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Sahil Kapoor, Head of Products & Market Strategist, DSP Mutual Fund, says top-line growth is slowing; we already have peak profit margins and drivers of profit margins are absent which can expand profit margins from here and then you question that if earnings growth is going to be 12% to 14%, why would you pay 23 times or in midcap 28 to 40 times earnings multiples? Those expectations will have to be recalibrated and possibly the markets will do that over the next 12 to 24 months.”

What is your market outlook in terms of equity markets in India? The smallcap and midcap indices were getting a bit frothy and the overall clamour was that it is safer to be in largecap stocks. Is that what you are changing your product portfolios to be in terms of what you are recommending to your clients?
Sahil Kapoor: When you look at the broader universe, small and midcaps appear slightly more expensive compared to largecaps on a relative basis. Recently, we came out with data that the median price to earnings multiple in the SMID universe – which is 101 to 500 stocks – is about 40 times. It was 20 times way back during the 2007 peak. In this bull market we have seen a very large expansion in price to earnings multiples and there are a number of parallels from comparison to the 2003 to 2007 rally or the 2017 bull market in small and midcaps and what we have today.

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There are similarities between these periods in terms of very low volatility, high participation and also very strong earnings growth. All three ingredients have been very similar across these cycles. At this point in time it does appear that mid and smallcaps are relatively more expensive and possibly only staggered purchases would be meaningful in that category. Largecaps, as you said, are relatively better. But in itself, this category itself is not very cheap.

So, we are not trading at average or below average valuations. We are still trading at 23 times which is way beyond our long-term average valuations. For example, if you go back to the biggest bull market between 2003 and 2007, at that point, the average multiple for a Nifty was 17, 17.5 times which is today at 23, 23.5 times. So, we are away from even our best bull market multiples. It is more logical to be cautious right now. The market is building up a very large earnings growth trajectory over the next one or two years or three years and some of those numbers appear to be a little shaky. Those earnings estimates may not be realised going ahead.

But at the portfolio level itself, what are you recommending clients because precious metal has been doing very well, whether it is gold and now silver is also catching up. Are you recommending increasing the weights in precious metal right now?
Sahil Kapoor: So, to be honest, we have been looking at precious metals for some time now. This is not the start of what I would call a more positive outlook on precious metals. We have been looking at and holding some of these metals like gold and silver in some of our strategies. So, the outlook has been fairly positive.

The recent price increase, of course, has brought these metals into the limelight. But if you look at the last five to seven years overall in USD terms, precious metals have not done well and at the same time if you were to create a checklist of what drives a precious metal bull market, let us say a huge amount of indebtedness created globally, huge amount of increase in money supply. At the same time, very large central bank buying. The only missing ingredient from a precious metal bull market was lack of investor participation from institutional investors. Largely, gold being a very reflexive asset class, usually when it starts to perform, when it enters momentum, one sees large institutions also participating. In this rally, the initial thrust came from very large central bank buying. The second thrust can come from institutional investors getting into precious metals as an overall segment. These are still early days from the perspective of a bull market taking birth in precious metals and I think possibly over the next few years, we will see that precious metals will catch up with their long-term returns and possibly perform much better. So, yes, this is a category that we think is poised for a good margin of safety.But there has been this renewed interest about foreign investing as well and, of course, a lot of houses had stopped investment, the foreign investments. But it seems to be picking up again. The US market has been doing quite well and China is very cheap right now. What are you recommending your clients in terms of investments in China or the US? Or as the Indian growth story is quite intact, long term is it better to stick to India?
Sahil Kapoor: It clearly depends on the kind of investor preference that we have. So, if you look at an equal weighted basket of Indian stocks, global stocks, gold and let us say Indian debt 25% each, over a 25-year cycle, it does give you 11-11.5% kind of returns post tax which is excitingly great and with drawdowns which are maybe 40% lower than just Indian equities.

It gives a good mix of , slightly lesser volatility and much better outcomes over the longer term. So, you do not face too much volatility. The global exposure is something which helps the portfolio over the longer term. At this point in time, overseas investment limits are curtailed. As even ETF investments have become much lower and there are limits put there by the regulators, the use case for global funds is limited as of now.

As and when those limits are revised, people will be able to take exposure through the mutual fund route. Wherever there is room, there are enough opportunities globally where there are a number of companies which generate huge amounts of cash flows and since markets are extremely global, there are a number of companies which participate in let us say not only US, their client segment or profitability comes from across the world. There are many such companies, great brands residing in the Euro zone and a number of companies in China where the financial matrices are now turning. There are a lot of opportunities globally that investors can look forward to but of course the participation through an instrument is something that people will have to solve for until the limits are revised.

Could you explain a bit more in terms of which sectors you think are fairly priced or where you have optimistic expectations and perhaps more downside?
Sahil Kapoor: If you look at the historical data, whenever earnings growth outpaces the nominal GDP growth, usually in that period we are in a very strong bull market. If you go back to the period between 2003 and 2007, you will see that in most of those years, earnings growth was way ahead of nominal GDP growth. If earnings were growing at 25% CAGR, nominal GDP was growing at 14-15% CAGR, an all-out bull market.

Similarly, some patchy years, for example, like 2010, where earnings growth outpaced nominal GDP growth, 2017 calendar year again earnings growth outpaced nominal GDP growth and similarly for the last three years earnings growth has outpaced nominal GDP growth.

If you look at the margin of how much does it outpace, for example, on a three-year CAGR basis, earnings growth has been 15% higher than nominal GDP growth rate, now this is the best case for earnings growth that we have seen versus the nominal GDP growth rate going back to history till the data is available and we hit that number very-very recently. That means we are performing as much to our potential as we have in terms of corporate profitability.

Then you look at two-three metrics. First, top line growth has slowed. If you look at the BSE 500, in the last two-three quarters, top line growth is between 5% and 6%. It was 20% plus just about six-seven quarters ago. Profitability has been very high. Profit growth has been 20-25% plus. But as you know the current earnings season which began just two days ago, the expectation of corporate profitability will be between 14% and 16%. For FY25, the Street is putting in estimates of about 18%.

When we look at numbers, top-down or bottoms-up, 12% to 14% could be a struggle and plus the last point, margins are also at peak. Corporate margins in India have not been better except one or two quarters because of base effects. This is the peak corporate margins that we have seen and I do not know what other drivers are left which can propel the margins higher.

So, if you put these three points together, top-line growth which is slowing, you already have peak profit margins and drivers of profit margins are absent which can expand profit margins from here and then you question that if earnings growth is going to be 12% to 14%, why would you pay 23 times or in midcap 28 to 40 times earnings multiples? So, I think those expectations will have to be recalibrated and possibly the markets will do that over the next 12 to 24 months.

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