Normally markets follow a style. It is growth, value, dividend or technology. Right now you got excitement in the value end and extremely high end tech market. Do you agree?
Markets are trying to find new winners and new categories. The deep value category is no longer value, metals or public sector stocks or the old economy business are no longer value. They are actually deep, deep value because they have done nothing for the last 8-10 years. So markets are vacillating between these two pockets where growth at any price is at one level and low growth at very reasonable valuations is at the other level.
As we continue to remain in this environment, over the last two or three months, you have seen value significantly outperforming growth at any price. The market is trying to navigate that shift and that is starting to get visible. In fact, the last one month saw a substantial outperformance of value over pure growth at any price.
What is happening to pharma as a cycle? Cipla management says there is some margin saving, but it is not like because of Covid, we have hit a gold mine. So, why are markets excited about buying pharma stocks?
Other than the last six months, pharma was struggling for a 3-4-year period and we have seen earnings improving for the last 12-18 months. But markets were not responding to it because markets had become extremely narrow and only a select set of stocks and business were doing well.
The earning cycle for pharma is certainly on an uptrend from the low base of 2018 and 2019 and very few sectors today offer this visibility of doubling earnings in a four to five year period. So, that is one. Second is valuations of these businesses were 30%, 40%, 50% and even 60% cheaper than consumer businesses. Some parts of the pharma businesses have characteristics of the consumer space. I think that correction also happened in terms of the re-rating which was visible to us.
More interestingly, the narrowness of the market is slowly broad basing. The pharmaceutical sector is participating. Metals are starting to participate. You will see possibly some other sectors like utilities, which is a forgotten sector in India, starting to participate and maybe some good news comes in public sector businesses.
You will have public sector and engineering business starting to perform. So it is more a function of a gap of earnings that was there in sector for the last four years. Most businesses are now talking about earnings doubling in a four-five year period in pharma and valuations — at least what they were three-four months back — were absolutely mouth-watering in that particular space. That actually has led to the significant change. Also the weightages in the indices were ignorable., about 3% weight in the index. People said they may avoid pharmaceuticals because they do not understand the FDA challenges and all that. But when the outlook has improved materially, not because of Covid but because of their own business cycle turning, participation will also improve materially. This has happened in pharma and should be visible in several other sectors over the next 12-18 months.
Can I safely assume that your view on pharma for next couple of years is constructive and you think we are in a secular bull run?
Clearly. An earnings revival is under way for the sector. Earnings will only get better from where we stand and that will support at least earnings led growth for businesses in this sector. That is where the visibility is today. Pharma was in a perfect storm. That perfect storm has now ended and you are in a reasonably positive operating environment. So we are positive on the sector from an earnings point of view and a re-rating element . is already over for the sector. It is only earning led returns which shareholders should expect in the pharmaceutical space over the next three-four years.
Where within metals would you find optimism?
Metals generally are coming out of a very difficult cycle of 8-10 years. This is again one of those forgotten sectors. They have never really delivered over the several years and valuations across the board are way below replacement value, way below the cash flows they are generating even in difficult times.
Some businesses had challenges because they were overly bought and so they have been battered by the market. When you see a shift where you believe prices are going to get better, the profitability of those businesses changes materially in the metals case. We think it is broad-based because we have seen all asset prices rise because of excess liquidity in the system plus normalisation of global demand and lack of any new capacity creation in the last five, 10 years.
I do not think large capacity creation has happened in metals globally over the last several years because of people avoiding this sector because of the excess capacity which existed. Normalisation in some of these sectors lasts very long and more so because today’s valuations do not reflect any large or any major uptick in earnings in this sector.
Ideally, margin expansion for this sector especially when excess capacity moves out, can be way bigger than all of us can understand today and the weights in the sector today in indices are negligible. In fact, the metal sector would weigh less than 2% in any large index today.
What is the reason for the underperformance?
It is clearly because for the first time we have seen a six-month moratorium, I do not recollect such a long moratorium in any environment and six months is a very long period for not collecting or not receiving money from customers.
Secondly, we still do not know the full phase or economic recovery, the festive season might be decent because we have a very low base over the last four, five months and then there is inventory creation for the festive season. But what happens post the festive season in Jan, Feb, March is also an important factor to look out for.
Secondly, prior to this, we have had a huge retail boom in India, in fact retail lending possibly doubled in a four, five-year period in the last five years and on the back of a reasonably high retail leverage in the system, we are getting into a slowdown which is pretty sharp and pretty deep.
So there are challenges for the banking sector. However, we believe the larger banks are far better placed because they have raised capital, they are well positioned to handle this kind of a problem but broadly for the overall financial sector, it does not seem to be out of the woods yet because no actual data is coming out when the companies comment in the next one, one and a half months in terms of how the moratorium has ended and how people are behaving.
Also by January, February, we would really know the NPAs from the Covid-impacted sectors.
Is this the right time to get into damaged sectors like hotels, travel and multiplexes?
The Covid-damaged sectors trade at bankruptcy valuations. They are way below book, way below replacement value and it is unlikely that these sectors would not normalise over a 12-18 month period. Directionally, with a 12-18 month period, a better operating environment is possible for these sectors. In fact, airlines are already working at 30-35% of capacity utilisation and so it is starting to happen.
When you look at these particular spaces, the valuations are completely in distress and these are companies which will survive this particular crisis because these are generally the leaders who have survived till now and have remained debt light.
Also I do not see any new capacity in these sectors for the next three to five years, I do not think any bank will have the courage to lend to these sectors beyond just retaining these assets. Virtually, there will be no new capacity creation for a 3-5-year period. Generally, these are long gestation projects and it takes that much of time.
Second with now new capacity coming in and a huge pent up demand under play on normalisation, we should well be in a bull market for these Covid damaged sectors in a 1-3-year period. So that seems to be a high possibility. In buying leaders or investing in leaders in these categories, the risk reward is disproportionately in favour.
What about the underrated or under-owned sectors — engineering, power? We continue to see some reforms there. Should one be upbeat on some of these names?
Power is making a comeback. If the reforms which are being talked about are implemented, it could be a significant improvement from where we stand for that sector. Also power or engineering sectors benefit from a lower interest rate environment. It directionally benefits them a lot and replacement capex starts happening.
Also in manufacturing, we have a low tax rate of 15% for setting up new capacities by FY23. This will create significant demand for the manufacturing side. The challenges from US-China trade issues are allowing other companies to look at India as an important source and that can also kickstart manufacturing activity in India.
More importantly, we will possibly see domestic demand because people are shying away from importing a lot. A significant amount of import substitution is supported by government policies.
These factors could drive the sectors over the next three, four, five years. Materially they represent very small pockets of today’s market capitalisation which means if larger amounts of money wants to chase these particular sectors, it will be a function of growth shifting to these sectors. In all probability, growth will shift to these sectors over the next one to two years and that will lead to possibly a significant outperformance of these sectors over a period of time.
In index representation, these sectors virtually do not exist. The whole EPC space in India has under 3% representation in any large index today, metals under 2% to 3%, engineering has very little representation. So, all public sector utility businesses, power virtually have no representation. These pockets offer tremendous value in an environment which at one level, you have got growth at any price and at another level, there is disproportionate deep value.
I see significant deep value opportunities in these areas and possibly a big rerating for these sectors is possible over the next one to three years as earnings in these sectors shifts. Every single pointer to that shift in earnings is visible today and as Covid stress eases, these are the sectors to watch out for.
In this whole ESG angle, there some of these sectors are dependent on the government. But the cash flows are so low that all the so-called road, bridge and the other EPC contracts will not be rewarded. In some of the stocks, the representation has been low for a long period of time?
It is a very valid point. The representation has been low for a long period of time and it has been an elongated cycle. The longer the cycle takes to turn, the bigger the possibility of a revival in those spaces. This has been the norm. Pharma also was a similar sector where six months back, nobody wanted to own it because it was not moving. Six months later everybody wants to own it because it is moving.
Today government finances may not be in the best of shape right but we are virtually at zero in replacement cycle demand for four or five years right and you never had a manufacturing tax rate at 15% for a new capacity if you do it before FY23. You never had a support or PLI kind of link support for a lot of sectors. You never had this US-China related tussle. You never had companies wanting to shift or create capacities in India for local demand. Import substitution was never such a large or a big theme in India. Interest rates were never this low, power availability has never been of this size. We think lot of things are happening much better in the manufacturing space today and if ever there is a chance for manufacturing to come back to India it is now.
Should we expect radical changes in your portfolio?
Directionally we continue to look at opportunities outside the index. It is the classic battle between indexing and investing. At different points of time, these markets switch from being an indexing market for the last three-four years (as broader markets and the economy are not performing). If we get greater confidence in terms of direction or broad basing of markets in fact last one or two months have been surprisingly differentiated returns for portfolios which are different for the market so I think if we see greater evidence for that we think this kind of a shift will happen. Also when investors look at it, there are large sums of liquidity to be invested. People have put a 30-35% investment in financials. But if they want to own even 10-15% of their portfolios in larger industrial engineering domestic-demand driven businesses, the swing in prices can be way material.
What is visible in pharma is likely to happen in some of these sectors. Maybe, it will take some time. For us, it is always within banking for example we would own the largest and the best capitalised banks and may go underweight in NBFCs and other areas. That underweight we actually move towards sectors which we think would be emerging from the next 1-5-year point of view.