The screen suddenly becomes so strong that it has a message: Don’t look at the big picture. Look at stocks. It is a way to explain that the screen will become shorter if you press the button.
We have demonstrated tremendous resilience in the face off continued bad news from FPIs and outflows from them. I would call it maturity and depth of market. I believe the market is giving me signals. The market isn’t foolish to ignore all negative news.
What do you think of the resilience? What could have gone wrong in the last four-five years? It has been war, oil shock, inflation, FII sales, and margins under pressure. Markets have not collapsed and earnings have not been upgraded.
It is important to view it from the perspective of the current economic cycle. This will help us make sense. The market is indicating that the economic cycle recovery that began seven-eight years ago is not over. While we might be experiencing some roadblocks, which was mainly due to the margin impact, clearly our central bank is not doing what the developed world does.
The inflation spikes in the developed world are much higher than those we are seeing here. Even the bond yield spikes in the US are much higher than the one we are currently seeing. India is diverging from the developed countries because of higher valuations.
China has hurt itself by the regulations they have imposed on tech companies. Russia has been outlawed and that has raised questions about Europe. All signs point to India being the only option to the developed world, particularly the US, which is the largest market where funds can be deployed. If the environment is inflationary, it is better to be in a stock than a bond. This is the message that the market is sending.
What do you make of the India market’s outperformance, at a time when S&P 500 has fallen around 8%-8.5% per month?
India’s micros have a lot more power than the developed countries. The GST collection and fuel sales, as well as road traffic, air traffic and hotel occupancy, are all indicators that indicate that the micros are strong. While there are certain impacts on margins due to freight and raw material costs, that is something we are dealing.
We haven’t received an earnings upgrade. Markets aren’t attractively cheap, if any. Inflation and energy shock will have a significant impact on the economy over the next two to three quarters. For FY23, we can expect no returns or low returns and even negative returns. That is what the current situation seems to indicate.
We are already in a phase, and there have been no positive returns since October last year. It has been nearly seven-eight months. Maybe a few more. It seems that the market reacts in uncertain times. Sure, there is inflation and high bond yields. However, it is not an unknown threat anymore.
Markets are factoring, portfolios are adapting, central bankers will adjust tomorrow Fed will do its first 50 bps increase. Markets have already factored in nearly seven-eight hikes leading to almost 3 percent, and bond markets have also adjusted. Now the question is: The question is: Will the growth continue? If the growth continues, then some operating leverage can offset the margin impact. Markets will not look beyond a few quarters of impact. This is not the way to look at our three-five-year story.
Markets will move to companies with better cash flows and brand pricing power, such as the Britannias and Nestle of the World, when inflation is back. This thesis has a problem because consumer staples and consumer durables are too expensive, and quality is trading at an premium. What will happen to money when inflation returns?
Temporary pricing power can exist in some industries where the demand is too strong short- to medium-term. You wouldn’t usually say that the hotel sector has pricing strength, but we are seeing that today’s room rates are high enough that people are willing to pay them. The occupancy levels are also very high. There is a strong uptrend in the economy’s cyclical component. This is giving a lot price power to many other sectors than the traditional sector. These are the areas that one should focus on from a business momentum perspective for the next four- to six quarters.
What have you done to improve your portfolio position since January?
We have reduced a lot our position in chemicals over the past six-eight month, where we believe that the market is factoring long-term growth. These stocks were once valued at single digit PEs five-seven years ago. Now they are getting 30 to more than 30 multiples. Some stocks are worth 40-50 PE multiples of earnings, which is unlikely to sustain; at the very least, the earnings growth rate is not likely to sustain. The earnings could sustain at a higher level. We have reduced that.
In the financials, we have also seen a steady increase in our weight over the past six-eightmonths. Financial can be used to refer to private banks, public banks, housing finance companies and commercial vehicle financiers. It also includes asset financiers, asset financiers, and gold loan companies.
Our focus has been on cyclical real estate recovery and business recovery. We want to concentrate on companies that address these opportunities, whether it is a bank nor an NBFC.
Perhaps steel is the new gold. Metals are a subject that has divided opinion for decades. What about metals today?
Metals are clearly in an uptrend. The supply shock drives commodity cycles, not the demand. While demand remains stable over a time period, it is the supply shock that creates the cycle. We are currently experiencing one such supply shock. I don’t see why steel prices should drop and therefore steel stocks should continue to grow at this moment.
We have not entered an era where cash flows are used to purchase large assets or the balance sheets are leveraged. Usually, you buy the asset and you sell the earnings. But it seems like the momentum will continue for some time. We do however take derivative play, but we have not yet taken any positions in commodities. If commodities do well, there will be some companies that will also do well in the commodity cycle.
What about pharmaceuticals, though?
The pharma companies have endured a long winter. The sector reached its peak in 2015. We are now in 2022 and the sector peaked in 2015. The primary reason for this downturn was, of course the accumulation of a lot supernormal profit in a handful of products. All those profits have been wiped out, and I am referring to the US generic plays.
The US generic play market has seen significant price erosion. The price erosion has been reduced to a large degree. The number of FDA issues has also decreased. We were given a window of two years where the focus shifted towards Covid portfolio. There was no incremental inspection. There was no incremental bad news.
Now the physical inspections have resumed. It’s good news and bad news. Good news is that all the delayed approvals are now coming through. Bad news is that some facilities could get into more trouble. But the pharma industry has learned its lesson. While a site may not have been approved by the FDA, the majority of companies and cultures are now following the US FDA standards. India is not the only country that can be used in the pharmaceutical supply chain.
It will be fertile ground, but one must be selective when picking. The US has fewer profit pools. From the next five-seven year perspective, biosimilars and injectables are still areas with a profit pool. Companies that have greater exposure to these areas are the ones one should focus on when purchasing a stake.
Domestics: The portfolio shifted to Covid over the last few years. This portfolio has been reduced.
You have always believed in the digitisation theme. We all know your opinion on the likes. What next? What are your big bets? Are there attractive opportunities to invest in the IT services sector?
I will start with the IT services. The boom in the US market and the digitization of the US is creating a derivative demand for IT services. The stocks have risen a lot in recent times. The valuations are higher than expected and there are still challenges on both the attrition and margin fronts. Some of the companies have been disappointed on the growth front.
So in this sector, I would recommend that you wait for 6-12 month to see how attrition is being addressed. Then, maybe you can find a better entry-point.
However, there are many different ways this digitisation theme could be played. Many of them are not listed and I believe that many companies will be entering the market in the next one-two year. The good news is that valuations have fallen in the US tech sector, regardless of whether it’s an IPO or private equity market.
Although there is a little more sanity to the valuations mentioned, the growth will continue. These companies will eventually come along, and they will be very good. If you find companies that match your valuation criteria, these are the companies to focus on. So it doesn’t matter if it’s Zomatos or Nkyaas, there will be many more companies that fit your valuation criteria. This is where it’s a good hunting ground for the company’s quality.
So, have the Zomatos in the world fallen enough that you can add more positions to your ranks?
Some of the items in the previous cycle were so expensive that it will take some time for them to catch up to growth. The growth is happening. The models are strong, and the industry structure has consolidated. These companies will be around in five years, ten years and beyond. They are changing their business models. They are now focusing on fast delivery, under 10 minutes, and non-food delivery.
It remains to be seen how they will handle this transition and what amount of cash it leads to. However, I believe these companies are solid. They won’t go down under, so it is important to keep them in mind. The question of whether to buy them or not should be answered in the next 6-12 month.