What are your expectations from earnings for the fourth quarter? Are we likely to see downgrades and has the market already priced that in?
It has been widely accepted and expected that earnings for the March quarter are not going to be very good. Individual companies in the consumer space have been highlighting how raw material prices have been high and consumer demand has been soft. Similarly, various other companies have spoken about rising raw material prices.
On the other hand, for exporters, shipping constraints and high shipping rates continue. So a large number of manufacturers in India catering to either the local markets or the overseas markets, are contending with higher raw materials and higher cost of energy and higher cost of transportation. Having said this, the aggregate market and especially Nifty earnings might not see massive downgrades simply because of the composition of the index. Banking and financial space, IT services, the oil and gas pack and telecom together make up nearly two-thirds of the index. And here, I do not see any significant downgrade. Metals probably will see a little bit of an upgrade. All added up, one might not see a significant downgrade at least on the frontline Nifty earnings. Drilled deeper, there are challenges and we have to contend with them as we go along.
We are seeing a really nice sectoral rotation in power, defense, pockets of FMCG and metal stocks. But IT, which has been the star performer for the last two years, continues to underperform. Has it peaked out?
If one looks at historical PE ratios or historical valuation ratios for IT services companies over a long period of time going back 20 or 25 years, barring the early part of 2000, IT services have never been so expensive. And they have been a great place to hide for the simple reason that they had spectacular growth over the last two years when the outlook on pretty much everything else was a little hazy.
Going ahead, valuations obviously are acting as headwind and so are costs. For IT services companies, attrition rates are high. Added to that, travel costs and office reopening costs have come in. But at the same time, demand remains very strong. I do not think there is any question about that. In the global macro backdrop, if one wants to pencil in higher inflation and possibly India being a little bit behind the curve on the rate side, we might continue to see a strengthening of the dollar versus the rupee and that might act as a tailwind.
So notwithstanding the valuations, IT may remain a place to hide though I would also caution that it is significantly over-owned because it has been a darling of the Street for the last two years. Most portfolios have a lot of it already. It is a tricky one to call. My sense is that we will continue to see earnings growth of 15% or thereabouts for the IT services companies over the next two years and that is the kind of maximum return from the stock price one can expect. There is no room for re-rating and if the dollar tailwind does not show up, there is probably a downside ahead.
Does one bet more on the bottom-up stories, the FMCG ones wherein the devil is pretty much unknown? and even Britannia and seem to be doing well.
Yes. I have been saying this internally and I will share it with you. I entered the market in 1992 and if you look at the BSE Sensex between 1993 and 2003, it went nowhere. Compounded annual growth in the Sensex over this decade was 2%. It sounds hard to believe but that is the truth and at the same time, there were plenty of mutual funds that gave a compounded annual return of 23-24% over this time period.
What happened was that post the Harshad Mehta boom, the markets had become very expensive, especially the front line names and therefore one had to generate alpha bottom up looking at different ideas, different stories, new listings. IT became a new sector almost; pharmaceuticals became a very important sector from being nothing at the start of that decade. I see a similar story playing out now. Valuations are expensive and therefore we cannot expect much action in the Nifty – the down 10%, up 10% kind of drama will probably continue – but we will have a lot of opportunities bottom up. This is exactly the kind of market where professional money managers and astute investors should be able to find good ideas that they can work with.
What do you think of the telecom sector? The government has reduced the 5G spectrum auction price, but instead of a 90-95% reduction which the operators had asked for, there has been a 35-0% plus reduction. Also, now the validity is for 30 years. So, on a net basis, the reduction in outflow is as miniscule as 3-10% for an industry which is grappling with cash flow issues, barring the big one of course.
In some sense, regulatory challenges have always been something to reckon with in the Indian context but at the same time, the government is cognisant of the fact that businesses need to survive and thrive. The kind of change in approach that we have seen in the telecom regulatory environment over the last two years would suggest that the government is very keen to have at least three players if not more. To that extent, while yesterday’s release may seem a little bit disappointing, I think there is more to come. I also believe that we will continue to see an increase in ARPUs for the simple reason that there are still a large number of feature phones out there and as people convert from a feature phone to a smartphone, they start using more data and that kind of helps the telecom revenues.
I think actually the regulatory environment is supportive. Obviously, there are things that need to be worked out between the players and the government and I am sure we will find answers to some of these questions as time goes by.
If one were to look at the smaller banks outside the SBIs and ICICI Banks, what should the approach be?
One has to be very cautious because the competitive landscape has changed in the sense that as liquidity tightens, we will see pressure on deposit rates before the rise in lending rates and in that environment, if there is a small bank that does not have access to deposits or has not been able to build a reasonable deposit franchise, then expecting NIM expansion is going to be a little tricky.
Having said this, the stronger trend is loan growth. We have seen some uptick in fiscal 2022 with loan growth of about 8.5-8.6% which is twice the rate that we saw in FY21 and hopefully this accelerates as we go along. The trend in stronger loan growth and lower credit costs is universal. It will help all the banks – whether large or small. One might be right in the sense that the larger banks have already significantly rerated and smaller banks are relatively cheap in comparison to the larger banks and as we have seen pretty much in every sector in the past, when a sector comes into favor from an earnings standpoint and an investor standpoint, first the leaders move and then the smaller businesses benefit. I hope this plays out, but obviously I would be cautious to the extent that if a bank does not have a deposit franchise or it does not have a lending franchise and it is just out there trying to muddle through, that might be a trade but may not be an investment.
At the start of the year you had said that no one stock market theme is going to dominate 2022. Till the month of April, sectoral rotation has certainly been at play. What is the strategy you folks are deploying? Any ideas?
Unfortunately I cannot speak about individual ideas but financials continue to be a place of interest for us where we have a significant overweight or reduce the overweight and continue to hope that the narrative of loans growth accelerating, credit cost coming off plays out and eventually results in higher stock prices.
Tactically, we continue to be neutral-ish on IT services. Among the rest, pharmaceuticals is an area of interest where stocks, at least the smaller ones have significantly underperformed the larger ones over the last two years and there is a reasonable amount of value emerging now. But for the rest, at least in our head, there is no sectoral preference.
We tend to be a lot more bottom up given the opportunities. If Nifty valuations are expensive, that does not leave much room for the broader markets to give sustainable returns from here. I continue to believe that we will see a weak day of the decade between 1993 and 2003. Maybe, this time it would not be so long, maybe instead of 10 years, it will be three years. That is possible but bottom up is the way to go. Individual stocks, individual stories, individual arguments is the way to go because there are companies out there which are not expensive and the macroeconomic indicators in India are looking fine.
Company balance sheets are looking fine, If demand holds up, then there is a lot of opportunity for different companies and at the same time there are a lot of very expensive stocks which will participate in the opportunity but delivering earnings may not remain only with the largecaps or the few quality names.
In September last year, you were pretty bullish on realty as a pack. Would you say that a large part of that trade is behind us?
Whenever it comes through, realty is a multi-year trend. Again, if you look back in history, we saw nothing happened in the real estate sector between say 1996 and 2002, Then we saw rally in demand between 2003 and 2010 and there has been a lost decade thereafter. Affordability of homes relative to median incomes has increased for white collar workers significantly; rates are still low, EMIs are affordable and the pandemic has taught us that we need to have more comfortable homes. I think these are structural drivers. They do not go away in a hurry. Demand is going to be extremely strong for the next one or two years, unless inflation turns out to be way worse than expected and something goes wrong in the rest of the world.
But generally speaking, I continue to believe that the demand for real estate will be quite strong. The stocks had rallied strongly and I was quite positive on real estate six-seven months ago but when this is a multi-year trend, one could still see more upside because when the sector is doing well, it tends to get overvalued. But I don’t think the realty stocks are overvalued even now.