large banks have significantly underperformed and there is a fantastic opportunity over there.I know people will tell me, oh, credit growth is too fast; RBI is trying to slow it down. Margins are going to be tight. Hey, but why are you getting it at the valuations that you are getting today? I have not seen India grow at any point of time without credit growing faster than GDP. These are the best balance sheets that some of the best run banks in our country have had in many years. The valuations are extremely attractive and I would be very surprised if this sector does not punch its way through the next two to three years and participate in the growth that the economy is likely to experience.

Remember, credit to GDP in India still remains very low, compared to any comparison you want to make. So, to my mind, the large banks which are pretty much part of significant weight in the Nifty, along with some of the other financial services play that would really be my sort of number one pick if I look at it bottom-up in terms of what is it in largecap which looks attractive. The second one, where valuation comfort has eroded because the sector has done well over the last one year, which is the pharmaceutical and healthcare space.

But I still have some sort of positivity in that area because what I am seeing is that companies are able to currently benefit from some of the growth trends in the local Indian market and at the same time, a lot of their international operations are running slightly more stable in terms of their profitability. The worst of the pricing cycle is now behind us. So, pharmaceutical and healthcare is another area. Again, it is a combination of large and midcaps, but that is another sector so to speak of bottom-up.

What according to you is looking priced to perfection and thereby has scope for disappointment if the earnings do not match? Who would have thought that M&M and Tata Motors are not going to match what the Street was anticipating in terms of their March sales?
Vetri Subramaniam: We loved the automobile sector in 2022. It was one of the few areas where volumes in the sector were running 20% to 25% below the previous peak and their previous peak happened in 2018. Now, this year, large segments of auto have finally pierced through the levels of 2018 volumes, not to say that they cannot continue to grow but I think a large part of the story in terms of the valuation re-rating, in terms of an improvement in margins because of operating leverage, a lot of that is done and dusted.

We are still positive on the auto cycle, but it is no longer something which really gets us excited because both operating leverage, margin improvement, and re-rating have played out. The number of legs it has to support itself are now quite limited. Another area where I am cautious and which may not be a consensus view in the market, is really the whole capital goods space. To my mind, private capex and in general capex is still not in a very strong place.

We only have to refer to some of the comments that the chief economic advisor also made recently at a large event where he talked about the fact that the private sector is yet to come ahead. But I find a lot of the stocks in the capital goods sector priced to perfection in terms of a strong industrial upcycle. First of all, I don’t know how high is the probability of that happening and even if it does, the valuations have removed a lot of the potential upside from those stocks.

Every market cycle follows a particular style. Sometimes value does well, sometimes growth does well and sometimes dividend yield does well. So, for the next three to five years, what kind of style are we in because post Covid, first it was growth, then it was value, now everything is khichdi. What would you bet on as a style for the next three years?
Vetri Subramaniam: That is a good question. There are two ways to look at it. One is I would actually say this is a time where you should think more about asset allocation and risk than about upside. There’s a very simple reason for it. Three or five year returns across equities are very strong compared to the median sort of outcomes you would expect over a three- to five-year period. A . significant amount of the upside has been driven by earnings. So, in general, we would say look more towards asset allocation products now, that is point number one.

The second thing that I would really say is, when you talk about that classic value and growth cycle, when I look at a lot of the constituents of the value cycle, I would say they still may look cheap relative to some components of growth, but relative to their own history, their own capability of producing high return on capital and being able to sustain the growth, a lot of them are now starting to look fully priced.

So, there is very little value so to speak left in that value style at this point of time and if anything starts to get a little bit shaky, I would submit that maybe growth actually has a little bit of an edge right now simply because those companies tend to have much stronger balance sheets and cash flows.

I know you are pretty bullish on the markets overall at the current juncture, talking about how the long-term story remains intact. But if there were to be any concerns, do you think that would largely come from the global markets? Would it have a mix of domestic factors?
Vetri Subramaniam: First of all, I should clarify, I am very bullish on the country. I am not so bullish on the stock market right now and there is a very simple reason for that. The valuations do not give you a margin of comfort. So, if you are investing for 10 years, you are doing a SIP, keep going. There is nothing for you to back on. But I would actually urge people that given where we are in the valuation cycle, this is a good time to rebalance your portfolio.

This is a good time to think more about risk from a rebalancing perspective, rather than to think about upside. So, my view is not quite what you described. I think the country will do brilliantly over the next 10 years. Equity markets will find it a challenge simply because whatever our potential is, has been significantly discounted into those valuations.

If the starting point is today and one has to say look at a three-year out kind of a scenario for largecap equity diversified schemes, historical averages of 12-13%, or 13-14% whichever year you look at it, for the next three to five years, are we likely to give returns which are above historical averages, in line with historical averages, or below historical averages?
Vetri Subramaniam: This is a probability question. There is no yes or no answer to anything. The long-term return is 12% to 13%. But you have got valuations at a point in time with trailing three- to five-year returns which are much superior to what you would typically get. I would actually think at this point of time, the outcome is likely to be mid-single digits, high single digits, rather than 12% to 13%.

There’s a great option right now; good quality corporate managed debt. It may sound boring, it may sound extraordinarily brilliant if you talk about debt.
Vetri Subramaniam: Debt is a good option now. One of the things I have experienced last year is that particularly among retail investors, HNIs and family offices, people have become very debt averse simply because of the change in taxation which happened in the mutual fund space last year. But I would say there are a wide range of hybrid products which still give a taxation regime which is better without giving you full-on exposure to equity. There are many of those products which as you suggested have significant debt sitting in them, it could be 75% debt, it could be 50% debt and those are some of the asset allocation products people should consider if taxation is such a key consideration for them. But I am completely with you on this. I actually think it is a reasonable and a good investment opportunity right now.