Shetty further says that for years, consumer staples traded at high P/E ratios, underperforming post-2022 due to valuation gaps, though defensive buying has spurred recent recovery. Capital goods experienced a boom in the last three years, but current valuations appear unsustainable as earnings normalize. Investors should exercise caution in these sectors where valuations deviate significantly from long-term averages.
The recent correction has made valuations in certain pockets of the market very attractive. There is no doubt it is absolutely a stockpickers’ market. Which are the pockets where you see value generating amid this volatility and when will the dust settle in? Where do you see the traction coming in to start with?
Nilesh Shetty: Yes, the uncertainty around tariffs has given an opportunity for stock pickers to pick up stocks that they want to pick up for the long term. Again, the assumption is that a lot of this uncertainty will fade in a few months. We are seeing opportunities coming up in logistics where we are getting closer to a level where we want to buy. Some pharma stocks are getting interesting for us. We continue to have a large allocation to private sector banks as well as stocks linked to the savings side of the household balance sheet including asset management companies, insurance companies, as well as broking companies.
So, the valuations remain fairly okay for us where we continue to have allocation and also, we have large allocation in IT services and consumer discretionary stocks where at least for the next few years, valuations look reasonable.
Since we are talking on the lines of valuation, I want to understand the connection between earnings growth and valuations. Are you still sensing a disconnect in a few pockets and having said that, are the last six months of this calendar year going to be in largecaps? What are you analysing?
Nilesh Shetty: Yes, in certain sectors, there has been a disconnect for many years now. We saw that in consumer staples. These stocks were trading at a very high price to earnings ratio for the better part of last decade. Post 2022, they have been underperforming because there was a big gap between the valuations that they were getting and the earnings that they were delivering. Recently, we saw some recovery in these stocks because investors wanted to have some defensive names in their portfolio. But otherwise, they still remain very, very expensive. We see that in capital goods as well. In the last three years, there has been a boom in these stocks.
Again, the assumption is these valuations are not sustainable. As earnings normalise for these companies, suddenly you realise why are you paying 70 times, 80 times to these sectors. So again, our sense is that investors need to be careful in these two pockets where valuations look not in line with their long-term averages.
Which are the sectors you are looking at? In the recent past, in terms of earnings, there was a clear distinction between private banks and public sector banks. How do you look at it?
Nilesh Shetty: We have always favoured private sector banks. Sporadically, public sector banks tend to do well especially in times where NPA cycle remains very benign; but that is not the norm for these public sector banks. The norm is they continue to have much higher NPAs than private sector peers and which catches up with them. So, trying to value these companies when the NPA cycle is very low, is not the correct thing to do. You may want to normalise that and bring it back to long-term averages. Then suddenly the valuation does not look that attractive for public sector banks.Private sector banks, of course, are far more efficient. They continue to price credit a lot better than public sector banks. At least our allocation has been favouring private sector banks and within that, quality private sector banks. We are not allocated that much to tier II private sector banks where we again because of this aggression in growth and trying to grow books they tend to sometimes rival public sector banks in non-performing assets.Considering the festive season will start from here on and will stay till the end of the year, what are those baskets, bouquets of spaces which one should eye? The consumption space, travel and tourism. Is it something which will follow from here on? Do you think the IT sector is not a near-term story anymore?
Nilesh Shetty: In the consumption space, you have to be careful because the festive season is slightly earlier than last year, and so the near-term numbers may show a spike in sort of demand and other things versus last year, but that is not sustainable because as the base shifts and last year because festive season was later. Suddenly you realise those numbers are not sustainable and you correct them. But over the medium-term, we continue to have large allocation to two-wheeler companies where we think valuations remain reasonable. We have trimmed a lot of them, but we continue to have a decent allocation there. We continue to have an allocation to a large tractor conglomerate where we think they are doing very well in the passenger vehicle space including some of their new launches, but these are the places where we are allocated to.
In IT services companies, we think long-term opportunities remain fairly bright. It is in the near term because of this uncertainty in terms of what is happening in the US which remains a major market for them. Even for their customers to commit large capex is not easy and you have seen a deferral of discretionary IT spends which has delayed a recovery in their numbers. But looking at where valuations stand relative to their sort of 5-year, 10-year averages, they remain very attractive right now. So, we continue to have a large allocation but you may need to be patient as an investor there. You may have to see a couple of quarters of more pain till things settle down in the US.
Looking at the volatility and uncertainty looming around, I want to understand or get a sense of your cash book. How much of a cash are you sitting on or what is the house philosophy on these terms?
Nilesh Shetty: Current cash levels are around 12%. Cash is a residual for us. If we do not find names where we can deploy capital and we are happy with the existing weights in the portfolio of the stocks that we own, what remains is cash. But again, if tomorrow we were to find opportunities where we think valuations are attractive and the company meets our liquidity and governance norms, we are happy to add. It is slightly above the long-term average. Our long-term average has been about 10%. It is currently about 12%. But like I said in this correction, there are a few names which are getting closer to the buy limits that we have for these stocks. And you may see those cash levels come down.
You mentioned your cash levels at 12%. Is it more of a time-wise strategy from three months down the line or six months down the line you may deploy that or it is event wise?
Nilesh Shetty: No, it is just individual stock specific because we are a stock picker portfolio, the portfolio that we build. It is just that we have not found individual names that we cover in our research database of 200 companies coming below our buy limit at the moment. So, because we do not find opportunities to deploy, what remains is cash. But if tomorrow three stocks were to come below our buy limit in this correction we will aggressively buy into those names and suddenly you will see cash levels come down.
What is your view in the banks and financial space? I am trying to compare the PSU bank space with the private bank space? There are a lot of news flows coming in one such which we have for the ICICI Bank and that is the reason we see an impact and in comparison at present the PSU bank space is doing well if you compare both of it. What is your take on the banks and financials, in particular the PSU and private bank space?
Nilesh Shetty: We are probably contrarian to the market view right now. We have a large allocation to quality private sector banks. We think valuations for that particular data set right now are far below their long-term averages. While for the PSU banks we think the valuations are above their long-term averages and for the quality of the banks that they are, perhaps you should be careful giving those valuations to these banks.
The private sector high quality banks have been time-tested with proven management quality over the last multiple cycles. In the case of PSU banks, in every cycle, they tend to do very badly probably because of mispricing of risk which I do not think has changed materially. So, our allocation primarily tilts towards private sector banks. We have one PSU bank which is the largest in the space in our portfolio where we think pricing of risk is slightly better than other PSU banks.
How are you looking at the universe of smallcaps and microcaps? This is one category where you definitely need to be cautious. But as a long-term investor, you really cannot let go of midcaps and smallcaps although we cannot take midcaps and smallcaps in one breath anymore. But having said that, largecaps are needed for stability and consistency in a portfolio and should be the best bet in the current scenario. Having said that, if you really want to give a boost to your returns by having select and quality smallcaps, what is going to be your bet here?
Nilesh Shetty: In terms of strategy, we are market cap agnostic. We will go where we think valuations are attractive as long as the company meets our liquidity and governance norms. But like I said, in the rally that has unfolded in the last five years especially after Covid, the small and midcap valuations have been very high and to get names which make sense at valuations that we are comfortable with has not been easy. We have a very low allocation to that space right now. In the process of trying to boost your returns and trying to allocate to this space, you may destroy a lot of returns because you are overpaying for some of these stocks.
This stock traditionally has been run by managements which are not of great quality and especially when liquidity dries up, the correction in share price can be very sharp. If you are trying to take an exit at that point in time, you might see significant losses to a portfolio. We have always been very careful of the valuations that we want to pay for businesses and right now across this space getting businesses that make sense in terms of valuations is not easy.