2 wealth creators, 1 wealth destroyer and a value trap
CIO – Equities
WF: Nilesh Shah recently made an observation (Click Here) about 3 focus areas for the Government: boosting farm income, lower taxes for middle class and reviving the real estate sector. The first two play into the overall consumption theme – which is where many experts believe valuations remain stretched. Which parts of the consumption theme continue to offer value in your view?
Harsha: The weakness in demand conditions for most consumer driven sectors is gradually deepening. Couple of quarters earlier it started in discretionary consumption, but now seems to be slowly spreading to even some categories in consumer staples. While the government is rightly focussing on reviving the consumer sentiment for better demand, the current valuations do not provide much comfort yet. Hence, we remain underweight on consumer driven sectors such as Automobiles, Durables and FMCG.
WF: Does the Government’s effort to revive the real estate sector offer an investment opportunity from an equity perspective, or would you rather wait for demand pick-up to consider real estate stocks?
Harsha: Real-estate sector has been reeling under multiple troubles -- muted demand, liquidity issues, rising cost of finance and regulatory change (RERA, cap on set-off of losses for multiple properties under IT, tax on inventory holding, GST and so on). Issues such as sizable project-launches without commensurate approvals and slower demand have led to significant cash-flow mismatch for developers. There has also been a delay in completion of projects across the industry. This has resulted in very high inventory levels in major micro markets. Land aggregators and developers are clearly being differentiated, given higher upfront cost of project approval, compliance under RERA and lack of buyer confidence. In the process, there is clear shift of demand from unorganised to organised/large developers.
While developers with execution track record and strong balance sheets would emerge as key winners in the medium to long term, there seems no respite in the near term. The sector will continue to be under pressure in the short term till the inventory levels decline.
WF: You recently talked about (Click Here) your preference for mid and small caps going into the elections. Is the correction done now in this space? Do you see value or is it only a relative value vs largecaps?
Harsha: The sharp correction in midcaps during 2018 brought the relative midcap valuation vs that of the Nifty back to 2014 levels, which was the time when this current leg of the midcap bull run started. Similar was also the case for small cap valuations vs the Nifty valuations. From those extreme divergent valuation levels, we witnessed a strong pull back rally in the recent past. However, even at current market levels, we believe that the time is still right for selective investments in quality mid and small cap companies with good managements, healthy balance sheets and high growth.
However, on absolute valuations levels, mid/ small cap segment is somewhat around fair valuations right now. The valuations of course are not as attractive as it were in 2012/ 2013 period, which were the most attractive levels in the last decade.
WF: Earnings at an overall market level continues to disappoint. Is the story any different in the mid and small caps space?
Harsha: It has been the same trend across market capitalisation baskets. In the quarter ending Dec 2018, the margin pressure was visible across the board despite healthy top line growth. There was a margin contraction of anywhere between 145 – 270 bps during the quarter for various capitalisation baskets ex-financials. Small cap basket witnessed the least margin contraction of around 145 bps.
WF: Some experts are now calling this decade as the lost decade for corporate India – given the prolonged earnings slump. What really is at the root of this decade long sluggishness in earnings momentum? What do we need to see to believe that a sustainable turnaround is underway?
Harsha: There was a strong investment cycle from 2003-2008 on the back of growing demand, strong credit flow and low interest rates. That was the bullish phase of our economy. During that period excess capacities were planned in anticipation of continued growth momentum. Post global financial crisis, when the demand collapsed most industries witnessed slump in earnings. In addition there were also issues on regulatory/ legal front for many industries. Since then the capacity utilisation rates have remained low in general affecting overall profitability. The resulting stress in asset quality in banking system also eroded profitability for many banks. Situation is gradually improving at least in some segments with improved utilisation rates. For sustained turnaround, another couple of years of strong demand is a requisite.
WF: Which sectors do you see creating significant wealth over the next 3 years and why?
Harsha: We continue to focus on domestic economy recovery plays in our portfolios. We like domestic cyclicals with high operating leverage. We remain overweight on Capital Goods and Cement sectors. In Cement sector, we expect pricing scenario to turn favourable going forward given continuing strong volume growth. The fortunes of the capital goods sector are also brightening up gradually. In addition, there is not much debt on the books of the capital goods and cement companies. The profitability improvement is going to be much stronger once demand picks up on a sustainable basis. We also expect Government spending to continue in infrastructure creation in the run-up to the elections, which augurs well for these sectors.
WF: Which sectors in your view are overvalued now and which sectors are value traps though they may look optically cheap?
Harsha: FMCG sector is trading at historically high absolute and relative valuations. With increasing concerns on sustainability of demand, we believe there could be valuation risk. Telecom sector continues to witness immense competitive pressure. We think the sector could remain an underperformer until the pricing power returns to the industry. Investors should also be watchful of many other beaten down stocks, where there is sustained sub-optimal return on equity and no visibility of a turnaround.
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