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Earnings are here, markets are here.
Earnings or markets are always anticipating future earnings.
But they are not coming.
This year again, earnings have been downgraded. We were looking at the beginning of the year but as you move forward, the base becomes favourable. So, the next year earnings looks very good. That fact is there are some challenges. In the last two quarters, we have seen the GDP growth slowdown materially and that has heard the earnings growth across though the tax cuts have given a kind of prop. Despite the downgrades, I think the earnings growth this year is still looking at around 15% growth, which is not bad.
But has the sentiment changed from where it was a month back?
Two things happened on the global front. As a result of the easy monetary policy, globally a lot of central banks have become very dovish. Global liquidity and money supply have started to increase again after contracting last year when US was tapering. We have seen the US going into quantitative easing (QE). The European Union is again talking about fiscal stimulus. So, the money supply globally has improved and that is giving rise to a feeling that there will be a revival in global growth.
That has changed globally and you can see money supply coming in. Money is flowing back into the emerging markets and in the last two months, FII flows have been positive. On the domestic side, there has clearly been a slowdown. It is doing its bit now. There is a clear acknowledgement of the slowdown and various efforts have been made to address the slowdown including recent tax cuts or attempts to address the NBFC problems by providing more liquidity into the system. All that is giving hope. Equity is not about the current but it is about looking into the future. While the current earnings are bad and economic growth print this quarter will probably be the slowest, still things will start to improve from here.
Rate cuts are also being slowly transmitted. Altogether, the market is feeling the worse is behind us and things will start to improve.
But the higher frequency data is disappointing. Inflation was higher at 4.5% largely because of vegetable prices. The SBI economist is making a case that the GDP is going to go below 5%in Q2. Telecom is in absolute disarray, leading to stress in the banking sector. On top of that, auto companies are saying that the festive uptick is over.What is that data point which gives you confidence that look the worst is behind us and there is light at the end of the tunnel?
The market probably is slightly ahead. If you look at what caused the slowdown in the economy in the last two quarters, a), the government’s spending contracted quite a bit in the last two quarters because of elections and that money started to flow back into the system. We have seen the government starting to make disbursals, so that supply from the government side is slowly starting to come in.
The rural economy has been fairly slow. The commentary from some of these consumer names has seen a slowdown even for auto names. The excess monsoon has created some kind of a havoc because of the reiterating monsoon. This season might still not be that great but it bodes well for the rabi crop and the water levels are good.
While the current earnings are bad and economic growth print this quarter will probably be the slowest, things will start to improve from here.-Mahesh Patil
The rural economy should start to look up in the second half. That would help consumption a bit. We have seen rate cuts of around 135 bps in this calendar year. The transmission has been slow and for a lot of companies and corporates who want to borrow, the rates are still fairly high, spreads are still very high. That will slowly start to normalise.
The problem in the NBFC sector is still not over but enough remedial measures have been taken over there and so there is no contagion effect. Also the good news is that wherever there have been companies which have been faced problem because of the global risk appetite coming back, there is money coming back. We have seen lots of investors — whether PE funds or other investors — coming in and trying to buy some of these distressed assets.
Some of these NBFCs are facing challenges on the liability side. As investors come in, that should slowly settle down a bit. We will see interest rate transmission starting to happen and that will help to stimulate some amount of demand on the retail side. These are some of the positives.
I agree that we will not see a sharp recovery from here. It will be a very slow and gradual recovery. Market at this point are probably factoring most of the stuff and we might not see a big upside from here from a near-term perspective. But globally, because of the easy money and low interest rates, valuations are fairly high. So, market could get into consolidation phase.
What has the strategy been in Aditya Birla? Where have you increased or reduced your exposure in the last month or two?
In the financial services sector, in the last four-five months we have increased our exposure in the insurance space because companies there have steady earnings visibility. Valuations have now again been kind of priced in but we see a steady compounding over there.
What is the right way to value an insurance company? When you look at the IRDA data, which talks about new premium selling, there is a decline from 20% to 7% for three months in a row. Is that temporary and if som then why are markets excited about insurance stocks?
When you look at the headline numbers — just like a top line in a company is the sales numbers — it is showing weakness because ULIPs are linked to the market. They are probably not growing as much as the adjusted premium equivalent, APE data. We call it equivalent to a top line for a company that is showing some weakness. But what is happening in insurance is that the more profitable products which is more protection, the growth is fairly strong there. Since there is under-penetration in that category, a lot of companies are now focussing on driving protection products where the ROE is much higher. So, the mix is improving and as a result, the operating profit growth is much stronger while the sales top line growth is weaker. In a normal parlance, if you compare with any other company, that is what is looking good and it is a more distribution product on the protection side.
As banks drive distribution, that is providing a steady growth to the earnings or the operating earnings for the insurance companies. That is how you value those companies not on the top line but on the ROEV.
You are bullish on telecom. What are you expecting with regards to the pricing environment and how things will shape up?
It has reached a point where for a couple of players, the overall profitability has come to a level where because of the government intervention also, there is a scenario where operators are willing to take price hike. It is going to be a long wait though because each company would have different dynamics depending on how the operating ratios are and how the debt burden is. That will decide in the longer term which companies will survive.
Having said that, clearly we have seen the players. The largest player who was aggressive in the market has taken some indirect price hikes and that has given room for the incumbents to also take price hikes and it looks like finally the price war has bottomed out. If somebody has to earn a decent return on capital, there is room for more price increases down the line and that would be positive for the sector in terms of news flow and in terms of growth, because we are not going to see more growth coming in because of increase in penetration.
We have driven penetration sufficiently. Obviously people will migrate from 2G to 4G and so data customer base would increase and that will drive the increase in ARPU going forward. We are fairly constructive on this sector. IT has to be considered on a case-to-case basis, but directionally it looks like the EBITDA numbers and growth will improve from here.
Where have you reduced exposure?
We had reduced exposure in metals earlier because though there is some kind of risk on that could see some upside in the metal space, but by and large overall global growth outlook will still remain fairly tepid. We were very positive on metals last year but we have reduced weightage over there. We are underweight that sector.
We have slightly reduced weightage in the consumer side also because of the valuations, though there is nothing too wrong over there in terms of a slight slowdown in growth. However, though we are down on consumer staple, we are still positive on consumer discretionary, consumer durable names. During the early part of the year, we reduced our exposure in autos but we are re-evaluating that as we are seeing some kind of bottoming out in terms of volume de-growth that we have seen in the last one year.
You have clearly said you are sticking to the Nifty companies, which you still see as growth companies going forward. You are also selectively looking at midcaps but gradually over the next year or two. How should one read that?
In the last one and a half years, the market rally has been fairly narrow. A few stocks have done well and so there is a valuation divergence across the largecaps and also within the midcap space. It is still early days. Unless the domestic economy gains significant traction, we would not see the mid and smallcap stocks really participate in a big way. So, it is not going to be across-the-board but picking selectively because of the marked lack of interest in small and midcap space. Quite a few stocks are available at reasonable valuations. It is more a stock specific valuation call, which we are looking to add in some of these stocks.
If we see the domestic recovery starting to play out, then there will be wider participation in the mid and smallcap space across the board. One should still stay away from companies with high leverage or promoter concerns. The risk in the mid and smallcaps still remains fairly high. We are not seeing a broad-based rally at least in the near term but if you take a three-year view and try to build up a portfolio, I think there are enough pockets of value in the small and midcap space.
Big companies like Bajaj Finance, HUL, Asian Paints have gained market share. Small companies have suffered cost of capital, inflation. Are markets telling you that these may be expensive companies but they are the only ones growing in this downturn? What is wrong in just sticking to those 10-15 stocks?
I would agree. These companies will continue to do well in terms of earnings, but somewhere down the line, as the markets and the cycle with liquidity and risk comes back, you would tend to move down the spectrum and other companies where multiples, earnings are depressed because of the slowdown that we have seen.
You are looking at companies where you could see big returns over the medium to long term, companies where there is a potential of high earnings growth and PE rerating. Some of these larger companies have steady earnings growth. Because the earnings have been right and PE multiples are fair, there is no PE rerating scope. They will continue to grow at the pace of earnings which would be around 10-12-13-14%. It is not a time to move out from some of the large names, we are still having them in the portfolio.
Incrementally one can add companies where earnings are depressed and where you could see a cyclical recovery or otherwise in earnings and some potential for PE rerating and over the next two-three years, these could generate alpha.
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