This cycle too shall pass, Manish Gunwani makes a bull case for midcaps
- Both time and price correction has happened in midcaps.
- In midcaps, we like hospitals, real estate, utilities, cement.
- We have assets to liabilities ratio of 10 which for US is about 7 or 8.
Life has changed for investors given where markets are in the last six months. What would you say?
In years of investing, we have seen multiple cycles like this. This is probably a fairly long correction, not in terms of price but in terms of time because probably it is 18 months since the broader market gave you any returns. But yes, a lot of factors came together. Essentially, a lot of Indian cycles are correlated with the emerging market cycle. The emerging markets themselves have been in a slow phase for the last 18 months.
On top of that, there was the NBFC issue which been like of liquidity shock really. They are not big in terms of the financial system but in terms of the steep fall in disbursements and loans given out, they had a big role in the slowdown. But my sense is probably it should improve from here.
Why do you think markets will improve? Markets only improve if there is deep value or an earnings recovery. The kind of stocks which are popular stocks with fund managers, there is a little bit of growth and good management comfort. Those are not cheap and I do not think anybody can put their hand up and say look agle 2 quarter mein earnings aane wala hai (earnings are going to improve in the next two quarters). So what is the bull case for market?
There are four big cyclical factors that work in an economy. a)The interest rate and monetary conditions. Obviously that has been very bad for last one year. b)Fiscal spending which given it has been an election year and given the fact that tax revenues have not scaled up, has been slow as well. c)Rupee went from 74 to 67 and that in a way is deflationary and anti-growth. d)Global growth in terms of capital flows because obviously India is fairly integrated in terms of trade.
There seems to have been a perfect storm where everything went wrong in last one year. But if you see yourself sitting here and think about what is going to happen for next one year, monetary conditions and the rupee are likely to improve substantially; in a sense, rupee has already improved a bit. It has depreciated 4-5%. That helps improve export margins, incentivise import substitution. Investors sitting outside are less worried more about further depreciation. So ideally for them, it has created a bit of value.
In terms of monetary conditions, the NBFC balance sheet is not that big. The banking system is Rs 150 lakh crore plus while the NBFC balance sheet is Rs 25-30 lakh crore. The ones under the cloud are probably worth about Rs 3 to 5 lakh crore. Even if you assume that the worst happens, the loss given default has probably gone up to Rs 1.5 lakh crore. Now if that is unlikely to shake a balance sheet of Rs 150-lakh-crore financial system.
But it happened in a concentrated period of time and the NBFC disbursals have dropped 30-40%. So there was a liquidity shock into the system which will improve going forward because we are already seeing the good corporates and NBFCs actually borrow three months , six months CPs at 5-6-7%.
So why is RBI maintaining that there is enough liquidity in the system? Why are banks saying they do not need capital? Why are corporates telling us that we want to borrow but banks are not lending to us. Is liquidity the problem or is willingness the problem?
Liquidity also has a soft element to it which is basically your animal spirits. Right now, the four big cyclical factors are going wrong and obviously a lot of people have lost their animal spirits and the banks do not want to lend because they are scared of NPAs; the corporates do not want to borrow because they have seen profitability getting hit. But that is what happens near the bottom of the cycle. At the bottom of the cycle you get the lowest interest rates because no one is interested in utilising that money and we probably are three-fourths or 80% whatever, we do not know the number because we will know the bottom only after we crossed it but we probably are very close to that.
So what do you do as an investor? Do you protect capital? Is it time to even ease out of the corporate banks or the top NBFCs or do you start hunting down the beaten down mid and smallcaps because they will give higher alpha whenever the market is to recover?
Today midcaps make a lot of sense because both time and price correction has happened even the aggregate valuations. Quality companies are relatively expensive at this point of time and so you are getting a lot of reasonably good businesses, they may not be the highest ROE businesses on the street, but reasonably good businesses at a steep discount or replacement cost, at a steep discount to book value.
One of the themes we like in midcaps is essentially these asset based industries like hospitals, real estate, utilities, cement which is difficult to put up versus the market caps they are trading at. Today if you want a lot of midcap cements trading at $40 to $50 per tonne, we all know that is a steep discount to replacement cost. Obviously the returns will come only once the economy recovers but as I said see what tends to happen is if you look at any country, your trend growth rate which has been there for 20-30 years, does not collapse overnight.
Be it in the US or India, around the trend growth rate you get cycles which are typically mean reverting because if your growth is low, inflation will come down, interest rates will come down and there will be a stimulus and growth rate will go back because the trend growth rate is about your demographics, education, health etc. which does not change for budget or FPI surcharge or lot of things we discuss day in and day out right.
So, to assume that auto sales will never grow in India again or that steel and cement demand will never grow is a bit of too much pessimism at this point of time.
But timing is also important. Would you buy autos now?
I am fairly bullish on things like commercial vehicles. But the other parts of auto have a long-term technology issue, which kind of makes the picture a bit more confusing. But I am ready to bet that a lot of the cyclical part of auto will come back.
You have a very large exposure to consumption, hotels, hospital, multiplexes. Here you are betting on discretionary consumption. Won’t slowdown have an impact on these businesses?
The best balance sheet today among the three parts -- households, government and private sector -- are in the households. In fact, we did a very rough calculation where the ratio of total assets owned by households (about Rs 350 lakh crore) versus the liabilities which is your loans from mortgages (Rs 30-35 lakh), is 10. We have assets to liabilities ratio of 10 which for US is about 7 or 8.
And you are able to get a fair sense because…
Real estate is the only one which is a bit of an approximate thing because rest of the stuff is RBI or industry data which is fairly real time. The point I am making is that the slowdown may hit your P&L, but the balance sheet is fairly superb. So to say that the Indian consumer will not come back is not a fair bet. Now the point is that traditional consumption stories which is your retailing etc. is a bit expensive. We are trying to play it through slightly. They are not the highest ROE businesses. You would love to own a 50% ROE business.
You are at a PE multiple of 20 but that is…
40 to 50 times earnings but there we see some operating leverage playing out because in 8-10 years, a lot of these industries like hotels or hospitals they have not done much in terms of market cap creation and today for suppliers to come in both equity and the fact that the cost of putting up that capacity (hotel or hospital) in a city centre is very expensive versus the market cap you are getting these stocks at.
So it is not a coincidence that you are buying Tata Group of companies. You genuinely think that individual companies have different levers it is not that you are bullish on Tatas; you are bullish on the businesses of Tatas?
Obviously. It is a group with high corporate governance which helps but it is not that we own every Tata Company. We are looking at each company bottom up.
What is going to recover from the storm, what will languish?
If you get a cyclical recovery, then the expensive staple stocks, for example, could languish to a certain extent. A lot of times, the recovery coincides with emerging markets’ recovery in which case, the emerging market currencies do well. IT could probably lag whenever the recovery starts.
What about the overall earnings cycle? How do you see it? Would there be some more pain before we see a recovery?
Obviously, the next three years on an aggregate level should be pretty okay, because some of the large contributors to Nifty earnings like corporate banks should come back. Obviously the timing goes six months here or there, based on how IBC resolution happens and stuff like that. But over the next three years, mid teens to high teen kind of CAGR in earnings should happen.
When we started the year, assumption was that we are in for a V-shape recovery. Now the V has become reversed, how does one really judge?
Markets are never easy. Would any forecaster have told you Maruti sales will drop 30%? No one knows. Typically forecasting is one thing we do but basically your biggest guide to making money is valuation because since forecasting is so difficult, the point is, the better your entry point on valuation, the more money you make over the long term.
Today, what the aggregate valuation is saying is true. Because of earnings cut, it looks expensive but you are getting a lot of stocks at historical parameters being very low. Utility trading at 7% dividend yield, midcap cement is trading at $40-50, a lot of the hotels, hospitals trading at a steep discount to the replacement cost. It will play out in three months, six months or nine months is anyone’s guess. All I am saying is give yourself a chance to make money by getting in at cheap valuations.
Where do you think the megacaps would move? Where is the future headed there?
I do not see absolute value destruction because the household sector balance sheet is very good. The earnings of these companies will probably still compound 10-15% whatever, but if we get even one-tenth of what happened in 2003 to 2008, these would relatively underperform.
Do you think one should avoid these FII-owned, FII-dominated stocks because they will sell what they have and they own these stocks?
I do not think you should look at it with that kind of prism or filter. Not every high quality stock is a sell to my mind because there are stocks which in terms of market opportunity have 20-30 years of growth. One of the good things you can do is just to see whether that sectors’ market cap globally is a multiple of what it is in India.
Can you give me an example?
If you look at organised retailing, Walmart is $300 billion. Just because the stock is expensive in retailing, to write it off saying that, I am never going to look at this stock because it is at a crazy multiple, is not fair.
There will obviously be pockets. Four-wheelers still concern me because the market cap in India is very big versus an EV to sales or the number of units sold of cars a GM or a Peugeot or whatever. They are very cheap versus what is there in India at this point, there might be a fair reason...
Are you suggesting they are going to fall more?
There could be genuine reasons that you have a distribution moat here. It is not valid in developed countries but no formula works in investing. You start comparing the market cap globally of that sector with what it is in India. I think it is a very good way of developing the investment thesis for a stock.
What is a screaming buy? Are they coming in from cement and utilities?
Style wise, it is just not the value stocks of cement, utilities, real estate and all that. There are also some growth stocks which we think are relatively cheap. But they are very few to my mind.
Cheaper from cement and utilities?
Value seems to be a bit more easier to pick at this point of time but again, the economy is very under penetrated and the consumer balance sheet is very healthy. You are going to see multiple decades of growth in consumer spending. If you take the US size of that industry versus the Indian industry, the ratio to my mind is about 35-40:1. You could say the stocks are expensive but that kind of ratio makes you wonder whether you should look for some serious positions in that sector.