Go bargain-hunting as markets near bottom: Saurabh Mukherjea
- Economy may bottom out in next 6 mths but market to bottom before that.
- There is an upside in CVs, auto ancillaries & pharma.
- Epect a gentle recovery towards the beginning of the next year.
We have the midcaps cheering, we are seeing FIIs starting to buy. Where are we poised at this juncture? Do you see a shift in trend or is it too early to tell?
From a macro perspective, the bottoming out probably will be in the second quarter. The quarter to September will probably be the worst quarter of economic growth. But from a market bottom perspective, I do not think we are that far away. For the last couple of years, I have been saying that markets are overvalued. A substantial portion of that overvaluation has been taken off. There is a little bit left. What should give us lots of cheer is steel prices are coming off, rubber prices are coming off, the currency is weakening, banks cost of funding is coming off, all of that suggests that somewhere in the next six months the economy will bottom out.
Typically, stock markets bottom out before the economy bottoms out. It could well be that we are closer to the bottom of the stock market even though GDP growth could come off for one or two quarters more. This is as good a time as any to think about building top quality Indian portfolios and benefitting over the next four-five years, rather than buying into all the doom and gloom that is being sold daily in our newspapers and broker notes.
When you say this will be the worst quarter for the economy, what are the factors you are considering? How can one be sure that the pain will not get prolonged because the word animal spirit is missing? Corporate have no desire to spend and the desire to spend by consumers has taken a back seat?
It is always difficult to call the bottom of the economy or the bottom of the stock market. What suggests to me that the second quarter growth will be worse than the quarter to June (Q1) is that most companies I have spoken to have said that August was a washout, both in the senses of heavy monsoon and a weak demand perspective.
I have confidence that the quarter to December (Q3) and the second half of the year growth will be better than the first half. First, if you look back at the previous financial year, the economy was in a pretty decent shape this time of the year. Last year in Q2, we had a pretty punchy growth, I remember auto numbers were pretty healthy. It is around November-December last year that the economy started losing steam and from base effect’s perspective, we will see H2 numbers perking up vis-à-vis H1 and therefore, in the second half of the year, we should see a favourable base effects.
Second, the conking off in the cost of raw materials is pretty punchy here. We are down 15-20% on steel and rubber. From the auto industry’s perspective, by Christmas it could well be that the cost of putting a car in a showroom for an auto OEM could be down by as much as 15-20%! Over and above that, the cost of money comes off, the banks start cutting rates. I know the banks are not yet cutting rates in a punchy manner but I do not think that is very far away.
I think the RBI too will cut rates at a fairly fast clip over the next 12 months. If rates start coming off and over and above that, the currency moves towards mid 70s to the dollar over the next six months, we have got multiple engines firing to perk the economy up.
I do not think we should expect a blazing economic recovery in the second half of the year. It is not going to happen but there is a good chance that in the quarter to December, the YOY growth prints will start perking up a little bit and early next fiscal, we will see the first signs of a tangible recovery. That is the mental setup I am working with. It does look clear though as August was a washout on all accounts on all fronts for the Indian economy.
I do not expect a V-shape recovery. Can I say that we are in for very moderate gains -- late single digit or maybe early teens -- from the market in the next 12 to 18 months?
We have had two to three quarters of economic deceleration and from that, for us to get a V-shape recovery will be a bit of an economic miracle to the extent that the economic deceleration looks likely to bottom out in the middle of this year.
It is fair to expect a more gentle recovery towards the beginning of the next year rather than a V-shape recovery. From a stock market perspective, there are so many juicy companies now, especially in small and midcaps -- high quality franchises, smaller franchises where valuations have come off considerably over the last couple of years and one cannot but feel that at the first signs of a gentle recovery, we will start seeing a degree of appreciation in those share prices.
It is difficult to call the market bottom, but it is looking like a good time for going bargain hunting in India even though there is a degree of risk out there. One should always realise that bargains are only available when there is a degree of risk. It does feel a little difficult from an economic perspective but one should go bargain hunting when you still feel a little of risk in the air.
Where do you think such a proposition lies within the broader market?
We have discussed this sector before but no harm in discussing it again. Auto is a sector where one needs to look quite carefully to the extent that there is an EV versus internal combustion engine disruption that none of us can do much about.
If we focus on those aspects of the auto ancillary sector where even if EV gains traction over the next five, six years, those elements of auto ancillary will be in demand. There are whole swathes in the auto ancillary sector where valuations or prices have come off 50-60-70%. That is where we are doing some bargain hunting. I would not like to disclose names just yet. Give me a little bit more time to do some more work before I come back to give names.
I do believe that in auto ancillaries there are high quality ancillaries, super balance sheets and dominant positions in that specific car part or motorbike part, where valuations have come off 60-70% and it is worth looking at those. I would say even in trucks where CV demand seems to be sort of falling every month, it is worth having a look at the CV manufacturers. There are only three that are relevant.
Again, I am doing some more work to figure out which CV manufacturer we should be looking at more carefully but there is an upside both in CVs and in auto ancillaries. The other area is pharma. It has been an unfashionable sector for a long time. Divi’s is the main stock that we have held in several of our clients’ portfolios but we are getting to that juncture where there might be other stocks that we would like to look at in the pharma sector.
If one had to look at two sectors with strong balance sheets, proven record of generating cash flow and shareholder value, auto and pharma are right there staring at all of us. We are going to get into a stage where the tastiness of the bargains on offer might prove too tempting for investors like me to resist beyond a certain point.
Auto ancillaries have corrected, valuations are attractive but the entire overhang of EVs which investors now will have permanently on their mind, will come later than sooner. But as a result, the sector will suffer and PE expansion will be capped. What is your view?
I so agree with you. What will happen is that the auto sector and auto ancillaries will bifurcate. There will be stocks in the sector -- for example crankshaft manufacturers, chassis manufacturers -- which will suffer from the EV overhang.
Then there will be stocks of manufacturers of side mirrors, windows, plastic panelling which goes inside cars, where the EV overhang is irrelevant because a switch from ICE to EV does not impact those parts of the car. We may be heading for a bifurcation in the auto sector between elements which face question marks on their growth rates as EV comes into vogue and other parts of the sector where regardless of EVs, demand will remain relatively robust. We are probably going to end up with two auto sectors – EV affected and EV unaffected.
Where do you see the bulk of the pain is still to come?
The main concern is over the financial services sector. If you ask bankers why they are not passing on the RBI rate cuts effectively between the lines, they say they are expecting more pain on auto sector NPAs.
There are plenty of car dealerships which have borrowed money which probably is going to struggle to repay those moneys. There are plenty of auto ancillaries which might still face a degree of pain. Obviously real estate developers, promoters who have borrowed money are struggling to repay. If you talk to the lending sector, there is still a great deal of jitteriness about NPA development certainly in the quarter to September, perhaps even thereafter.
So can our NBFCs, HFCs and private sector banks get out of the funk that they find themselves in? From an investment perspective, it is easy for me to say we hold HDFC Bank and Kotak Bank and I also own these stocks personally. But from a sectoral perspective, when will our bankers and lenders get the confidence that the NPA cycle is behind them and they can take a bit more risk? That remains a big unanswered question. I have not met too many lenders in the last six weeks or so who have any confidence that the NPA cycle has bottomed out and that remains a source of concern for all of us.
I always appreciate some of the classic compounders that you have. Abbott is a classic compounder. You have it from the last two years. Is the classic compounder now reaching a level where you feel you need to get out? Abbott is gold but yesterday, it was at an all-time high!
What I have been able to do over the last several years is to realise that in an economic boom, they will compound earnings at 25-30% and in difficult times like the ones we are living through, these sorts of stocks compound earnings at 15% to 20%. So even in the quarter to June, the earnings growth of our consistent compounder portfolio which is made up of stocks like Abbott, was 17%.
So in difficult times also, this portfolio chugs out good returns. If two to three years out, we are in a raging economic boom, I reckon earnings growth will be 25-30%. It is not going to go beyond that. These portfolios give you good absolute returns, bull market or bear market but what what you are highlighting and correctly so is in a raging bull run where if the markets running up 30-40%, a consistent compounder portfolio could underperform. Even in a raging bull run, this portfolio probably will give around 20-25% rather than 30-40%. It will underperform in a raging bull run but we find ourselves outperforming at an astonishing rate.
In the last 10 months, we have outperformed the market by 10-11%. Across cycles, you end up with 20% and if you end up with 20% in India across cycle, I will happily take it and so will most of our clients. That is what we have tried to inculcate in our client base, the willingness to play the long game, realisation that in a bull run Abbott could underperform, but in three out of four years, Abbott will give you better returns than the market and pretty consistently it will gun out 20% returns.
That is a good outcome for people like me and most of our clients and hence we will patiently stay wedded to the Abbotts, the HDFC Banks and the Kotak Banks of the world and these are both personal holdings and client holdings. It is the willingness to play the long game rather than trying to call every turn of the cycle.
Given that we are starting to see a pickup across the midcaps, anything new that is catching your eye, any new trend? I know you mentioned ancillaries earlier but would you at least be in wait and watch mode if we start to see that momentum on a sustainable basis across the broader markets?
We all see the macro numbers, we are trying to see if the financials of say the auto companies have cracked decisively. If you see Maruti, its operating margin has cracked considerably in the last what six-seven-eight months and it is not just volume conk off for Maruti. The margins have cracked decisively which from an investor’s perspective, is a good outcome because that way earnings are getting hammered alongside the share prices coming off.
But in case of Ashok Leyland, the margin crack has not yet happened big time though it is obviously a dominant player in CVs in south India, a powerhouse franchise. That is something worth looking out for. If you can get class franchise, volumes have come off and margins are coming off and that is when you can start thinking about buying a class franchise.
When I was in my erstwhile job in Ambit, in 2013-2014, we put a buy on Ashok Leyland, when it was at Rs 15 or so. That is how we thought it through. We said volumes have weakened, margins have come off. In fact, margins were non-existent; it was a loss-making company. At Rs 15, we put a buy on Ashok Leyland and it went all the way up to 150-160. Now, it is down to Rs 60-70. That is the dynamic I found useful in my previous bear market experiences.
Watch for volume conk off and then watch for the margin conk off. When both have conked off, start thinking of buying power house franchises which you know will do well on across cycle basis.