How are you reading all the news around you given that we are in the midst of a healthcare crisis? How does that tie in with the market mood?
In the near term, this is clearly a pretty big crisis. The number of Covid cases seems to be accelerating and in the very near term — if I were to take a one month view — markets may be headed for a little correction because this is going to be driven by earnings cuts.
Both the commodity price risk as well as the risk of Covid surge are not completely priced in the consensus earnings. So as the results keep coming, earnings will keep getting downgraded. But I do not expect the market fall to be significant because incrementally, the visibility of vaccines accelerating is improving.
We have done another report where we highlight that in the most bearish case, about 34% of Indians will be vaccinated by the end of this calendar year and in the bullish case that number could be about 48% of the population. That is a pretty wide spread and I am sure that we will settle down somewhere in between, which is encouraging. As more and more vaccines keep getting approved and the news flow keeps accelerating, the markets will look forward and not worry so much about the surge that we are seeing Covid cases right now. There will be a slight correction from where we are on the back of earnings corrections, but then we continue to be constructive on the markets long term.
Which are the sectors where you see an earnings surprise in the near term? Where do you think there is going to be a disappointment on account of the state wide lockdowns in the second wave?
In the near term, the defensive sectors like healthcare, staples, IT are going to throw up surprise beats because they have relatively nothing to do with the lockdown and the lockdown helps them. In the near term, defensive sectors will do well from an earnings perspective as well as relatively. But it is a short-term trade. Otherwise, looking ahead, we are bullish on cyclical sectors like financials, industrials and materials. They will do well and the common binding theme across all of these cyclical sectors is going to be the capex theme. We are at the start of a multiyear capex cycle. As the cycle keeps accelerating, all the cyclical sectors will do well.
Why are you bullish on utilities like NTPC, Power Grid?
Utilities had become ex growth predominantly because a large part of the transmission capacity or the coal-based power generation capacities have already been set up. These companies need to reorient themselves and need to find avenues for growth from the newer areas in comparison to where they are.
Instead of coal power, can they accelerate on renewable power? Can they get into the hydrogen theme which is too early in India but which will become a very big theme over time? Can they diversify into power distribution business which is likely to open up pretty soon on the back of the new law that is in the works.
One factor of growth for these companies will be how they diversify into newer businesses. We are about a couple of years away from that curve accelerating. In the meantime, if you are a patient investor, some of these stocks are very cheap. If you do not mind waiting, then this is a very good price to get in.
If you really want to time the inflection point of earnings, that is going to be a couple of years away but it is surely going to come for these companies. The second factor that will drive the valuation multiple for these companies is the interest rate because the interest expense for these companies is a pass through. But the discounting rate that we use in our DCF model is dependent on where the 10-year G-sec bond yields are. So when the G-sec bond yield starts coming off or correcting, that is the time to get bullish on these companies.
Discretionary stocks are sounding a little muted. Do you think the argument is different this time in terms of how demand was seen to come back later in the year or are there better options available in the cyclicals?
The financials, industrials and materials are not super expensive. In this market nothing is very cheap but financials, industrials and materials are in a comfortable valuation zone. Discretionary stocks are not. Discretionary stocks are trading at life-time high valuations. The earnings growth built in these stocks is very high. There is a chance of disappointment from there rather than positive surprises plus commodity risk. So about 47% of the sales of a typical discretionary stock is commodity cost and a large part of this is commodities things like steel. Steel has already gone 75% up from June last year but the discretionary companies have kept on getting upgraded.
I think the earnings are likely to get cut and in the context of that, valuations for those stocks look very expensive and that is why we are underweight on that sector at this point in time. We would like to play the recovery story through the financials, industrials and materials pack.
When you take a one-year or three-year view, what are you factoring in?
I would argue that from both the time perspectives, in the cyclical story, we are expecting high single digits, early double digits growth for the capex cycle over the next couple of years. From FY24 onwards, it will accelerate meaningfully on the back of private sector capex coming back and this time, the possibility of private capex coming back in FY24 is very high on the back of the government opening up a lot of monopolies to attract private and foreign capital.
So the point is that the cycle itself will slowly gradually keep picking up and if that happens, all of these stocks will see their earnings getting upgraded over time or over the years. Their valuation multiples will expand on the back of earnings catch up. So both from a one-year and a three-year perspective, these stocks are reasonably well priced and one can ride the whole cycle from a multi-year perspective too.
One space that I see in your top bets continues to be the staples, is that not a worry when it comes to staples purely because the raw material costs have been inching up?
You are very right but two things I would say there. First of all, until the second Covid surge started, we were actually neutral weight on staples because we thought that the markets may be headed for a little bit of a correction. We increased our weights in favour of the defensive sectors from a short-term perspective and staples is clearly one of those.
So, a) it is a near term or a tactical call on being overweight staples, not a long term thesis, number one. b) Specifically on the raw material costs, within the discretionary space, the ability to pass on the entire raw material cost is relatively low and that is why we are underweight on discretionary consumption. But within the staples, the ability to pass on the raw material price hikes is actually very high. So I do not particularly worry about commodities or raw materials hurting the staple companies. By and large, the 15-20% earnings growth that the sector is likely to deliver is adequately priced into these stocks and that is we are neutral weight from a long term perspective.
