Jun 20, 2017 05:02 PM IST | Source: CNBC-TV18

Earnings may not improve in 3-4 quarters; high valuations likely to continue: Credit Suisse's Neelkanth Mishra

Neelkanth Mishra of Credit Suisse said that the momentum was weak and broader economy was unlikely to pick up any steam. He suggests looking at stocks or sectors that offer supernormal growth.

Several voices have been continuously debating about the battle between valuations and fundamentals in the current market.

High valuations have been a subject of debate in the current market scenario for a while now. Several voices have highlighted how it is very essential for earnings growth to fire up now to be in sync with valuations. But is there a recovery in sight?

Credit Suisse does not feel so. “I don’t expect earnings to improve in the next 3-4 quarters. The momentum is weak and broader economy is unlikely to pick up any steam,” Neelkanth Mishra, MD & India Equity Strategist at Credit Suisse told CNBC-TV18. He added that the economy was going through structural transitions and this period could last longer.

Having said that, Mishra said that the market moves were largely driven by PE ratio. Any correction in this market would only be if a global liquidity fall is seen, he added.

So, what should one look for the market?

Mishra recommends looking at stocks which return higher than nominal GDP growth.

“We look at sectors where supernormal growth is possible,” he told the channel. Among such sectors, he said that electrification in India had improved significantly. Because of power, he explained, you will see better demand for consumer electronics. Technology, too, is enabling dramatic changes on how banking is conducted. All this will bring down the total cost of lending.

Meanwhile, Mishra also sees structural tailwinds for NBFCs and prefers housing finance companies.

Simultaneously, on farm loan waivers, Mishra said that the fiscal impact of this will play out over years. He highlighted that farmers were quite savvy and knew to differentiate the kind of loans that were waived.

Below is the verbatim transcript of the interview.

Anuj: Right now it is about liquidity trumping valuations, do you think that should continue or do you think the market is factoring in that valuations would also come at par, earnings will improve over the next three-four quarters?

A: No, I don’t expect the earnings to improve over the next three-four quarters. The momentum still looks quite weak, the broader economy is unlikely to pick up steam in the next three-four quarters because we are going through some very structural transitions. I call it house under renovation, so we are breaking down a lot of vicious cycles we were stuck in and then rebuilding in what hopefully will be a much healthier and a much faster growing economy.

However, the period of transition could last a lot longer than just three-six months. Now from the perspective of markets, the first question to be asked is does Indian macro economy really matter for the markets. Fundamentally, of course you can find a lot of reasons why it should not because in most years the market moves are driven more by price to earnings ratios than EPS changes and even EPS changes in the listed space are not necessarily very strongly correlated with the gross domestic product (GDP) growth numbers.

So my sense is that given that liquidity does seem very supportive and it is not just India – if you see price to earnings ratio, they have gone lower, even the US markets hit all-time highs yesterday. So this seems to be a global phenomenon and if any correction has to happen on liquidity, it will again be driven by what is happening globally.

Till then, I think the markets will be less concerned about near-term macroeconomic uncertainty and valuations could stay high for long. What we have done in our recent notes is try to come up with frameworks where if we have to choose between very high P/E stocks, how do we do that, which are the stocks, the market is effectively pricing in a tide, the market is assuming that almost every sector in India will do well, everything is under-printed and India eventually will grow very fast. What we have found is that it is not true and it is much better to be selective.

Latha: Just to finish that argument, you said this is a house under renovation with GST, with the chase after Black Money, therefore when can there be a broad swathe of economic growth which translates into earnings growth?

A: It is very hard to say whether this correction last like four quarters or six quarters or eight quarters but it is definitely not two quarters. At this stage that is relatively safe to say. Some of the corrections that are happening are much more subtle but equally fundamental. So our cost of capital is likely to come down because for the longest time as an economy, we have had very high cost of capital partly driven by government policy, partly because of technology, partly because of small government etc, now we are seeing that food inflation so we are finely dealing with food surpluses, we are finely dealing with at least at the central government level, lower fiscal deficits and we can discuss farm loan waivers if they disrupt that the reduction of crowding out and I think that this will overtime manifest itself in much lower cost of capital, a high price to earnings ratio is cheaper cost of capital, equity capital and as rates come down, I think overtime we will see a healthier economy. It is very hard to say whether that happens in four quarters or six quarters.

Sonia: The other theme that you have been talking to us about is how you should look for businesses that are growing their revenues faster than nominal gross domestic product (GDP) growth and it is very tough to find those kind of businesses in this market. Have you been able to identify any such themes?

A: That is the most important question. Right now, 24 percent of BSE 500 companies are trading at about 30 times earnings. Five years back only 6 percent of such companies were trading above 35 times. So it is very important to instead of blindly buying anything in consumption or the non-banking financial companies (NBFCs), we look at sectors where such supernormal growth is possible.

As you rightly said even in the last 15 years, even the topline growth for two-wheelers or four-wheelers has been above nominal GDP growth. Now going forward, I think we have to look for areas which are seen changes in enablers. For example, electrification, it is a theme we have been working on for several years now and in a recent report, we highlighted pictures taken by NASA, which show that night time luminosity in India has improved significantly. Particularly in areas which earlier were very weak. In Maharashtra, Uttar Pradesh (UP), Bihar, interiors of Andhra Pradesh. So these are areas where earlier electricity availability was very bad. Now there is electricity. So eventually this will mean better demand for consumer electronics, white goods as well as brown goods, demand for fans and mixer grinders and so on and so forth.

Similarly, I think technology is enabling dramatic changes in how banking is conducted. It is also sharply bringing down the costs of lending for example. If you do manual credit evaluation, it takes a lot of effort and therefore it is very expensive. If you do cash disbursements, cash collections, it adds a lot to your cost, if you do in account disbursements and deduct EMIs directly from account, it saves a lot of cost for the lender.

Therefore, some of the NBFCs could be growing rapidly. In particular, we like housing finance companies because if interest rates come down, the demand for mortgages picks up. So there are various themes where the enabling environment can drive growth, which is faster than nominal GDP.

Latha: It was in May 2016 that you first wrote in a report that you see farm prices falling and therefore a rapid fall in interest rates and you reiterated in September 2016 when you all went very big on finance companies, housing finance companies and NBFCs. But they have run up a lot, look at stocks like Bajaj Finance, they were running anyway and they got fresh legs to run from January onwards, wouldn’t valuations be an argument in the NBFC space, especially housing finance?

A: Housing finance – on some of the NBFCs, I think what happens is that while there is a structural tailwind, therefore the medium-term outlook for growth is very strong. What also happens is the firms have to execute on it and have to execute on it with good quality. So sometimes what you see is that if you start getting very cheap funding and somehow you get into this rat race of being forced to grow fast because the market is giving you valuation because everyone else is growing fast and the sales guys targets are being set by what their competition is doing, that leads to a lot of indiscipline.

Therefore on some of the names, we have sell calls in NBFCs as well not because fundamentally their business will grow slow but because some of them are trading at 4-5 times book and we are not as comfortable as we were one year back on the quality of lending that is happening because eventually giving money is easy, getting it back is the tough part.

Latha: Let's complete the farm loan waiver argument, how does that square with your stock picks?

A: The farmers are generally quite savvy and the loan waivers are happening for what you would call the working capital loans. There are two types of agri loans; crop loans and non-crop loans. Non-crop loans are term loans used to buy tractors or cattle or whatever and farmers are generally quite savvy in terms of differentiating between what is being waved and what is not being waved and in particular database based lending and that is a power of database based lending because some of the databases that exist in India are quite dump, I have seen my credit report, it is not too much data there, so I wonder for someone who doesn't have mortgage and credit cards, how does the database help. The database helps because it becomes a deterrent because once you get a bas score there, you are ruled out of loans for a long time and the farmers know that.

So if you are in the Microfinance Institutions Network (MFIN) database and you are seen to be defaulting especially when the government has not declared a loan waiver there, so the risk there is a lot lower. There will be a risk, everyone operating in states like UP, Punjab and Maharashtra needs to be extraordinarily careful but that snowballing into a massive credit default risk for NBFCs is -- I see this manifesting itself in slower growth. So what happens is in loan waivers, while the headline is what politicians want to talk about because the bigger the number the more the political impact; the fine details get years to work out, for example the 2008 waiver, it was announced in February, it was confirmed by the cabinet in May, the first disbursement happened in December and for the next two-and-a-half years the banks kept getting their money, so it was executed over two-and-a-half years. The final tranche was actually given four years later.

So it takes a long time to even identify who the beneficiary is, even Maharashtra for example, is still trying to figure out whether land owner should get it but if that is the case and if there is a tenant farmer, should they not because the tenant farmer is taking the working capital loan; should they not benefit, should it be crop specific, should it not be crop specific. All of those details have to be worked out. It takes a long time, the data is scarce and therefore the fiscal impact of this will play out over several years. I wouldn't worry too much about fiscal deficit this year going out of whack.

Coming to the impact of this, the growth is where things suffer. So as the farmers are not sure whether their loans are getting waved, they start slowing down on their repayments and the banks then hold back, so we have seen that in Andhra Pradesh and Telagana where we have seen agri loan growth slow very sharply around the time that the states were giving their waivers and that is something that can hurt the NBFCs as well because they may be forced to slowdown lending in some of those areas.

Anuj: Let's now discuss a theme that has worked out beautifully for you. You have got the bottom here which is metals. Give us your thoughts on this? We have seen a dream run for steel in particular. Do you think we are still in the middle of the cycle or nowhere near the top of the cycle? How should investors approach this space now?

A: When we upgraded last year the expectation was that that this was a restocking cycle where we had seen three years of steady price declines and everyone including from automakers to yellow goods makers everyone had destocked because prices were steadily falling. And as soon as the prices bottom out, everyone will want to restock and the steel companies couldn't see and see very sharp production growth which is something that has played out. So by this time, when we upgraded last year, I had thought I would be downgrading by this time but the change that has happened is that there seems to be much greater focus in China for example, to curtain their excess supply. What has also happened is that Europe, which is a very large economy, is now growing faster than anyone expected after many-many years of a slowdown. The US consumption which has slowed a bit but it is actually holding up about 2-2.5 percent. So the global growth expectations are now a lot steadier than they were one year back. Therefore, I still think that this is a sector which is under owned, a lot of people always thought this was a one year trade so they stayed away from it but there is still room for the stock to do well.

Sonia: The other theme that you spoke about lately is personal credit could grow over the next two-three years and that could be a big value sector to look at. We have a couple of big companies there like Bajaj Finance, some of the smaller ones like Shriram City Union Finance. Can you briefly mention the groundwork for why you like this sector?

A: India has been stuck in a vicious cycle where there is a lot of demand at the lower end of the spectrum because 70 percent of our non-agri employment is in enterprises with less than 5 people and they cannot afford to borrow Rs 20-30 lakh, Rs 1 crore. Whereas the way our lending system was structured because if you are doing manual credit evaluation, as I said cash disbursement and cash collections, the cost of doing that was so high and it was so hard to scale up that people weren't use to giving Rs 20-30 lakh loans and what technology is now allowing you to do, as a company, is scale a business which lends at much smaller ticket sizes than what we were used to and that opens up a whole host of new opportunities and I think Shriram City Union Finance is a company that focuses specially on that ecosystem.

Sonia: We have discussed a couple of your themes, the personal credit theme, the metal space, but now let us talk a little bit in detail about the theme of the enablers of electrification and we have spoken about some of those names, Havells India, Voltas. Tell us what the growth in this space could be because some of the segments like the consumer products segment like Bajaj Electricals for example, has seen very subdued demand over the last couple of quarters.

A: This is a theme we have been highlighting for a while that even in 2011, a third of Indian households had no wires going into their houses. So there was a very low electrification in states like Bihar. Only 16 percent of the houses had wires going into their houses. And on top of that there was a poor quality of electricity available. So even if you had in many other states, wires going into their houses, the quality of electricity available was very bad.

What is now starting to happen is I think, with power availability improving and it becoming electorally important for state governments to deliver better quality power to more people, electrification has improved dramatically in states like West Bengal, Bihar, Uttar Pradesh, the percentage of households connected has gone up substantially. And as I mentioned, the night time pictures taken by satellites of India, very clearly show that the power availability has improved as well.

What this means is that even if there were households in many areas who could afford to buy a mixer-grinder or an air conditioner, but they could not or would not because they was no electricity can now start buying that. So the way the penetration stories in India work is that you are forced to cut prices or keep nominal price the same and real prices keep falling and that is when more households are able to afford but in the case of enablers like electrification for people selling consumer appliances things can improve because of the environment changing.

Now, I think the last several quarters, and the companies can see very different results on the same sector, lots of dynamics within the sector has well but there have been disruptions because of demonetisation, there was supply chain related disruption and GST could be coming up as well. So you will see disrupted numbers, but if you are looking out 2-3 years, this appliances and brown and white goods would actually be growing faster than nominal GDP.

Latha: There is another theme that you told us during your investor conference this year and that was IT. You said that 2016 your discovered sector was metals and then it has ran and is still running. If I remember right, you said in January, 2017, IT could be the undiscovered dark horse. You still stick with it?

A: Yes, I think it has not been a very good call so far. I think many of the fears, and I still hold on to my view, many of the fears that are affecting investor sentiment in this sector are quite a bit temporary and people are not buying because the sector is not doing well. One positive sign and the recovery in US and Europe or rather the stabilisation of recovery in US and Europe, could actually mean that there should be a cyclical effect on their order books as well. And whenever they correct, there could be a sharp rerating in terms of price to earnings multiple. So if we are selective in some of the names that we own, I still think that they can provide good returns in the rest of the year.

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