Service sector, which contributes 60 percent to Indian economy has turned sluggish, which indicates that growth environment has deteriorated significantly, says Nilesh Shah, MD & CEO, Envision Capital.
“It was more like the last nail in the coffin in the sense the services sector was so far was growing at above GDP,,” he told CNBC-TV18 in an interview. The HSBC Services Purchasing Managers' Index (PMI) contracted for the first time in 20 months to 47.9 points in July from 51.7 points in the previous month. CNBC-TV18’s managing editor Udayan Mukherjee also feels that poor service sector growth data is an alarming bell and could lead to GDP downgrade going ahead.
Despite poor macro data, the market has managed to stay in the 5,500-6,200 due to support from few consumers and IT stocks, but it may not be able to hold these levels for long, he cautions. IT sector is likely to extend its outperformance, but valuations in largecap consumer stocks are in a bubble zone, he added.
The banking sector is poised for more downside and private sector lenders will lead this underperformance, he said continuing his bearish tone.
Given the bleak prospects of significant revival in the macros, one should avoid rate sensitive and economy sensitive sectors for the next few quarters. Bet on select pharmaceutical and some tier two consumer stocks which have managed to sustain 10-15 percent growth even in this environment.
Below is the edited transcript Nilesh Shah’s interview with CNBC-TV18
Q: What did you make of the big disappointment that we saw in the services sector data yesterday and how are you positioned in terms of growth going ahead?
A: It was more like the last nail in the coffin in the sense that the services sector has been the strongest pillar of the Indian economy. It has been a sector which has been growing at gross domestic product (GDP) beating rates and it has formed a large component of India’s GDP. Even now the growth in the services sector has turned sluggish indicates that in general the growth environment has deteriorated significantly. I do not think that is essentially a good thing to happen in this environment.
Q: Last many quarters we have at least floated around, thanks to eight or ten stocks in 5,500-6,200 range. Do you think it will hold out in the face of such poor data?
A: It is going to become very challenging. Those eight or ten stocks have been largely from the consumer sector and to some extent the technology sector. I believe that the technology sector is set to outperform, it has been delivering continued outperformance over the last few months and that is because of a revival in the US economy and strength of the dollar versus the rupee.
However, in the consumer segment, especially the largecap consumer names, valuations have been on significantly higher side, more like a bubble territory. So, I do not think that the largecap consumer names will be able to sustain these kinds of valuations. We are going to now see even further increased polarisation versus what we have seen in recent times. I do not think that is essentially a good signal for the market.
Q: How are you approaching it because it has been a long wait; this year has not passed very well, looks like things are not improving in a hurry. How do you approach investing right now in these difficult times?
A: The strategy to continue to avoid essentially rate sensitive, economy sensitive sectors. Unfortunately it’s a very large component of the investable universe and that is a segment which will continue to get punished and underperform till we do not see any major revival in the economy. Revival is hard to see at this stage.
The safest sectors within the economy have been the consumer side and again there valuation is a challenge. Therefore what is going to be very interesting to see is to continue to look at technology stocks, select pharmaceutical stocks and some tier two consumer names, which even in this environment are sustaining 10-15 percent growth. They are probably around 20 price to earning (PE) multiple. This maybe probably the right strategy to adopt for next few months or next few quarters.
The downside to the banking sector still is very evident given that the asset quality is continuing to deteriorate. Some of the banks which have managed to the asset quality well will have pressure on margins because of the latest developments in the money market. Particularly private sector banks which have been doing well, will continue to underperform going forward and not deliver the kind of returns that they have delivered over the last two-three years. It is a very narrow set of sectors which will continue to deliver outperformance over the next few quarters.
Q: If you had any positions in the capital goods space that you perhaps built in the last year and the hopes of a new finance minister coming in and getting the house in order and perhaps no spurring the investment cycle. Would you offload all your positions?
A: Fortunately, we do not have any capital goods stocks in our portfolio. But, if somebody still owns them, should be prepared for another 15-20 percent downside. It doesn’t look likely that over the next one-two quarters we would see any improvement there.
One is seeing a lot of frontline bluechip companies in the capital goods sectors either seeing 40-50 percent shave off in their operating profits and in fact some of the other leading names have also reported losses. I think this is a phenomenon, which has been there now for one-two quarters. It is something which could even continue over the next one-two quarters and you would now see the reverse side of operating leverage play out for these companies.
Q: You were making the point about how some of these capital goods names are under quite a bit of risk but from the more credible lot, which is the space that could get hurt the fastest now?
A: It looks like the capital goods engineering sector will continue to get further beaten down. I think the biggest risk is in the banking space and that has been a safe haven especially the private sector banks and some of the leading non banking financial companies (NBFCs). Despite all the claims of risk management and asset quality, they too become an extremely vulnerable space over the next few quarters. Given that one is going to see increasing risk of defaults happening.
So far we are seeing some amount of willful defaults but one is now going to see some defaults coming in because of the circumstances that individual borrowers are in. That is one segment which is where you see the biggest risk. Even some of the private sector banks despite the shave off that we have seen still trade between two-three times price to book. This I believe is expensive in context of the current economic environment.
So, I believe that is one area which looks the most vulnerable, second is on the consumer side, especially the bigger names. You have seen this quarter the numbers not living up to expectations. You are seeing now growth rates having decelerated, margins under pressure and if this happens for another quarter or so, you would see some kind of pricking happening even in the consumer space.
Q: Your point in banking is interesting because many of these stocks like Yes Bank and IndusInd Bank have had meaningful corrections but you think these private banks in the context of how much public sector undertaking (PSU) banks have corrected in terms of valuations can be start to trade at 1.4-1.5 time book?
A: I would probably say that the probability of them going below two times price to book is very high. If you look at most of the public sector banks, they use to trade at a marginal premium to their book values. Now they have come down, their valuation itself have halved about 1.25-1.5 time price to book to about 0.5 times price to book.
I think on a similar kind of a basis if these private sector banks have been trading at three-four times price to book, I would be surprised if they start trading around two times price to book. If not, then 1.25 or 1.5 times price to book because a few of them had some differentiated business models which look very vulnerable. This means that if a lot of them probably were dependent on the short end of the money market to borrow and lend at the long end. We are facing an inverted yield curve and that is going to post serious challenges in their margins.
The asset quality is going to come under pressure and it may not be a complete washout like the way we have seen in public sector banks. However, surly you are going to see a lot of cracks there in terms of their asset quality. So, even a marginal deterioration in their asset quality will have a disproportionate impact on their valuations.
Q: What is bothering public sector companies because across the board we have seen some massive price destruction; Coal India, NTPC, Oil and Natural Gas Corporation (ONGC), all the oil marketing companies. Why has the market taken such a dim of anything that had got the PSU tag?
A: At the fundamental level most of these companies have not delivered in terms of their operating parameters, be it revenue growth or operating profit growth. I think as a basket we have seen a deceleration in terms of the fundamentals and that has been the biggest worry.
However, apart from that the whole frequent revisiting capital market to offload a stake in them brings about a liquidity overhang in terms of the stocks. So, that is the second factor and third is that a lot of the global investors have been overweight on this pack. As you see a lot of these global investors begin to make those underweight Calls on India, it is pretty natural that if these stocks are part of an exchange-traded funds (ETF) or large index traded funds, you would see selling happen there and lastly.
There is also an apprehension of a concern that if the balance sheets of the public sector banks will be put to use to raise foreign currency bonds or foreign currency debt and if that were to happen in this environment to further expand leverage ratios may not be a great idea. So, I probably believe that you are seeing a combination of all these factors play out simultaneously along with depressed market environment which is leading to some kind of capitulation in these stocks.
Q: What about telecom, do you think that can put its hand up as a comeback candidate?
A: I believe that this is one of those serious comeback candidates and of course a couple of years back there were several concerns in terms of either the balance sheets of some of these companies or of course the headwinds which the sector was facing.
However, it looks like a lot of that has now receded in the background, some of these companies especially the frontline companies have now registered smart improvement in their operating performance and I believe that investors are relatively underweight. It is one of those very few pockets which is registering growth apart from technology or media on a very selective basis.
Probably telecom is the third pack which is delivering some kind of earnings growth in this kind of environment and I won’t be surprised if you continue to see outperformance on the telecom side. It is pretty much a scenario like the late ‘90s where technology-media-telecom (TMT) as a pack, which delivered significant outperformance and superlative returns and it looks like the history is going to repeat itself.
Q: With the exception of media, there pretty much boiling down to Zee Entertainment and the rest of the pack is not quite moving, is it?
A: I think that is the unfortunate part of it that you probably have names like Zee or Sun TV Network or a couple of names in the print media side which will continue to do that and that ensures or will probably contribute to valuations going overboard for those select one-two names because of lack of other names to deploy capital.
So, it is probably that just that one-two names which might do pretty well. But on the whole if you look at technology, telecom and media as a combination, it is quite possible that as a basket it would tend to outperform in this kind of an environment.
Q: If in the next day or two we get the Parliament nod for foreign direct investment (FDI) in insurance and pension, do you think that will lift the rupee or the market or it will get brushed aside like many other recent FDI announcements?
A: It could provide a temporary fillip to essentially the rupee; you could see some bounce back happening there. We might see levels of 61-61.25/USD go back to 59.5-60/USD, the kind of levels that we saw recently on the back of Reserve Bank of India’s liquidity tightening (RBI) measures. But it is not something which is going to be a significant game changer on a standalone basis.
It will have to be a comprehensive set of initiatives or comprehensive set of measures which will strengthen the rupee rather than one sectoral FDI cap getting relaxed because that relaxation will come in with some kind of string attached which is that a cap on the voting rights. So, one has to see how the serious the foreign insurance players see this as does this become a speed breaker or they are fine with for the time being and then wait for further relaxations down the line.
Q: Do you see any game changer between now and the next election result which can turn the mood on India around or galvanise growth in any meaningful manner?
A: At this stage it is hard to see that in terms of any change or significant improvement in the economic environment. It is possible that the earlier signs that would be evident would be maybe around the later part of this calendar year maybe sometime in November-December on the back of a strong monsoon and the festival season coming in, you might see domestic demand pickup based on that and that could provide some kind of a base in terms of the economy itself.
So, I believe that in the short-term the impact of favorable monsoon will have a positive impact on the growth rates but whether that would be good enough to essentially lift the economy out of the current growth rate around 5 percent to 6-7 percent, at this stage it is pretty hard to say. The second big factor is that if there are any signs from the US Fed that the bond buying program will continue; I know it is hard to see that in the current environment and the current context but if that were to happen that it is getting postponed significantly, I think that should essentially come in as a favorable positive.
So, these are the two big game changers so to say because in this environment even small change, which can contribute in a small way to the economy, could be clubbed as or classified as game changer. Therefore, these two or three things could lift the mood, lift the sentiment and maybe improve growth rates.