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Why Prateek Agarwal is avoiding commodity and PSU stocks for now

Q2 could be better than expectations while Q3 may look at tad softer.

ET Now|
Nov 01, 2019, 01.48 PM IST
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We want to stick to businesses which can compound earnings over a long period of time and increase valuation gradually, says Prateek Agarwal, Business Head and CIO, ASK Investment Manager. Excerpts from an interview with ETNOW.

Markets are starting the New Year with new highs and it has been pretty cheery all around. What are you making of the current momentum?
The change in sentiment after the tax cuts has been very sharp. Reforms lately has been favouring the equity markets sentiment and this is going to continue. India is a place where given the low equity penetration, you expect the flows from Indian population to mutual funds to get stronger as we go forward. When sentiment revives and FIIs also end up buying, you get the kind of market we are looking at just now.

Let us talk about the earnings season that has gone by. We are seeing a lot of upgrades coming in and it has not been as bad as one would have expected in this quarter. Majority of the Q2 earnings have come in above Street estimates. How have you looked at the earnings picture so far?
We have been positively surprised. Earnings have been better than what Street projected but just a small caveat. Street got a bit bogged down by the auto numbers, the quick data that comes in every month. Those numbers have not been good. However, other spaces do get impacted by how the inventory moves from factories to the retail channel and this time around, the festival season was a bit ahead versus last year and part of the inventory would have moved in Q2 versus what would have moved in Q3 last year.

There is a sense that Q2 numbers would look better than expectations while Q3, where people are very positive, may look at tad softer. . We had discussed this internally. However, if you go forward, Q3 has a very low base effect as that was the start of the NBFC crisis last year and it was the first really soft quarter.

The fourth quarter four of last year was good and that will be the base this year. But once again, Q1 and Q2 of this year would be the base next year. Over the next four quarters, you have a low soft base for three quarters. We would tend to see strong YoY growth over the next one year and that is something to look forward to.

What is the outlook on stocks that have had a chequered past? The likes of YES Bank, Essel Group, RBL Bank, Indiabulls -- it is a pretty extensive list, given that some of them have been able to weather the storm and seen some positive news flow post that. For investors, does it make sense to take bets on these names or is it a complete avoid?
Many of these businesses had structural problems to start with. Housing finance business has inherent ALM mismatch and if you lend too much to builders where inventories are stuck, you have a bigger problem. On paper, a lot of these businesses look good and you can have a very strong growth. There are weaknesses in these businesses and over the last eight years, we have not ventured around to any of these businesses.

We do not see ourselves venturing into most, if not all, of these names going forward as well. Today, we are undergoing a very strong reform phase. The going gets tougher for businesses which have as yet not been able to find their feet in the marketplace. As reforms are carried out and more rules and regulations are in place, we get more formalised, more organised and some of these businesses will find it even tougher. Besides the names that you have taken, it will be broadly true for the mid cap and smallcap stocks.

To my mind mid and smallcaps do well in a stable rule regime, a good growth backdrop etc. Rules change when growth is slow this is a part that is best to stay away from.

Are you looking at cyclicals as a theme to play out going forward? What would look attractive within that theme?
So with a backdrop of soft global economic outlook, commodity businesses are not something that we are doing. While some of them look reasonably valued for a very long period, investors may have to start to look there. But we are not looking into this space and are looking at businesses which benefit from the softness in commodity prices.

Our thesis for some time has been to look at users of commodity with pricing power. In a soft economy, the improvement in gross margin, even with some small amount of sales increase would end up driving PBT increases. In durables, FMCG, etc, you have seen almost without exception, an improvement in gross margins and some small sales increase as well, which has resulted in a sharper increase in PBT line. We will stay put there for some more time.

What about the PSU theme? Are you closely looking at Concor, BPCL, SCI?
We are following the space. It is a very cheap space and if the government changes the manner of disinvestment into the public markets and prefers the strategic route, that is very, very welcome. Strategic value of these businesses would be significantly higher than what the market place will provide. It has got two benefits – one, the crowding out effect in the domestic market does not happen; FDI and longer-term money come in. The valuation that the government gets is better and so all round benefits.

Yes some of these businesses are very cheap. BPCL, Concor all are good businesses and should find a lot of traction. Some of these businesses are fully valued on domestic cost of capital but offshore, even if you assume a 2% borrowing cost and a 3% to 4% rupee depreciation at a 5- 6% incremental cost of money for many of the offshore bidders, the valuations that these businesses can command can be substantially higher.

So yes, we are looking at this space closely but then we are also aware that this would be in most cases, a one-time big pop and that is not something that we do for our clients’ portfolios. We want to stick to businesses which can compound earnings over a long period of time and increase valuation gradually. So PSU are not our thing, but yes we are clued on.

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