Fund Manager Talk | Why Atul Bhole is keeping IT stocks on his watchlist

Atul Bhole, Executive Vice President and Fund Manager at Kotak Mutual Fund, identifies IT stocks as a potential under-the-radar opportunity amid current market uncertainties. While the sector has underperformed year-to-date due to concerns over US economic conditions and AI disruption, Bhole sees compelling reasons to pay attention to this overlooked space.

Edited excerpts from a chat on market outlook, smallcap investing and sectoral trends.

The markets have rallied sharply from April lows. How sustainable do you think this uptrend is, especially in the context of rising valuations and global uncertainties?
Amidst global uncertainties, the Indian economy is showing incredible resilience. The macro stability in terms of twin deficits & inflation, rates, currency has been tested multiple times in the past few years and India is coming out shining on each of those occasions. In addition to this macro stability, we are able to maintain relatively better growth rates. The government and RBI are collectively putting efforts to improve the demand conditions. No doubt, favourable flows dynamics, which essentially an outcome of improved macro, is supporting the markets. While valuations are on the higher side, improved stability and growth opportunities may keep supporting the markets. Obviously, some volatility cannot be ruled out in light of uncertainties & investors should learn to take advantage of the volatility.

Many investors are again raising eyebrows on valuations in the small and midcap space. What do you think?
Small & midcap (SMID) valuations are undoubtedly at premium to largecap as well as to their historical valuations. Versus largecap, while SMID valuations are expensive at aggregate level, like-to-like business valuations are similar. For e.g. largecap apparel retailer & SMID apparel retailer are similarly valued. Higher proportion of banks, utilities & commodity stocks make large-caps appear less expensive. These stocks generally trade at lower P/Es due to business characteristics.

When compared to historical valuations, a couple of points to ponder over re-rating of the SMID universe. First, stable macro & growth opens up more opportunities & allows SMID companies to chase those growth opportunities with sharper focus. Secondly, over the years, SMID companies’ resilience in terms of margins & balance sheet has improved with size & scale – they can absorb shocks much better than earlier. Third, corporate governance standards & capital allocation decisions also experienced good improvement with regulatory & investor involvement as well as managements’ own learnings. Fourth, few of the high growth themes like hospitals, EMS, durables etc are present only in the SMID universe. We believe these factors enable SMID to trade at higher valuations vs historical range.

Keeping in mind the above factors, we believe investors need to manage the risks of SMID investing through asset allocation & systematic investing through MFs. Risk management is an ideal way to approach the SMID valuation conundrum rather than avoiding the risk.

What filters do you use to separate sustainable small-cap stories from those riding temporary momentum?
Momentum stocks typically ride any compelling narrative valid at that point of time & largely lack business or balance sheet strength. Investors are typically dragged either by greed or FOMO in these cases. Such stocks have certain peculiar features like illusory prospects (almost story-like) about future growth, most often -lesser free float, promoters with nil or compromised track record etc.

Strength of the business model & promoter/management quality has to be the starting points for evaluating any SMID opportunity. Longevity of growth, margin sustainability, robustness of balance sheet, return ratios, industry structure etc goes in the evaluation of business models. Management evaluations primarily involve looking at execution track record as well past actions relating to capital allocation etc.

Studying the quality as well as diversity of the investor base proves to be an important & useful filter in separating rice from the chaff.

Consumption, capex, and financials seem to be the market’s favourite themes right now. Are there any sectors you believe are flying under the radar?
One can keep an eye on the IT sector which has not performed particularly well YTD. Concerns over the US economy & AI-led disruption are keeping the IT stocks under check. While we can’t predict broad economic trends perfectly, the scenario doesn’t look like getting very precarious & US banks/corporates financial health is relatively better this time. Assuming normal business cycle returning, IT spending can come back. After every major technology adoption, Indian vendors have actually experienced more volume of work. Earning growth expectations of IT companies range are not very different vs broader market. Stocks, particularly large-caps are trading at relatively reasonably valuations & provide dividend yield support of 2-2.5%. These factors merit attention.

Additionally we are also keeping watch over the chemical sector. While the sector was going through a down-cycle in the past 2-3 years, companies are continuously investing behind products, client engagements & facilities. The persistent price fall of 2 years seems to be over & prices are stabilising now. There are initial hopes for revival by companies. It may need some more patience, but provides a good opportunity to accumulate select chemical stocks.

Nifty now has 3 stocks - Trent, Jio Financial and Eternal - trading above 100 TTM PE levels. Do you see this trend as a sign of the market accepting triple-digit PE stocks as part of the mainstream narrative?
Nifty inclusion or exclusion is a function of the set mechanism of following free-float market cap methodology & is separate from valuations of a particular stock.

From time to time, few companies emerge, which exhibit high growth potential with a large target opportunity set & their perceived ability to capture those opportunities. The market collectively tries to discount the future growth for each company & assigns a price. In few cases, such valuations can appear high compared to near term profitability as the companies try to invest disproportionately ahead of time & seed the market. Such incidents need to be evaluated on a case-by-case basis and cannot be generalised as mainstream. Pertinent to note that, even when the market is collectively accessing the growth potential, there are risks of following herd mentality which can be completely misplaced. Changes in regulatory, competitive or tech environments can support or derail such hypotheses.

We've seen promoters, PEs, and VCs aggressively selling stakes recently. Do you see supply-side risk to the market?
The increased supply can be seen as a stabilising force to absorb the flows coming into the capital markets. It is providing incremental avenues to the money managers to invest & keeping the price levels in check at aggregate level. The fresh money raised through QIPs/IPOs are also on the rise and actually providing growth capital to corporates. Promoters paring their stakes is an obvious signal that they are considering their shares trading at higher than fair valuations. However it needs to be seen as an additional input in an investment evaluation. There can be errors of judgement about future potential or promoters can also have different goals like diversification or other uses like charity, buying real estate etc at a particular life stage. We have many examples where stock prices go up even after promoter stake sales. Stock prices would respond to earnings growth over a long time. Money may be taken out of markets with such stake sales but at the overall economy or market level, it remains in circulation & helps overall growth.

How should investors approach sector rotation, and do you see any early signs of leadership change in Indian equities?
Business cycles & sector rotations are really getting shorter even since Covid. We are observing that stock prices in any particular sector factors in positive news flows or earnings uptick pretty quickly. Simultaneous information dissemination as well as herd mentality/ FOMO drives such moves. At the same time, sectors going through a down cycle or lack of triggers, at times, are ignored. Even for most astute of investors, it is very difficult to capture all such sector rotations.

In chasing sector rotations, invariably investors end-up building positions towards the end of the rally & then get stuck at near-peak costs. Another important element to weigh is the tax treatment when one tries to sell from one sector & get into another. It can set back the compounding almost by a year or two.

One way to approach sector rotation is contrarian thinking- buying what is going through a down-cycle & is ignored by the markets. It needs sound research backing to build conviction & considerable patience as well. Another way is building a basket of better companies across sectors with slight sector deviation & keep re-balancing their position sizing at the margin. The second approach is simpler as it takes away the timing element to a large extent. Diversified mutual funds or business cycle funds offer good solutions which can deal with this issue with research backing & tax efficiency.