Cement may be an outperformer in 2023: Nirmal Bang CEO Rahul Arora

Nirmal Bang CEO Rahul Arora said his pick was Ultratech in the large cap space, the JK twins in the mid cap space, and Birla Corp and Sagar Cements in the small cap space. (Representative image)

Cement may well be the biggest overweight sector in India this calendar year as it benefits from capital expenditure earmarked by the government, says Rahul Arora, Chief Executive Officer of Nirmal Bang Institutional Equities.

In an interview with Moneycontrol, Arora said the cement industry is a strong contender, provided commodity costs and inflation stay in control.

He pointed to Budget 2023, which included substantial capital expenditure by the Indian government. The government's emphasis on railway and road development means cement, a crucial raw material, will be in high demand.

He expects cement growth to reach 7 percent to 10 percent, given the upcoming election year and potential for premiumization and cost control. Arora also noted that many cement companies had good cash flow balances and were expanding capacity. Some of these new capacities are set to come online in the current calendar year, with volume growth expected to follow in the next year or two.

When asked about how investors should position themselves in the cement industry, Arora said his pick was Ultratech in the large cap space, the JK twins in the mid cap space, and Birla Corp and Sagar Cements in the small cap space. Arora suggests being nimble-footed while trading in the commodities sector. Edited excerpts:

What do you make of the entire commodity space, given that most brokerages are bullish on the space after China’s reopening?

I think there are two factors at play when you look at commodities. I think there's the Western world and its demand for commodities. And then there's China. If you look at the period over the last 30 years, in the run-up to the pandemic, I think you had a situation where China accelerated its GDP growth by about 10 percent to 20 percent in most years. And at that point in time, obviously, when they created infrastructure and capacity, they were a guzzler of commodities. The question is, even though China is opening up right now, to what extent can they potentially grow? I mean, there are all kinds of estimates of between 2 percent and 3 percent to about 7 percent and 8 percent. So even though that means that they will be a consumer of commodities, the rate of growth is incrementally coming down in the Chinese economy. Now, the counterbalancing force to that, of course, is that the US Fed seems like it is going to go on hiking interest rates for a while.

And when we entered this current calendar year, the thought was that the first half of this year is going to be painful and the second half of the year is probably going to end up looking better. And there was talk about rate cuts and things like that. But I think that rate is sort of getting reversed now where people think that the first half of the year is probably going to be what was thought to be the earliest second half of the year. So I think it has got a bit jumbled up. And I think that recession has been pushed back a little bit. So even if you have China opening up and the West slowing down, it probably could land up being a net neutral as far as commodities are concerned.

From India's standpoint, most economists are taking our GDP growth as somewhere between 5.5 percent and 6 percent for the next fiscal year. So again, on that basis, I don't know, of course, a lot of it will be contingent on government spending. But I think I'm not sure whether it will end up being an investment portfolio kind of positioning for me. I think I'll be probably nimble-footed and look at it more from a trading perspective in certain leaders like Tata Steel, Hindalco, etc. I think you'd have to be very nimble-footed when you play this sector, as opposed to looking at it from a long-term investment call. I think that trade to a large extent, to me, has played out.

With more Fed rate hikes in the offing, rate-sensitive stocks are expected to remain in the limelight in the year while Information Technology may take a back seat. Do you agree?

I think if you look at the banking sector in India, I think the challenge today and has been for some time for most banks in India is deposit growth. And I think you've seen deposit rates in the system rising. That's obviously had a little bit of a bearing on the way people are perceiving equity markets and the kind of returns that equities will have to give vis-à-vis beating the fixed deposit rates right now. But I think if the challenge remains in terms of garnering incremental deposits from here, it will have to be seen whether banks have enough levers to counter that rising cost of deposits by other means so that their net interest margins don't contract in a very substantial way. So that is one aspect on banking. The other, of course, is that the credit growth in the system for the last 15 to 18 months has been in the range of 15 percent to 18 percent.

And if India's nominal GDP growth slows down to somewhere between 10 percent and 11 percent, you know, if that credit growth number comes down to say, 11 percent, 12 percent, 13 percent, you're talking about at least a 400 or 500 basis points slowdown in credit growth. So I think there are two challenges in the banking sector right now. Both of which could be overridden very easily. I think if the banks are able to show levers to counteract the compression in net interest margins, and the economy doesn't slow as much as we're anticipating. But these are the two genuine concerns that I think the banking sector is probably dealing with. And in that backdrop, what kind of valuations do you want to ascribe to the banking sector in India? On IT, if you remember, when the pandemic hit us, just a case in point, right, Persistent Systems, which was a stock that was about Rs. 480 rupees when the pandemic started, went up to Rs. 4,800.

It was at 10x in a matter of 15 to 18 months. So the point is, even if some of the stocks correct 50 percent from the top, you are still at least 3 or 4x in the money if you caught either the bottom or somewhere close to the bottom. The only problem with IT, of course, I see is it's so linked to the Western economies and the banking sector in many cases, that if you do have a slowdown over there, then it's very possible that the total contract value or the order book intake of the IT companies need not necessarily translate into the actual revenue growth. We'll also have to see how the rupee plays out and what kind of tailwinds, if any, it provides to the sector and the cost structure. Because if you have a situation where the topline goes down and your costs go up, your margin gets squeezed that much more. So I think IT should be okay for the next three, four months.

But I think as you start seeing the economic impact of the rising interest rates in the western part of the world, I think there will be a second order impact on the IT companies. But for now, I probably say that they may be able to tide over for the next three or four months, at least till the next earnings season comes out and the commentary that is told to us…So I think banks have been slightly neutral to overweight even now. IT more neutral-ish. I think you can look at stocks on a case-to-case basis. But to make a thumping buy on both the sectors right now, I'd probably choose banks over IT.

Talk about the cement sector- a couple of positive indicators out there. Probability of GST rate cuts, price hikes and expansion by the Adani Group. But how do you look at the sector and which are your top picks within the sector?

I think that could probably land up being the sector of the year if commodity costs, inflation do not come back and hit in a material way. And the clues for this sector pretty much lay in the Union budget presented by the Finance Minister earlier this month, where I think we've all seen the kind of capital expenditure numbers that have been put out by the government of India. Now see, the thing is a part of this could also be because it is an uncertain global environment. So we don't know how much we can export. And if global companies are not going to produce as much, it may also have a bearing on how much we can import. So when you look at the formula of GDP, which is basically consumption plus investment plus government spending plus exports minus imports, I think the last two variables are very contingent on the global economy. In India, I think if you see post Diwali, you've actually seen a bit of a slowdown in consumption, when we talked to a lot of companies under our coverage universe over the last three, four months. There has been a little bit of a pullback on the growth rates. I'm not, at any point, hinting that the growth rates are decelerating.

I'm saying the rate of incremental growth is probably coming off over the last three, four months. So you're basically left with investments and government spending. And typically at a time like this, government spending leads private sector investment. And that's where I think the government's thought process came in from in the Union budget when they announced that huge expenditure in capital spending. The point here being that if you break it down further, it's talking a lot about railways and roads. And for that, one of the biggest raw materials that you need is cement. So our own assumption is, and coupled with the fact that this is a pre-election year, you could land up seeing cement growth somewhere in that range of about 7 percent to 9 percent-10 percent. On top of that, if you have a little bit of premiumization for some of these players and costs under control, you could see a fairly soon significant uptick on EBITDA (Earnings Before Interest, Tax, Depreciation and Amortisation) per metric ton that cement companies in India are going to be showing vis-à-vis say what they've shown in the last couple of years.

I think the cash flow balances are good on most of the cement companies, they are cash-rich companies. Capacity expansion for a lot of these people is on track. In fact, some capacities are even coming on in this calendar year and the volume growth impact of which will be felt in the next one or two years, which gets factored into the estimates of cement companies. Now, in terms of how to position yourself, obviously, ACC and Ambuja have been governed by some other factors. Beyond fundamentals, as well right now, though we do think that there is relative value in both of these stocks. But I think for a retail investor today, if he or she is coming in with absolute comfort, we'd probably look at playing it through Ultratech in the large cap names. And then you could probably look at the JK twins, which is JK Lakshmi and JK Cement in the mid cap space. And if you want to really go down the market cap chain, I think you will look at names like Birla Corp. and Sagar Cements, which are small cap. So I think the largest, obviously, cement players, I have given you two in the mid cap space and two in the small cap space. But this from our house perspective to land up being one of the biggest overweight sectors for the current calendar year.

Let’s talk consumer discretionary. The incremental growth seems to be slowing down. Within the space, any names that look attractive given their earnings potential or valuations?

You can actually break it down into cyclical and structural. So I think let's take hotels as a case in point, which is a cyclical industry and definitely a consumer discretionary industry. I mean, if you go on to MakeMyTrip or EaseMyTrip and look at the kind of hotel rates that are being charged on a per room basis for a night, I don't think those kinds of rates…, you know, you probably have to go back to the upper end of the economic boom that we saw in 2007-08 to get anywhere close to these rates. And I still don't think the rates were as high back then. So I think these are probably all-time highs that you're seeing on occupancy, all-time highs that you're seeing on rates, and this could probably apply to aviation as well, more so in terms of rates. And I think for a lot of these companies, they have actually rationalized on manpower, so those structural cost savings are already in the price. So I think incrementally from here, if they are unable to sustain these kind of occupancies and rates, which is my worry, I think you'll probably land up seeing some amount of earnings and multiple compressions. I still think for the next one or two quarters, these guys may still sail through, but I think incrementally a lot of what an entire cycle can capture has probably got captured too soon. And I can give you a parallel, say for example, in the chemical sector.

When this entire lockdown started and people started almost saying that the India needed to be the alternative to China and China Plus One came in, the entire chemical sector, the stock prices went up 3x to 4x…And if you see post that first six, eight months, over the last 15 or 18 months, chemical stocks have pretty much gone nowhere. So I think that may actually end up being the case for a lot of consumer discretionary names. That's not to say it's a blanket avoid. I think some names, particularly in the quick service restaurant space in India, do offer value. I think if you look at names like Westlife Development, which runs the McDonald's franchise, that looks like a very interesting one. Devyani International, which runs half of the Pizza Hut and KFC franchise in India, looks like an interesting one.

So, I think there is still value in consumer discretionary names in India. If you extend that into air conditioning and so on and so forth in terms of consumer durables and electricals, …it could end up being a fairly good year for Blue Star and Voltas as well. So I still think there are pockets of value in consumer discretionary, but I would not be a buyer across the board. I think in a lot of cases, valuations have priced in the next two, three years of earnings as well. And I think we need to be very careful in terms of the kinds of companies that we allocate our capital.