Quality over valuation: Saurabh Mukherjea on navigating market turmoil, his preferred sectors

While valuing a stock is crucial, relying solely on valuation can be misleading. During periods of market turmoil, it’s the quality of a company that ultimately stands the test of time, according to Saurabh Mukherjea, the founder of Marcellus Investment Advisors.

In a conversation with Mint on an episode of 'How To Invest In Samvat 2081', Mukherjea said that when the financial system collapsed in Britain and America in 2007-08, he realised that valuations are often deceptive. He emphasised that relying on metrics like PEG (price/earnings-to-growth) or growth at a reasonable price could be misleading because, under deep duress, only quality holds up.

Mukherjea argues that quality matters, especially in a country like India, where institutions are weak and corporate governance can be inconsistent. However, he cautioned that overemphasizing quality could also be harmful.

“You overpay for quality because it helps you navigate tough times better. You want companies that are high-quality from both a corporate governance and a franchise perspective, but you also have to be careful not to over-invest in quality. If you do, and interest rates rise by 5 per cent, you’ll be taken out on a stretcher,” Mukherjea warned.

He advised investors to define quality carefully and avoid companies with unclean books, an unproven track record of capital allocation, or weak balance sheets.

Mukherjea said that in the current circumstances, if one has three portfolios of high-quality large, mid, and small-cap stocks, he would unquestionably recommend opting for large caps.

Markets could be ripe for correction

Mukherjea believes that the Indian economy has entered a cyclical downturn after a strong two-and-a-half-year economic recovery post-Covid-19. With recent earnings turning weak, there is a possibility that the Nifty 50 index could correct from current levels. If the market does correct, small and mid-caps are likely to fall more than large caps due to their sharper rise previously.

“I think we have entered a cyclical downturn. Results for the quarter ending June 2024 were weak, and the results for the quarter ending September 2024 are likely to be weaker still. Given this, the valuations of the Nifty 50 appear rich, suggesting a potential correction at the overall index level over the next six months or so,” Mukherjea said.

He also noted that high-quality large caps potentially have more room for valuation re-rating than high-quality small caps, given that many large caps in India are still relatively small within their sectors.

Mukherjea illustrated this with examples like Titan and HDFC Bank. Titan’s market share in the jewellery sector is under 10 per cent despite compounding 1,000 times in 20 years. Similarly, while HDFC Bank is twice the size of Citi Group, its market share in India is just 12 per cent. This indicates significant growth potential within these sectors.

“I’m not so sure that there’s going to be a massive growth discount, and I think it’s reasonably clear that in many high-quality large caps, the valuation re-rating ahead is potentially steeper than what you’ll see in high-quality small caps,” Mukherjea added.

Positive on IT, pharma, and FMCG

Despite the ongoing economic slowdown in India, Mukherjea expressed optimism about the IT services, pharmaceuticals, and FMCG sectors.

For the IT services sector, the beginning of the US Fed’s rate-cut cycle is a positive sign. In FMCG, the government’s focus on providing sops and subsidies to the poor is a key factor. For the pharma sector, falling raw material prices are beneficial.

“I think IT, pharma, and FMCG should serve as good safe harbours during a classic economic downturn. Within these sectors, look for well-run, clean, high-quality companies with strong track records of capital allocation,” Mukherjea advised.

“Fundamentally and structurally, India is in great shape with strong corporate balance sheets, a healthy banking system, and financially stable affluent households. However, cyclically, we are going through a downturn, creating excellent opportunities to invest in high-quality companies at sensible valuations,” he added.

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Disclaimer: The views and recommendations above are those of individual analysts, experts, and brokerage firms, not Mint. We advise investors to consult certified experts before making any investment decisions.